Franchisee Consolidation Grows

Trend To Spread Beyond Restaurants

Consolidation - this has arguably been one of the largest and most important trends in the franchised sector over the past few years, and it’s not hard to see why. One definition of consolidation is “a solidification and strengthening”; terms that also describe two of the most critical aspects of running a successful multi-unit operating company today. While we expect this trend to continue in the restaurant industry, we also believe that consolidation will have a significant impact on other franchised brands in new and exciting ways.
The consolidation trend in franchising has historically been driven by traditional, restaurant industry tier 1 and tier 2 brands in the QSR and Casual Dining segments.  The economic reality of declining traffic, heavy discounting and prime cost pressure, combined with heavy governmental regulation, has created a much more complex business model for our industry.  Smaller operators have taken the brunt of these changes, and in many cases, the answer has been to sell to a “consolidator” in the same franchised system.  These consolidators typically have an established organization and infrastructure that allows them to deliver a level of professional management and leverage fixed overhead costs in a way smaller franchisees simply can’t match.
The traditional consolidation model witnessed in recent years will remain prevalent as we move forward, but this activity is likely to slow down as the seller pool of small companies, whom operate top tier restaurant brands, shrinks. To be sure, we believe that this specific archetype will maintain its strong momentum for the foreseeable future; with large absolute numbers, a significant number of aging franchisees, and a new era of sophisticated buyers looking to achieve rapid growth, this form of consolidation is not going anywhere soon. Tier 1 and 2 brands have been the frontrunners in attracting buyers seeking growth through mergers and acquisitions due to the sheer number of restaurants in their respective systems, large geographic footprints, and simply a greater number of available opportunities to consider.
Eventually, there will come a time where these massive consolidated operators, will reach a critical mass and no longer have the desire or ability to acquire more stores. We have already started seeing certain franchisors implement size limits on their franchisees, creating incentive in these large scale operating companies to seek opportunities in new franchised brands. Although mega-franchisees benefit from their immense size due to the greater predictability of operational results and returns through economies of scale, implementation of modern technology, market control, and fixed cost leverage, there is still a point at which big becomes too big, and benefits turn into inefficiencies.
Now the question is, once top tier consolidation slows, where will this leave the franchise industry? First and foremost, we suspect that strategic buyers will turn their attention to tier 3 and 4 restaurant brands, as well as regionally specific brands. It is within these smaller brands that the greatest untapped potential for consolidation lies. The opportunity in this segment will additionally attract a greater number of interested purchasers due to the inherently lower valuations these brands receive. Also meaningful is the risk and reward tradeoff a buyer would encounter upon entering a less mature brand’s system with high growth opportunity. In turn, this leads to another appealing aspect of consolidating brands smaller in scale: the buyer’s greater ability to control a larger portion of a system’s franchised universe. This is especially desirable when purchasers are seeking “the next greatest thing”, with the intention to enter a system at the ground level into order to obtain superior control within a brand.
We are already seeing this consolidation trend follow suit in the non-restaurant franchise world. While it remains true that restaurant franchising is the most widespread use of the business model, the industry will inevitably become overpopulated in the future. This saturation in the restaurant realm will make franchisees seek outside opportunities that have a less competitive purchasing process. The industries that are likely to see an uptick in attractiveness include auto services and repair, service businesses such as house cleaning, day spas, health centers, fitness centers, senior care, pet care, dry cleaning, and early childhood development. The opportunity for franchising consolidation in the future is immense, as transactions in these industries are desirable for the same reasons as the smaller restaurant brands: purchasers are typically working with lower valuations and have a greater chance of controlling a significant portion of the franchised system.
The bottom line is that the franchising business model works. It enables entrepreneurs to run their own businesses without falling prey to the fundamental risks of creating a new and unique concept. Operating a franchised brand gives buyers a sense of safety and security, having stemmed from the existing familiarity with the concept. We will continue to see the application of the basic, time honored concept of franchising push itself into other non-food industries; this is clearly the free market at work, with the survival of the strongest business models, like franchising, reigning supreme. It is because franchising has proven itself time after time that it’s an incredibly successful way in which to run a large, multi-unit company that we believe there are no upper bounds in what can be achieved in operating businesses in this domain.

