Private-equity groups apparently didn’t think much of the restaurant industry in 2021. That’s at least if you consider the small number of deals they made for chains during the course of the year.
The investment firms largely kept quiet, outside of a few notable deals such as the acquisition of Freddy’s Frozen Custard by Thompson Street Capital Partners or the investment in Duck Donuts by New Spring Capital, though they did invest heavily in small, upstart concepts. Some private-equity groups that have long been big buyers, notably Sun Capital, backed out of the business altogether.
Strategic buyers, on the other hand, couldn’t get enough of the industry. There were small deals, like the $1 million flyer Amergent Hospitality is taking on PizzaRev, or the $1 billion acquisition of Firehouse Subs by Restaurant Brands International. Most of the acquisitions last year were from owners of existing restaurants seeking to combine operations.
Don’t expect private equity to stay on the sidelines for much longer. Much of the reason private equity kept out of the industry last year was their inability to figure out valuations. Yet, with more time to understand the post-pandemic economy and valuations promising potentially strong returns down the line, such investors could dive right back into the business in 2022. That could make industry mergers and acquisitions that much more competitive in the coming year.
“Private equity remains very interested in investing in restaurant systems,” said Tom Wells, managing partner with 10 Point Capital. “Coming into '22, you could see a lot of restaurant transactions. It could be a pretty good full year.”
There were 41 deals of restaurant chains in the industry last year, including five initial public offerings and not including sales of franchisees—which can be difficult to track. There were 12 deals involving private-equity firms and 23 strategic acquisitions, including an unannounced acquisition of the sandwich chain TooJay’s by Earl Enterprises. There was one deal in which the buyer was not disclosed, for Quaker Steak & Lube.
The proliferation of multi-concept operators has been a big trend in recent years and is expected to continue. But private equity has long been a presence in the industry’s dealmaking and its absence has been notable.
A number of such investors in private conversations complained about the difficulties of valuing restaurant companies in the current environment.
The problem is that some restaurants recovered quickly in the post-pandemic world, while others struggled. There was a sense among many private-equity firms that some chains were getting a sales boost simply because of COVID, while some of those struggling may be getting overly punished.
Adding to the uncertainty were recent increases in labor and supply chain costs that either were or were not “transitory.”
“Does the comp performance go back to normal or stay elevated?” Wells said. “Now everybody is dealing with inflation, which is another hurdle.”
Despite this uncertainty, valuation multiples for brands have only increased. The IPO market promised large returns for restaurant sponsors in 2021 and some of the strategic deals were notable for how much value the buyers put on the chains they acquired.
Firehouse Subs was acquired at a multiple of 20 times earnings before interest, taxes, depreciation and amortization, or EBITDA. But even some of the deals Fat Brands made for companies like Fazoli’s and Twin Peaks raised a few eyebrows.
Strategic buyers can often afford to pay multiples financial buyers cannot because they can improve profits by combining some operations and laying people off, using the euphemism “synergies.”
Private-equity groups keep their purchases for about five years and look to flip them. They shy away from businesses when valuations get frothy. The uncertainty only makes matters worse.
But all these circumstances could also pull them back in. For one thing, the strong valuations being given to some restaurants either by strategic acquirers or the IPO market could make it more attractive to private-equity firms that potentially see a big payday down the road.
“For five or six years there were almost zero restaurant IPOs,” Wells said. “Now there’s one almost every other week. Private equity looks at that and sees the multiples and that brings them back into the segment.”
One thing that could keep any buyers out is thinning margins. Restaurants’ labor costs have soared in recent months. Leisure and hospitality wage rates are up 13% over the past year. In addition, food costs are up more than 11%. Those are the two biggest costs in the industry.
Sellers prefer not going to market when profits are weaker. “Margins are down,” Nick Cole, head of restaurant finance for the lender MUFG, said on a recent episode of the RB podcast “A Deeper Dive.” “Businesses are feeling a little bit of that inflation pressure. Business results are down and I think will be down in the fourth quarter and into the first quarter of 2022.
“That does tend to put a damper on M&A activity.”
But Cole still believes that deals could come as margins normalize and the year goes on because the same fundamentals are still at work—namely, that the industry is consolidating, and large-scale, multi-brand operators continue to look for bolt-on transactions to grow larger.
In addition, there are other buyers out there besides private equity and strategic deals. Several special purpose acquisition companies, or SPACs, are eyeing restaurants and will be increasingly pressured to get deals announced by the end of the year.
Then there are the private-equity firms. And Wells, for his part, believes they may grow more comfortable valuing the restaurant space as the year progresses. “It’s easier to look at the last six months of 2021 and have a much better feel for how things are going,” Wells said. “And there were a lot of trends that have accelerated.”
And, fundamentally, there is a lot to like about the restaurant space, particularly after the pandemic. The industry’s sales have more than recovered from the shutdown-caused declines in 2020. The government stepped in for the first time with a package designed to save the industry in the Restaurant Relief Fund. Consumers, meanwhile, proved they would adapt to new methods of using restaurants, like curbside service or third-party delivery, as long as they can get their prepared meals.
They also have pricing power, even after having raised prices 6%-plus over the past year. “Restaurants make a ton of sense,” Wells said. “Yes, you’re going to deal with margin compression. But if you can get prices higher, gross profit expands on the revenues. You can make that work.”
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