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Is private equity bad for franchising?

Investors’ growth-at-all-costs demands can lead to bad decisions, says RB’s The Bottom Line.
Photograph courtesy of Quiznos

the bottom line

Private equity loves franchising, and why wouldn’t it? Franchising, after all, is a quick-growth strategy that frees brands from all those annoying capital costs. Once they grow to a certain size, franchises provide their owners with a relatively stable and profitable flow of cash.

But investors’ focus on growth at all costs, and their determination to flip such brands in a relatively short period of time, can be bad in the long run for both the franchises and the franchisees, who are the ones on the hook for loans taken out to build new units.

We recently spoke with Caroline Fichter, an attorney who represents franchisees, for an upcoming edition of our “A Deeper Dive” podcast.

Fichter has represented numerous franchisees in lawsuits against franchisors and found that many of these brands struggle because they try to grow too aggressively outside of markets where they are most known.

And then she said this:

“It’s to the point now where if I see a private-equity owner during a [franchise disclosure document] review, and a really high, aggressive sales and growth pattern, that’s a significant red flag.”

Now, a couple of caveats.

There are a lot of good, high-quality private-equity firms that legitimately focus on franchisee unit economics. And there are plenty of them, such as Roark Capital, that hold onto their investments for a long period of time.

What’s more, in my years covering the restaurant business, I have seen numerous examples of entrepreneur-owned companies that grow with reckless abandon, convincing small-scale franchisees to open units too quickly, only to watch them fail later on.

Management, not ownership, tends to be the primary culprit when expansion gets too aggressive.

Yet private equity lends itself to such aggressive growth scenarios, which can frequently lead to problems in the franchising space.

Private equity buys companies to generate returns. And they frequently have to generate those returns in a certain period of time, meaning they don’t necessarily have the brand’s long-term health in mind.

In a franchise business, growth means signing up operators. Under pressure to add new locations, franchisors can frequently take shortcuts during that process. They may sign up operators that don’t quite have the operational acumen to do the job, for instance. Or they open locations where they should not open locations.

They might sign operators in far-reaching markets where the brand is not as well-known. While some brands, such as Shake Shack, have such name recognition that they can grow anywhere, the vast majority of restaurant brands cannot do that.

Concepts that jump markets have to take significant steps to support those restaurants in those markets. Too often, however, these franchisors rely on the franchisees to market their restaurants locally. That is difficult for any franchisee, let alone an operator with less experience.

What’s more: Private-equity firms focused on costs might not provide the support these franchisees require.

And then there is the matter of debt.

Private-equity firms love leveraged buyouts almost as much as they love franchising. Essentially, the firms will borrow much of the cost of their acquisition, which can load these companies up with debt. They will also borrow funds to pay themselves dividends.

That puts more pressure on the companies to expand and sign up more franchises. But that also drains cash from the business and hurts a franchisor’s ability to support their operators.

The worst franchise collapse in restaurant industry history, Quiznos, was the victim of such a leveraged buyout. That business grew too aggressively under a single entrepreneur, who then sold off a minority share to a private-equity firm in 2006, using a $600 million leveraged buyout.

As the company’s franchisees began to struggle, it could not take steps to support them because of all that debt. The result: The company is less than one-tenth—one tenth!—of the size it was just a decade ago.

Another such situation is Papa Murphy’s. Lee Equity Partners bought that brand in 2010, using a lot of debt. The company expanded aggressively using small franchisees in a system with low unit volumes.

Many of those franchisees were in Southeastern markets, far away from the company’s Pacific Northwest home. They struggled and sued the chain (Fichter represented many of those franchisees).

When the brand started having struggles in 2015, franchisees began closing units. Papa Murphy’s ultimately improved sales and was sold to Canadian operator MTY Group.

As I said, plenty of brands not owned by private-equity firms make many of these same moves. But prospective franchisees of any brand should pay close attention to ownership, and expansion strategy, before signing on the dotted line.

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