A Model of Success: Franchising's Future Grows Bright

Franchising has proven to be a successful and popular business model since its mainstream inception many decades ago. There are three constants that have fueled the growth of franchising over its long history: the desire to expand, the need for capital to fuel that expansion, and the goal of operating seamlessly across large geographical distances. While the earliest uses of franchising can be traced back to the Middle Ages when the church was seeking to broaden its central government control, it is Ray Kroc, who discovered McDonald’s when it was still a small California hamburger stand, who is credited with developing the restaurant franchising model that we know today.

This enticing operating platform has grown massively in scale since the 1950’s, becoming one of the most prominent and favored business models for those with a desire for self-employed vocation. The concept of franchising has become one of the most important and influential in the business world, but has it reached its tipping point? In this article we are going to discuss the current state of the franchise industry as well as what we can expect to see in its future.

Current State

Today, the method remains robust, with more franchise concepts alive and thriving than ever before. While the multi-unit restaurant industry continues to be the most ubiquitous in the franchising world, this lucrative model has spread across a variety of industries from early childhood education to doggie day-care. So why is it that we are continuing to see such positive momentum?

One key factor is the consumers’ strong reliance on the power of branding. Franchising leverages the power of branding by providing mass scale in terms of advertising, market penetration, and customer recognition. There is also the power of legitimacy (whether perceived or accurate) that accrues as a benefit to the most recognizable brands. Many people are less inclined to dine at an independent concept that they are unfamiliar with, preferring the comfort of sticking with a known, established brand. A widely known brand name carries a lot of clout, putting potential diners at ease on the value/experience equation. People like to know ahead of time what kind of food and service to expect, giving the widely known brand names an immediate advantage over the unknown option.

Entrepreneurship also plays an important role in the franchising industry. There is a large and growing number of people who aspire to run their own business, but there is also great uncertainty when it comes to creating an entirely new concept. Franchising provides an opportunity to be self-employed while subsequently mitigating the risk of an independent concept.

Another important facet of franchising’s success stems from today’s accessibility to debt financing. Lenders are very comfortable with the franchise model, having lent in the space for many years now, perceiving it as a safer option than most, and therefore providing funds that are more readily available.  Lender’s aren’t just lending to an entrepreneur, they are lending to an individual business that is backstopped by a meaningful number of other potential operators, and even the franchisor, should their borrower not perform.

Just like debt financing, individual equity has greatly contributed to the ongoing success of the franchise model. In today’s economic landscape, individuals are less enamored with investing in securities (stocks, bonds, annuities) and are instead looking for investments where they have more individual return opportunity. This comes in the form of control adjusted risk.  If an owner-operators risks their treasure, but has the means to oversee that capital and an ability to voice their opinion about the business and its operations, this can become an appealing lifestyle and investment alternative. Another appealing aspect is the notion of often steady cash flow generation from this initial investment.

Private equity supports franchising much like individual equity, but on a larger scale. The abundance of capital available in many of today’s private equity groups is staggering, and franchised concepts have become one of the most attractive investment opportunities available. Many private equity firms have embraced the franchise model due to the lower risk/return scenarios that franchising provides, and we expect to see this trend continue for quite some time.

The scarcity of new locations and markets also contributes to the success of franchising. Many of these brands are real estate or location dependent. Given the lack of acceptable new locations available in today’s marketplace, the valuations of mature, developed brands will continue to increase.

Lastly, the operational transfer of risk is an increasingly popular trend, and proven advantage, among franchisors. Those who are developing and expanding successful brands have the capacity to shift the risk of operation and capital to others while generating strong return on assets. This is why we continue to see franchisors undergo refranchising initiatives, selling off their company operations to franchisees. This is a trend that we believe will remain compelling and active in the years to come.

Forecast for the Future

Considering all of these dynamics, the future of franchising is bright. We will continue to see strength and growth in the franchise segment, as franchise operators further invest in mature brands through organic growth and consolidating M&A activity. There are still many entrepreneurial franchisees who are reaching retirement age and will create additional buying opportunities for the foreseeable future.

Additionally, we will continue to see the evolution of new industries adopting and growing the franchise model that haven’t necessarily done so before. Many of these will likely be within service industries, where we have already begun to see some franchising occur. These businesses include beauty services, like hair parlors and waxing salons, massage parlors, pet care, health care, and housecleaning services. We expect to see a widespread embracement of the franchise business model in these industries, with companies seeking the same success as the aforementioned first adopters. It has become increasingly clear that because of the immense success franchising has achieved, this business model is here to stay. 

