Are franchise M&A agreements too bloated?
Illustration by Jonathan Hankin
When Sun Holdings bought 51 McAlister’s Deli restaurants from several franchisee groups last year, CEO Guillermo Perales also committed to open 47 new units for the brand. The deal stood out for its ambition, but the well-known Dallas-based restaurant operator with more than 1,000 stores takes it in stride.
“We’ve been an aggressive developer for several years. Over the last three years we’ve built 200 stores,” Perales said in an interview in February. “You cannot just grow by having your base and improving your operations. That doesn’t get you anywhere.”
The deal is an example of a trend in franchise M&A in the last couple of years—ever-mounting requirements to build new stores under increasingly aggressive schedules as a condition for franchisor approval to get the deal done.
Even as many brands “paused” their opening and/or remodeling requirements during COVID-19 woes, the underlying trend remains. Whether you find it alarming or exhilarating depends on your point of view.
“It’s a train wreck for the industry,” said Chris Kelleher of Auspex Capital, an investment banker behind many of last year’s biggest deals between franchisees. “It’s not only leverage, but it’s the impact on the existing stores.” The classic example: You’ll have two stores doing 110 percent of the average. Then you add a third store.
“The franchisor is getting a million dollars in extra sales, which they get top line and they get the extra royalty dollars so they’re happy.” Meanwhile the franchisee is “probably making less money.”
Carty Davis with C Squared Advisors says there’s often “not a lot of analysis” from lenders and others funding these merger and acquisition deals with big development pieces.
Also, he’s seen deals with ever stricter requirements. “If you’re supposed to open in June of 2020 and it doesn’t, they pay royalties anyway. It’s also a way for the franchisor to control who’s the buyer,” he said.
Calling his DNA “very cautious and conservative,” Kevin Burke of Trinity Capital said “a lot of franchisors have lost sight of the risk of development,” because analytics improved dramatically for the last 15 years. “This led to “much better site selection. A lot of development got done.” Meanwhile, publicly held restaurant companies, especially, needed more and more unit growth to please shareholders. QSRs in particular flooded in.
Burke gave an example of a deal he advised last year: The franchisee wanted to buy 30 stores, but the franchisor demanded another 30 stores to build, at an estimated cost of $1.5 million each. “So we’ll be at a $45 million deal, and the company can’t support it, and we don’t have the resources to guarantee it.” The deal did not close.
“Asking someone to develop needs to be rooted in the fundamentals of how many additional sales dollars are available for a given concept and a DMA that’s fairly built out,” Burke said, referring to designated market area. “You can’t put 10 pounds of stuff in a 5-pound bag.”
‘Connected by the hip’
Then there’s the rest of the story, coming from those big multi-unit franchisees doing the deals, of course. To paraphrase Perales: You need a big enough package to make it worth your while.
Casey Askar of the Michigan-based Askar Brands has been on both sides of the fence. As a franchisor of a pizza brand, for example, he signed a developer agreement and the operator didn’t succeed. “So I’ve experienced those failures, and I’ve had those successes,” he said.
He signed a 47-store package in Florida with Dunkin’ earlier this year. “They obviously did their homework. I think what they liked with us is we had the operational know-how, the track record. And we had the finance piece. Being a family office” that also operates petroleum, restaurant and other brands, “we were kind of a one-stop shop for them.”
“It all depends on the strength of the brand and the capability of that developer. If you go into a franchise that has 15 locations and they want X, Y and Z and they don’t have any real brand recognition or support, it’s probably not a good thing.”
He also noted a flood of private equity firms into the franchise M&A space in recent years. “You get a lot of suits that are looking to invest and move other people’s money, but don’t have the right experience in this space. So they come in, they overpay for things, everything is an expense, and that doesn’t work either,” he said.
“You’ve got to have the right operator that knows this industry like the back of his hand, and you have to have the right financial partner that’s connected by the hip with this operator.”
‘It’s a good thing’
David Bloom, chief development and operations officer for Capriotti’s, notes his brand, like most, is putting development agreements on hold. “We had 20 shops scheduled to open, with hard dates on the books,” he said. When it’s over, he expects to take a second look at those deals.
“We’re going back with all our real estate brokers in every major market, and re-evaluate what’s going to become available. We’re looking at either new opportunities or even relocations of some of our older shops,” he said.
Jody Luihn, with Luihn VantEdge Partners, is a Yum Brands operator in the Southeast. Newly backed by a family office, he is actively looking for Taco Bell acquisitions as well as building four to five restaurants a year, a limit he believes is comfortable.
“It’s balancing in terms of what your capabilities are,” he said. “There’s pressure from the brands to build new restaurants, and I think that’s everywhere. Everybody’s trying to grow their brand. So far, Taco Bell and Yum Brands have been reasonable on new growth projections,” Luihn said.
To him, “It’s a good thing. When you’re in a brand like Taco Bell, and you’re getting the returns you’re getting, and we’ve seen sales increases for the past eight years, you get pretty excited about opening new stores.”
He warns against overpaying. “There’s a lot of that going on out there, with people getting out over their skis in terms of multiples.”
Does he have a multiple in mind he sticks to when doing deals, he is asked? “Yes,” he replied.
But does he want to reveal what that is? “No,” he said with a laugh, “because I’ve got a lot of friends out there bidding against me.”
Beth Ewen is senior editor of Franchise Times, and writes the Continental Franchise Review® column in each issue. Send interesting legal and public policy cases to firstname.lastname@example.org.