Investing in the Restaurant Sector

In the last several years we have seen a proliferation of private equity investment in the restaurant sector. Many of today’s leading restaurant chains started out with significant private investment. This private investment was secured through established private equity funds or private placements where the individual restaurant owner/entrepreneur elected to seek out individuals interested in the concept and management team.

Historically, the restaurant sector has attracted angel investors. The reasons for this attraction have often been based on an investor’s: (i) love of the restaurant industry, (ii) desire to be part of a “happening” social experience, and/or (iii) hope that they are investing in the next Wendy’s, McDonald’s, PF Chang’s or The Cheesecake Factory. However, while investing private money for these reasons is understandable, it is not terribly prudent and is based more on emotion than on a logical investment process.

Even though historically private equity has funded the restaurant sector, there is now a certain “discipline” to investing in this sector. Private equity groups, who historically were looking at high-growth “home runs,” have realized that the restaurant sector, while perhaps not always able to create the next Google, can provide a valuable and somewhat unique cash-flow-oriented growth investment. This article addresses the general concepts behind his “discipline” and the parameters private equity groups use in examining and deciding on an investment of capital for growing a restaurant concept.

Private equity investment can be divided into three segments:

    1. Investing in restaurant concepts that are going to grow, but not franchise;
    2. Investing in restaurant concepts that involve franchising; and
    3. Investing in franchisee groups.

There are certain basic investment parameters that apply to all three of these segments:

• Appropriate Unit Economics. A restaurant company, whether it is a “white tablecloth” concept or quick-serve restaurant, has to have compelling unit economics. Each unit needs to generate significant cash flow (unit-level EBITDA) showing a significant return on investment. Investors should be looking at unit-level cash flow in the 15% or higher range. High-volume “white tablecloth” concepts should be higher. Low volume quick-serve restaurant concepts might be lower than 15%, but a reasonable level of cash flow is critical for a threshold investment.

• Rate of Return. The rate of return on any investment for an equity group should exceed 20% and, by and large, should exceed a return on investment of 30%. In order for the restaurant sector to continue to attract equity capital, a 20%-plus threshold of return is crucial.

• Skilled and Thoughtful Management. Once the equity investment is made, the existing management team may not necessarily be the team that can optimally grow the concept. Many equity groups (whether a franchisor, franchisee or concept investment) look to supplement management. The management team has to be a group of experienced people who have developed a strong concept and know how to continue to evolve and strengthen the business. In most cases, the equity investor is investing in existing management.

• No Excess Baggage. An equity group investing in a restaurant concept needs to make sure there is no excessive baggage (i.e., no pending lawsuits, no creditor issues, no tax issues and, in the case of a franchise system, the franchisees are not financially stressed). Even though restaurant companies evolve, the target cannot have significant baggage that would have to be dealt with before the investor group invests. Too much “hair” means that the investor group will move on to another prospective investment.

• Structural Barriers. Equity investors like to see clean corporate structures. They do not want to see corporations that have the concept in one entity and the operating units in another entity. Some equity investors are interested in immediate distributions, such as mezzanine funds. In many cases, investors are looking at entities that can utilize different classes of stock. Investors also like to see structures that can accumulate earnings at the lowest possible tax rates, which does not necessarily mean flow-through entities. Many equity investors are not interested in flow-through income, which requires payment of tax by the investor and state tax filings, and would prefer to see cash accumulate at the business level and be used for growth.

• Conceptual Uniqueness. After unit economics, conceptual uniqueness is the next most important point for a franchisee, franchisor or concept to attract investment. Concept uniqueness means it has a significant demographic following or “legs” (i.e., a market position that has appeal and will continue to have appeal in the future). The concept should not be perceived as a fly-by-night concept (e.g., spaghetti in a bucket). This staying power may be a problem for fast, casual dining concepts. We do know, however, that several components of the restaurant sector are always relevant (i.e., high levels of service and quality fresh foods). The concept of “legs” is generally difficult for an investor to evaluate. Those of us in this sector can sometimes get enamored with what we think is the next great concept. The investor has to have an objective view of the concept and whether it will last.

• Ability to Fund for the Next Level. Equity investors will, at many times, provide different levels of funding — the initial funding and funding for growth. However, equity investors are also looking to make sure the restaurant company is able to attract additional investors. No one likes to be the only person at the party. Additionally, it is crucial the concept has the ability to attract debt financing. Good restaurant concepts that attract equity investors have the ability to provide appropriate leverage. This means they are able to secure senior debt which is less expensive than equity investment and mezzanine financing. Therefore, good concepts should be able to support a reasonable amount of debt — something in the neighborhood of two times cash flow or debt-to-equity ratios of 2 to 1.

• Exit Strategy. The majority of equity investors (whether individuals or funds) focus on an exit strategy. While there may be different exceptions for individuals who are strictly looking at a cash flow and annuity approach, in most cases the equity investor is very concerned from the outset about an exit strategy. The restaurant concept needs to be looking at whether the concept: (1) will attract a strategic buyer, (2) will grow enough to secure appropriate leverage to take out the equity investor, (3) has good, quality management that can successfully carry out a Management Buy Out, and/or (4) attract a new level of equity to take out the old equity.

• Sophisticated Advisors. Equity investors look for a company to have sophisticated advisors, and the question should be asked whether the company has taken into account the importance of having quality, experienced advisors who will lead it down the correct path. Many times advisors will help the company find equity investors as well as convince equity investors of the value of this company and how the company has been positioned.

In summary, there continues to be a huge potential in the restaurant industry to attract equity investment. However, there are a number of issues that need to be grappled with, and a restaurant company has to be pro-active. The company has to be able to answer the key parameters addressed in this article to position itself as a viable investment when pursuing (or being pursued by) equity investors.

From October 2004 Restaurant Monitor

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Dennis Monroe

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