Deconsolidation: A Future Trend?

Consolidation is perhaps the single most significant trend we have seen in the restaurant industry over the past decade. It is easy to understand why current-era franchisees and investors have chosen this direction. Under the right leadership, consolidation leads to greater predictability of operational results and returns through economies of scale, implementation of modern technology, market control, and fixed cost leverage. This is why we have entered into the era of the “mega-franchisee,” but as these entities become ever more massive, is there a case to be made for these organizations to strategically divest assets, becoming smaller over time?

There are two catalysts for where a mega-franchisee could find deconsolidation to be the best course of action: when it reaches an inefficient tipping point in the context of day-to-day operations or when it becomes more beneficial to break apart the whole to maximize shareholder value as it relates to an exit strategy. 

Clearly, big can become too big.  As we see with large company operated brands, inefficiency can erode the entrepreneurial enthusiasm and control that originally fueled these businesses.  It is true that on the way to scale, there are great efficiencies and performance boosters attributed to streamlined leadership, professionalized systems and procedures, and direct accountability.  At some point however, the size can have the opposite effect.  Inefficiency through decentralized control and oversight may lead to inferior performance and loss of accountability, as well as unnecessary growth of supervisory and general & administrative costs.  The franchise model has always thrived on a close hand of control and oversight, ensuring above average performance.  Technology deployed across operations, human resources, finance, and marketing has largely been the most influential force in this equation.  It has helped operators move up the point of diminishing returns, but to date has not removed the tipping point from the equation.  At this juncture, returns are hampered, growth slows, and operators could find themselves forced to simplify in order to reignite the core business and/or correct balance sheet issues.

Maximizing shareholder value is another catalyst for dividing restaurant assets.  Whether an organization has reached its point of diminishing returns or not, there is real value in breaking a mega-franchisee into multiple parts upon a sale or other exit strategy in the current marketplace. Due to the massive scale of this franchisee’s restaurant holdings and the long-term relationship with the brand, it’s safe to assume that this company could have control over multiple, distinct market geographies. This presents the mega-franchisee seller with a couple of challenges and therefore opportunities for buying groups.

First, there is the chance that no qualified buyer can be identified for a business of such a large size.  Second, even if a buyer is found, there is no guarantee that the franchisor will share their sense of optimism with respect to the buyer’s qualifications and the perceived risk to the system.  Additionally, in the today’s market, small and medium sized franchisees are bidding most aggressively on individual, adjacent markets with minimal general & administrative assumptions attached to their valuation.  So, while the entire transaction would likely require a large institutional private equity buyer, who would look to the historical oversight expenses, smaller individual market buyers might help drive more margin to the pro forma EBITDA they are buying.  It’s also worth noting that individual buyers might see other store level P&L opportunities in purchasing assets out of the mega-franchisee that are particularly attractive to them given their geographic interest and structure.  

This essential argument bears some similarity to what has gone on with corporate refranchising over the last five years, with new buyers finding unique individual market opportunities and subsequently paying a premium price for them.  Franchisors are selling those assets at a discount to where the brand itself trades.  In return, for that step down in valuation, they get a predictable royalty stream and diminish future capex requirements.  In contrast, the mega-franchisee that seeks the same kind of divestiture by separating markets may actually see a step up in overall value by selling their markets individually. 

There are a number of takeaways from the ideas expressed in this article.  The first is that we expect to see continued consolidation.  The best operators in our industry will certainly continue to leverage their infrastructure and technology to push the bounds of what it means to be in the top 200.  However, this consolidation is not without a ceiling to the benefit of smaller, nimbler buying groups.  We frequently hear that these groups are frustrated by losing deals to the mega-franchisee, but we advise that time and patience will afford opportunity just as it has with brand refranchising.  Additionally, there is the “risk and reward” factor concerning the franchisor.  As franchisees pursue further growth, we do see some franchisors taking steps to limit the risk associated with concentration.  Some franchisors have imposed caps on the number of units one franchisee can acquire. Others have taken a more aggressive role in the transaction approval process by limiting private equity participation or by exercising their right of first refusal to control the deconsolidation process, subsequently reselling the individual markets of the mega-franchisee.  However, the most important conclusion you can make is to control your own destiny as it relates to your M&A activity.  As a mega-franchisee, ensure you understand the value of the whole versus the parts of the sum, and as a smaller buyer, make sure you are prepared to be nimble when mega-franchisee transactions take place.

