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Take advantage of private equity while the ardor is high


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Private equity is in love with the restaurant industry, but the infatuation may not last. In 2005, 29 of the 101 restaurant merger and acquisition deals tracked by investment banking firm J. H. Chapman in Rosemont, Ill., involved equity funds. Major private investment purchases in 2006 include Potbelly Sandwich Works, Marie Callender’s, Fox & Hound, Del Taco, 49 percent of Quiznos and all 790 Pizza Hut units of multi-unit franchisee NPC International.

Competition is fierce. “Whenever there’s a good deal out there, I guarantee that 10 PE firms will be chasing it,” says Patrick Silvia, vice president of National Restaurant Brokers in Atlanta. And more deals are coming. All investment bankers and private equity partners interviewed, including Silvia, say they are working on additional franchised restaurant transactions that will close before the end of the year.

Multi-unit franchisees who also hope to snag a portion of the $750 billion amassed by the nation’s private equity firms, to expand or to retire, should act quickly. In its latest newsletter, investment banking firm The Cypress Group, in Scottsdale, Ariz., warns that private equity firms make fickle suitors. “These groups have steadfastly invested capital in favorable industries when operating results are strong, financing is readily available, and exit strategies such as IPOs and private sales are feasible and predictable.” If industry profits dip, or if investors can’t get out of deals as richly as they’d like, private equity firms will abandon the industry for more attractive partners.

Casual dining already feels the sting. Applebee’s systemwide sales dropped 2 percent in May, for example, and guest counts fell by almost 6 percent. “A lot of Applebee’s multi-unit operators missed the boat,” Silvia says. “Because they were winning last year, they didn’t want to leave the table. Now that they’re losing, it’s too late to get good prices for their units.” Silvia’s Rule No. 1 for multi-unit franchisees courting private equity: Sell when you’re making money.

Other industry leaders also have advice for multi-unit franchisees. J.B. Hewetson, an associate with The Cypress Group, says that the vast number of private equity firms look for companies with $10 million to $30 million in EBITDA—earnings before interest, taxes, depreciation and amortization. “There’s a void in the market for deals in the sub-$10 million range,” he says. If your restaurant company’s operating cash flow is less than $10 million, you may want to consider increasing it, by making acquisitions before entering the private equity marketplace.

But be careful about shopping for additional brands. With most private equity firms, it’s all about the exit strategy, and selling a multi-branded company can be tricky, Hewetson says, unless all the brands are equally appealing to a future buyer.

Don’t expect to get the same high prices that private equity firms are paying for franchisors, says Rob Hill, a partner with J. H. Chapman. When a private equity firm buys an entire franchise system, he says, they’re getting a brand they can grow and C-level managers to help them expand. A multi-unit franchisee’s growth may be restricted by franchisor-imposed territories, and if you’re selling to retire, the private equity firm will have to replace you.

New York-based Sentinel Capital did just that, says founder and managing partner David Lobel, when they purchased distressed multi-unit Churchs Chicken and Taco Bell franchisees. In both cases, the CEOs they found after extensive searches—Lee Engler of Border Foods in Golden Valley, Minn., and Aslam Khan of Falcon Holdings in Oak Brook, Ill.—eventually provided the exit strategy, by buying the multi-unit companies themselves.

But finding a new CEO is so difficult that Lobel advises any large multi-unit operator who hopes to cash out and retire in the next few years to select a successor immediately. “Then, when you present yourself to the market,” Lobel says, “you can say that this guy was hand-picked and trained to run the company when I’m gone.”

Provide incentives to keep key managers around, too. Paul Rubin, a partner with Olympus Partners, a private equity firm with $1.7 billion in capital in Stamford, Conn., says, “When we bought K-Mac, a 147-unit operation of Taco Bells, KFCs and Golden Corrals, the top 22 employees had an average of 20 years with the company. We’re always looking for multi-unit franchisees of good brands whose management teams have strong tenures.”

Get your books ready, too, says Nick Peters, president of Prometheus Capital in Atlanta. Prometheus recently purchased a 24-unit IHOP franchisee that it’s growing to 40 units, Peters says, and will close on a multi-unit QSR operation before the end of the year.

“If you want to be attractive to private equity firms,” Peters says, “remember that we do math for a living.” Get your books and records in order—“We’ll be sending in an accounting firm to verify your profitability,” he says—and take personal expenses off your balance sheet. “Don’t over-promise future profits,” he advises. “It destroys your credibility.”

And don’t be too discouraged about missing that boat. “You can still get top dollar if your own operation is good, even if the brand as a whole is not doing well,” says Silvia.

Some locations are so good that they’re immune to fluctuations in the marketplace, he says.

Peters expects competition to heat up even more for multi-unit franchisees. “We’re bullish about the sector,” he says. “Buying up franchisors would cost more and provide a lot more risk. It’s easier to pay royalties than have to worry about such things as developing new products and national marketing plans.”

Unlike other private equity firms, Prometheus has no plans to exit the multi-unit franchisees it purchases. “Why flip a good investment?” Peters asks. “If we sold it, we’d have to replace it with something we don’t know as well.”

Neal Aronson, president of the Roark Capital Group in Atlanta, says that selling a multi-unit franchisee to a private equity firm is like fitting together pieces of a puzzle. “It takes a terrific multi-unit operator together with a strong financial backer operating stores under a brand with consumer appeal and a franchisor management team dedicated to helping franchisees be successful. That is a lot of pieces to get right—which is what makes it hard. But when all the pieces come together, it can be quite lucrative for all parties.

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