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Rising labor costs could slow restaurant acquisitions

The labor environment could slow what has been an unprecedented level of restaurant merger and acquisition activity.
Scott Mitchell

The restaurant industry has been the source of an “unprecedented” level of merger and acquisitions activity for the past year and a half. But labor costs could put a stop to that, as profitability concerns could keep buyers at bay.

That, at least, was the conclusion of a panel at the Restaurant Leadership Conference in Phoenix.

Earlier, Technomic noted that deals involving restaurant chains skyrocketed in 2017, from 11 deals valued at $4.1 billion in 2016, to 38 deals valued at nearly $21 billion. “It’s not just private equity, but other chains looking to continue to grow,” said Patrick Noone, executive vice president of business development for Technomic.

Michael Phalen, managing director and head of retail investment banking at Wells Fargo Securities, said there’s been “unprecedented activity in the restaurant sector” the past 15 to 18 months.

That could change, however, if labor costs keep rising. Unemployment is at 4.1%. And rising minimum wages and competition for labor is driving up wage rates in the restaurant industry and hurting profits.

Wage rates in the restaurant industry are up 4.2% so far this year, compared with 2.3% for all employers, said Hudson Riehle, senior vice president of the National Restaurant Association's research and knowledge group.

“The thing I’m paying most attention to is labor,” said Ken Pendery, CEO of First Watch, which was sold to Advent International last year.

Aziz Hashim, CEO of the private-equity group NRD Capital, which bought Ruby Tuesday last year, agreed that labor costs are a major barrier to future deals. He says that other growing competitors outside the industry are draining talent. He said he takes Uber frequently and often talks to the drivers.

“Eighty percent of them should have been working in the restaurant business,” he said. “We’re losing talent to this type of gig economy.”

NRD on Tuesday announced a minority investment in the hospitality human resources technology firm Harri, which Hashim said was part of his firm’s effort to address the labor cost issue.

Panelists on Tuesday suggested that the management and culture are vital elements in any acquisition. “Management is a big piece,” said Pendery, whose First Watch has acquired some brands itself over the years. “Not only middle management and upper management, but management leadership at the restaurant level. Do they like the brand? Are they proud of the brand?”

Unit economics are also important.

Hashim said that it’s one of the most underrated elements in any deal, especially for franchisees. “I’ve found that when I was a franchisee over a 20-year career, the brands I was in were bought and sold multiple times,” he said. “I was shocked how few times I was contacted by a potential buyer.”

Hashim said he would never invest in a brand that he wouldn’t be willing to sign on as a franchisee.

He also said that “franchisee quality” is an underrated element in restaurant deals. Many restaurant companies promote large development agreements that ultimately go unfulfilled. But that can be a potential red flag. “It’s really in the seller’s interest” to know whether there are a number of unfulfilled development agreements.

Adam Burgoon, partner with the private-equity group KarpReilly, said that investors should target companies that can evolve over time. “It’s not just how good a concept is, but about how it can evolve over time,” Burgoon said.

He also said that companies need to have a “scalable culture” that can be the same as the brand expands. “It’s the simplest thing,” he said. “Everyone has pride in what they do, and a pathway.”

Indeed, companies can easily outgrow their culture. “If we grow too fast, that’s what destroys the culture,” he said.

Hashim said that buyers need to be careful about how much they spend on their acquisitions, a key point given that multiples for many brands have skyrocketed in recent years.

“You have to have powder on the side to invest in the company,” Hashim said. “Don’t go so hard into an acquisition that you can’t invest in the business.”

He also said that buyers should be careful about thinking that the only thing they need to do when buying a struggling brand is remodel.

“You have to fix the food, the experience, and the marketing before you spend hundreds of thousands of dollars on stores hoping that’s going to be the answer,” Hashim said.

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