The Power of Getting Started

“The secret of getting ahead is getting started”- Mark Twain

Financial and first time buyers are showing tremendous interest in the franchise space, yet as they are continually out bid for attractive opportunities, the frustration in entering certain systems may be at an all-time high. Why is this the case? One reason is because they typically will have to accept a below market return on their first deal in order to be competitive. This is also known as the price of first time entry, a key facet of doing deals known to industry insiders.

At the other end of the spectrum, we have seen consolidation in the big franchise systems in recent years, which has in turn created the “mega franchisee”. Why does it seem so easy for these massive franchise operators to continue to grow their holdings, while these other prospective, qualified  buyers struggle to gain entry?

Sitting in the position of a first time buyer or new entrant to a particular franchise concept can be a huge challenge. Not only do you have to prove you are capable of operating in a new business model, you also have to worry about making the right connections to earn the designation of “legitimate prospect”.

Let’s assume we have three hypothetical Buyers: Buyer A is a new entrant, Buyer B is a small to mid-size franchisee in the system, and Buyer C is a mega franchisee. Employing his business savvy, Buyer A made it onto the short list of potential buyers for our hypothetical franchise transaction. Why is it that this buyer is still at a disadvantage? Lack of Operating Leverage.  Because Buyer A doesn’t have an existing operating infrastructure to leverage in their favor, he enters the game down 2-0 from the start.

This is where Buyers B and C have a distinctive advantage.

Consider Buyer B. As a franchisee in the system in question, he has an immediate advantage over Buyer A. Buyer B is already familiar with how this franchise system functions and has the ability to leverage his existing infrastructure and business platform to operate additional stores at a lower cost than Buyer A.

Yet it is Buyer C that typically has the greatest advantage of all. Not only does Buyer C have the existing infrastructure and business platform to leverage, but he has also grown to a level of operational sophistication where he can operate the business at lower costs thereby producing higher profit margins enabling him to either pay a higher price or enjoy a higher return than Buyer A. This well-oiled machine of an entity has the ability to take on new stores with very little incremental costs associated with the acquisition. Buyer C has full confidence in exactly what action they will take to integrate the acquisition, as they have done it many times before.

These factors all heavily influence the purchasing power of Buyers A, B, and C. Buyer A, with no existing business platform to use to his advantage, has very little room to maneuver when submitting a bid to hit his targeted ROI.  He’s left in a position where he has to purchase the business including the seller’s infrastructure and platform of operations. As a result, his cost of infrastructure on this transaction will be higher than that of his deal competitors who can acquire the transaction with a far smaller incremental cost. This ultimately translates into Buyer A submitting a lower actual offer in order to achieve returns that are enjoyed by Buyers B or C.

The net effect is Buyers B and C can “overpay” by the standards of Buyer A because their forward multiple is much lower than the trailing twelve month multiple. Because of this, Buyer A needs to be prepared to pay a higher price to secure a market competitive deal. His other option is to consider buying a business that has more challenges and therefore less competitive but with additional risk.

At some point, Buyer A has to get started, and usually that means paying an above market multiple to acquire the ongoing business platform. It is once Buyer A completes this first acquisition that he will have put himself into a more competitive position amongst his peers, making the next deal he bids on work more to his advantage. This is the cost of entry in the restaurant industry, but it is important for Buyer A to remember that he has the potential to become Buyer B and even Buyer C in the future.

Red Light? Yellow Light? Green Light? What are signals telling you?

We have made progress digging our way out of the pit of economic meltdown which we tumbled into in 2007, but we certainly have a long way to go before we experience the vibrant economy we enjoyed in much of the 1990’s and the early-to-mid 2000’s.  For many, it seems like we are in a state of purgatory -- not knowing if we are heading to heaven or hell.  So where does that leave business owners today as many face critical decisions regarding exit strategies?  We are finally seeing positive signs that the window of opportunity to sell businesses is open.  Will it last?  Many owners seem to be at this intersection, but also seem to be having difficulty determining if the signal is Red, Yellow or Green.  Let’s take a look at our view of the signals as they relate to various elements impacting the transaction world. 

