Contributed by Tom Kent
Last week, I and a number of my colleagues attended the International Franchise Expo in New York City. This year, the International Franchise Association held a bonus session on private equity investing in franchising. Panelists at the session included franchisor executives, principals of private equity firms, investment bankers and consultants. The discussion was informative and insightful and confirmed what I have seen in my franchise practice over the past several years.
Franchising continues to attract increased attention from private equity firms. One recent shift is that smaller private equity firms are entering the franchise space. During last week’s session, several private equity firms identified the fundamental reasons that Franchisors present an attractive target for private equity. Namely, the franchisor offers a predictable recurring revenue stream, requires relatively low capital expenditures in order to maximize growth of an established brand, and are often driven by business concepts that have broad consumer appeal. Of course, prior to investing in a franchisor, the private equity firm will conduct extensive due diligence on the franchise system. One of the panelists indicated that understanding the “tone” of the system was critical in the diligence period. That is, understanding the relationship between the franchisor and its franchisees. Most panelists agreed that the central focus of diligence is gauging the health of the system’s unit economics. The investor will verify that the business model makes economic sense from the franchisee’s perspective. The panelists agreed that, in most instances, unit economics will trump the number of units in a franchise system. Other considerations for the private equity firm include the continuity rate of the franchisees, whether the royalty component of the franchise is sufficient to support the system (as opposed to the need to sell new units to support the system) and the strength of the franchisor’s management team.
The panelists indicated that in return for the private equity investment, a private equity firm will generally require majority control of the franchisor. This dynamic can create issues with an existing management team and therefore it is critical to identify the right partner for such a venture. In terms of timing, a typical investment will have a window of five to seven years with smaller franchise systems requiring a longer hold period for the private equity firm to obtain an acceptable return.
During my career, I have had the opportunity to experience these transactions from both sides of the table. In the late nineties, I was in-house counsel in a franchise system that was acquired by a private equity firm. The due diligence period was taxing for our relatively small in-house legal team and there were significant concerns among our employees once the transaction was announced. However, we completed the deal and the transaction allowed the founders to exit and provided the company with capital that was used to expand the footprint of the brand significantly. Private equity is not a one size fits all proposition. Recently, a franchisor client that was in the midst of the diligence period with a private equity firm pulled the plug on the transaction because the ownership team could not get comfortable with the idea of losing control of their business. Fortunately, this realization came to light prior to closing the transaction.
My time at the International Franchise Expo was most worthwhile and I recommend attending the Expo next year.