How could you grow your business with a $50m private equity investment? Would you expand into new markets, roll out the prototypes you’ve been dreaming of, or deploy new technology to make it even easier for diners to get your food? We’re predicting a lot of activity in the lower middle-market segment, where strong valuations and solid growth are attracting a lot of interest. Already this year, firms representing $3–$4b in buy-side capital have approached us, looking for the next big thing in foodservice.
The world of private equity investments is complex. Here we offer a brief overview of PE funds operations, focusing specifically on each stage of the deal, while a second post has a six-step guide for getting a restaurant operation transaction ready.
Want even more? Check out our investment glossary, with key terms every restaurant operator should know.
A typical private equity firm has a group of general partners, or fund managers, who raise capital, find investment opportunities, and oversee the organization’s portfolio. (For more on the investment landscape, deal types, and key terminology, see our glossary.) These funds don’t select businesses that seem like they will grow on their own; instead, they take an active hand in building value over the life of the investment. Most general partners have deep expertise in managerial strategies and want to help their investments streamline operations, optimize efficiency and performance, and grow in a sustainable way.
This means private equity firms are by and large strategic, as opposed to financial, investors. Financial buyers have a more hands-off approach: they want to put money in, let the existing operation grow it, and take it out a few years later. In contrast, strategic buyers recognize their target investments as collaborators in value growth.
Some firms specialize in specific industries, while others are striving to offer a well-rounded portfolio to the institutional and individual investors who put capital into the fund. In either case, private equity firms expect to take an active role in managing the businesses in their portfolios.
The investment funds come from the firm itself and from limited partners — often pension funds, insurance companies, or other nations’ sovereign wealth funds, though HNWIs sometimes contribute as well.
Firms invest in and acquire companies that seem likely to increase in value over the course of the investment. This may mean the business is underperforming or undervalued, or it may mean that the general partners recognize that the restaurant has something special: a new concept just waiting to go national (or international), hold on a hard-to-claim market share, or an operational system that could revolutionize the industry.
Regardless of a firm’s area of specialty or reason for investing, most follow a similar life cycle:
General partners solicit funds for a particular project from limited partners. The firm may define these projects narrowly (“acquire in Bob’s Fine Dining on Spruce Street”) or broadly (“invest in a restaurant chain in North Africa”)
After signing investment and acquisition deals, fund managers work with the restaurant’s executive team to grow revenue and improve margins. Cash flows tend to break even in years three to five.
The length of the hold period will vary. Some firms, like Berkshire Hathaway, prefer longer hold periods, which allow management and efficiency improvements to mature. Others go for quick flips, with investments sometimes lasting as little as 12 weeks (in the case of Blackstone’s 2016 sale of Strategic Hotels & Resorts).
Today, the average hold period is just over five years, up from the much shorter 3.3 year (median) between 2006 and 2008.
Funds sell their stake in the company or make an initial public offering (IPO). General partners claim 20% of the profit and distribute the rest to their limited partners.
Fund managers walk a tightrope. On the one hand, they have capital that must be put to work. On the other hand, they have a group of investors expecting a certain rate of return, so they must avoid risky deals that won’t deliver.
To find the sweet spot between profit and risk, funds undertake intensive pre-deal research into their targets’ financial, legal, commercial, and operational status and prospects. Each step of the deal timeline involves increasing scrutiny and discussion, all building to a final bid that satisfies both parties and sets them up for post-deal success.
After a PE firm raises money, it must decide where to put it. Fund managers go through seven stages of research, due diligence, and negotiation to find a partnership or sale that fits in with their strategic goals.
Firms locate target investments and acquisitions in a number of ways. Using their own research or intermediaries, they’ll learn about opportunities that other firms may not be aware of. (Many fund managers approach our consultancy for just this insider knowledge, so that we play matchmakers in their next deal.)
Restaurants may also circulate teasers to alert private equity firms to new opportunities in a process known as a public auction. Before contacting the target, the firm will conduct preliminary studies to assess the opportunity. If it seems like a good investment, the fund manager and restaurant will sign an NDA, and the restaurant will share its Confidential Information Memorandum.
The firm may present sellers with an LOI, which outlines the deal in broad terms and may contain an exclusivity clause. The sell-side team should share this document — especially language around an exclusivity period, purchase price, and deal conditions — with legal counsel, as it may contain unfavorable terms.
The PE firm will conduct research on the industry, hold discussions with expert consultants, and build preliminary financial projections. The restaurant will provide confidential to help fund managers embark on a thorough round of financial, legal, commercial, and operational due diligence. (See our due diligence checklist to understand which documents investors are likely to request.)
If due diligence doesn’t surface any red flags and the investment appears to be a good strategic fit, the firm will submit a first-round bid. In public auctions, where more than one firm is involved, the sell-side team will select which firms move on to the next round.
Following a more detailed investment model, the firm will lay out its comprehensive investment thesis, explaining why it’s looking to invest in this particular operation, and its strategic plan. A Preliminary Investment Memorandum will summarize the opportunity for the benefit of the firm’s Investment Committee.
A Final Investment Memorandum (FIM) will be drafted, informed by further buy-side due diligence (often conducted by third-party consultants). The FIM includes purchase price and preliminary merger agreements, which describe changes to the target’s management team, employment structure, stock options, and so on.
Though it’s called a binding bid, there’s still room for negotiations. The potential investor and target company will meet to discuss every detail of the offer. The PE firm will come with lawyers experienced in investment transactions — and so should restaurant operators.
To prepare for this process, restaurants should start about 18 months before the desired closing date. In that time, they should undertake the same in-depth study of their organization as investors will throughout the pre-deal process. With this information, the operation can accurately estimate its value, identify red and yellow flags that could negatively affect the transaction, and speak more confidently about the deal to potential investors.
Aaron Allen & Associates is a leading global restaurant industry consultancy specializing in growth strategy, marketing, branding, and commercial due diligence for emerging restaurant chains and prestigious private equity firms. We help restaurant operators and investors make informed decisions, minimize risk, and maximize sustainable value. With experience on both the buy- and sell-sides of transactions, we have a robust understanding of trends and factors impacting restaurant chains and private equity funds around the world. We help protect, enhance, and unlock value throughout every phase of the investment lifecycle. Collectively, our clients post more than $100 billion in annual sales, span all 6 inhabited continents and 100+ countries, with tens of thousands of locations.