Worldwide Economy

Yellow Light, at least for the time being.  This could turn to Red at any point.  There are well- documented troubles around the globe and most likely other problems that are as visible.  Turmoil in the Middle East and North Africa, coupled with European financial stress in Portugal, Italy, Greece, and Spain is having a significant impact on worldwide markets.  China and Brazil are still growing, but at a slower pace.  Japan’s economy faces major challenges.  The list goes on.

Domestic Economy

Yellow Light.  United States government spending is out of control.  Deficit problems continue to accelerate with no solution in sight.  Political gridlock has created an environment where virtually no progress has been or can be made on this issue.  Consumer confidence has improved somewhat as the general population is no longer focused on an economic meltdown, but overall conditions are far from rosy.  There seems to be more of acceptance of today’s economy as the new reality.  Housing seems to be reaching a bottom and consumers have reduced their overall levels of personal debt, although debt levels ticked up during the holiday season.  Technology continues to be stable with some segments doing very well.  Retail and Restaurants have improved, but consumers are cautious.

Political Environment

Red Light. The US has become politically dysfunctional.  There is strong Right versus Left sentiment, resulting in neither party being able to effectuate the critical decisions necessary to “right the ship”.  This polarization will play a huge role in the upcoming election.  The implications for business owners, such as the cost of doing business, government regulations, personal and business taxes, and incentives to invest, are huge.  But despite the large magnitude, the direction of the impact on business owners is not determinable, due to the political uncertainty. 
Capital Environment
Green Light.  Capital providers are actively deploying capital.  Credit parameters are more conservative as a result of tighter underwriting criteria, but lending is occurring and debt availability is improving.  Equity markets are liquid and have relaxed return requirements resulting in more favorably-priced equity alternatives than we have seen in quite some time.

Deal Environment       

Green Light.  While the M & A markets have not completely forgotten the recent bottom of the economy, investors have largely moved on and are focused on the future.  The marketplace is supporting new deal activity, especially non-distressed, quality companies which have weathered the recession with positive trends.  Single tenant real estate values are also improving.  Cap Rates are declining due to the lack of available interest rate investment alternatives providing a reasonable return.

Brand  Environment    

Different brands, even in the same space, are flashing different signals.  Some top-tier, national franchised brands thrived through the recession on new product offerings, value price points, and trade-down traffic.  Others revamped menus with solid price point menu items and revamped signature products, along with new image restaurants as the recession drew to a close.  Yet others continue to struggle and lose ground.  At the same time, many up-and-coming regional brands, mainly fast-casual, performed very well throughout the recession, and are showing very strong results at present.  And certain second- and third-tier concepts continue to demonstrate excellent resiliency as they chug through thick and thin.  How the market views your business is certainly impacted by the overall performance of the brand with which you are associated.
Personal Situation         
Where you are personally in your business life cycle is also an important consideration.  Some owner/operators have thought about retirement, only to have those thoughts dashed on the rocks of recession.  But after surviving the downturn, those thoughts are stronger than ever as they vow “never again” to experience that.  Some owners have family or long-time partners who would like to take over the business.  Other owners may see that the performance of their business, even if improving, is probably as strong as it’s going to be for the foreseeable future. Based on a review of your personal situation, the timing could be ideal to monetize the equity in the business or diversify your risk with a partial liquidity event, sale of a market or real estate holdings.  And yet others may be new to the business and have a 25-year time horizon to succeed.  The signal being flashed in this category depends entirely on your personal situation.      
As we cycle out of the highly volatile environment experienced by almost every restaurant operator in the past several years, signs are pointed toward an environment where operators have improving opportunities for deal alternatives. Restaurant entrepreneurs will be well served by taking a fresh look at their individual situation as they contemplate their business opportunities, personal situations and liquidity alternatives available in today's marketplace. One common theme we've all learned over the past several years is that macro economic conditions beyond our control can have a dramatic impact on our business valuations, deal flow and M & A alternatives. For many operators, it's an opportune time to "go to the woodshed" and contemplate the best course for you and your business.