The private equity world is currently a sellers’ market, but this won’t last long. High asset prices, intense competition among bidders, and ongoing geopolitical instability have made deals harder and harder to come by, meaning that there’s lot of dry powder looking for safe — and profitable — homes. (In fact, our consultancy has been approached by $3–$4b in buy-side private equity looking for actionable restaurant investments over the last year.) But, with a new recession likely by 2020 and the pace of exits slowing, both high-net-worth individuals (HNWIs) and institutional investors may begin to shy away from private equity.
Restaurants looking to attract investments should start preparing now in order to secure capital while the market still favors their position.
Signing a deal with a private equity firm can mean a substantial difference in a restaurant operation’s valuation, which can have profound effects on the organization. Not only do PE organizations provide the funds necessary to optimize operations, expand into new markets, or build and deploy prototypes, but they also come with extensive management and analytic expertise to guide their partners through these new stages of development.
But the process has its risks. The investment and restaurant teams may disagree on how to reach their goals, as private equity managers might prioritize short-term growth over long-term employee and supplier relationships. Even when buyer and seller agree on strategy, deals can fall apart over valuations, financial records and models, operational stumbling blocks, and organizational challenges.
When done correctly, raising capital from a private equity firm can launch a restaurant operation into its next stage of growth. With shared values, beliefs, goals, and objectives, individual firms come together, the sum of their efforts becoming far greater than its parts.
This guide, which includes an overview of the private equity world and a six-step process to get a restaurant transaction ready, will help the executive team spot red and yellow flags, find good strategic fits, and make the most informed decisions about their companies’ futures.
Step 1: Recruit External Experts Who Understand the Process
Most large enterprises — not to mention startups — don’t file taxes without consulting multiple internal stakeholders and recruiting some external help. Private equity deals will likely have a more significant impact on a restaurant’s long-term success than any one year of tax returns, so a similarly rigorous approach is needed before embarking on a capital-raising venture.
Here are the key members of the sell-side deal team:
- Internal stakeholders to make sure the deal aligns with the organization’s key values
- An attorney to vet letters of intent and bids while offering sound advice about the regulatory environment
- An investment banker to help write the pitch book and scout potential investors
- A sell-side advisor with experience in restaurant investments to guide the company through each step of the process, help them understand the private equity marketplace, and provide unbiased opinions about the organization’s financial, operational, and commercial position
Step 2: Define Deal Breakers Before Taking Bids
Receiving an investment offer is validating: it demonstrates that the investors see the same potential the restaurant operation as its executive team. Combine those positive feelings with the sunk-cost fallacy — which makes humans more likely to make a bad decision after they’ve spent significant time and money in a process — and you could have a recipe for disaster.
Before putting themselves in that situation, a restaurant’s deal team should determine what they want to get out of an investment or sale — and what will make them walk away. Key questions include:
- Where will the restaurant be in five to ten years? How do the founder, CEO, and other key players fit into this future?
- What’s the opportunity? What will create big returns for the restaurant and its new investors?
- What kind of partnership supports these goals? Does the executive team want a silent partner or a hands-on collaborator? Will they offer a controlling or minority stake?
- What’s the lowest acceptable investment?
The sell-side deal team should treat these answers as a kind of constitution, helping them recognize a bad deal for what it is, whether it becomes obvious early in the process or moments before closing.
Step 3: Look for Investors with Similar Values, Goals, and Beliefs
Private equity firms spend a lot of time looking for and studying potential investments before contacting the target organization. Restaurants looking to raise capital should do the same.
When evaluating potential investors, the executive team should consider:
- The fund’s experience in foodservice
- The size and outcome of previous investments and acquisitions
- Current portfolio
- Regional expertise
- Strategic orientation
The last point is perhaps the most important. In an ideal scenario, the restaurant and its PE partners have the same goal in mind and agree on the steps needed to get there. By their nature, however, private equity firms are focused on bringing up valuation — if they don’t, they aren’t meeting their investors’ needs. The executive team might end up feeling that some of its priorities, often employee and supplier relationships, are being minimized.
A sell-side advisor can help operators spot these red and yellow flags, ensuring that the restaurant’s concerns are addressed before it’s too late.
Step 4: Determine Valuation Ratios to Ensure a Fair Purchase Price
There are two ways to make money on a sale: you can buy low or sell dear. When PE firms focus on improving performance and growing a company, they are ensuring that they can sell their stake at a profit. But they also want to buy low, because that will only increase the return on their initial investment.
To ensure it receives a fair offer, a restaurant should determine its value in advance and not let the buy-side deal team control this part of the conversation. Especially important in this process is assessing the value of intangibles, which include intellectual property (recipes, proprietary ingredients, training programs), brand recognition, and customer loyalty.
The four most common techniques for calculating a restaurant’s value are:
- Discounted Cash Flows
- Run rates
- Analyzing previous PE deals involving similar companies
- Benchmarking the valuation of publicly traded restaurants with similar qualities, such as location, size, and segment
Each has its drawbacks. Cash flows don’t include intangible value, and run rates are based on current performance. Neither can account for hard-to-predict changes that can radically affect revenue. For example, when Blue Apron went public in June 2017, it initially planned to offer shares between $15 and $17. But Amazon’s acquisition of Whole Foods scared off investors, dropping prices to $10, essentially cutting the meal-kit service’s valuation by a third.
Private equity deals are, well, private, and the valuations of publicly traded companies go up and down based on market forces. To make sure volatility isn’t a factor, benchmarked valuations should be cross-referenced with other methods.
Once a company settles on enterprise value (EV), it will want to calculate valuation ratios, such as EV/EBITDA, EV/EBIT, or EV/Sales. These figures give potential partners a clear picture of the operation’s profitability.
Looking at publicly traded restaurants in the US, it’s easy to see why there’s been so much private equity activity in the foodservice industry.
Since 2008, the median valuation ratio has doubled from 5.3x to 10.9x. Some big winners — like Wingstop and Shake Shack — are even posting multiples in the thirties. (For some stunning valuation figures, look at the food delivery sector.)
Financial advisors on sell-side restaurant deals can help calculate value effectively and assess if the timing is right, so that sellers neither leave too much on the table nor scare off potential investors.
Step 5: Performing Sell-Side Due Diligence Will Surface Obstacles
Investment firms conduct multiple rounds of due diligence, digging into the target company’s financial history and future, the industry and market landscape, and its operational strengths and weaknesses. Restaurants seeking private equity financing should do the same before considering any offers.
Having a clear view of an organization’s finances and operations, not to mention key industry and market indicators, allows the executive team to identify — and correct —obstacles to the transaction before potential investors discover them on their own.
Proper documentation also streamlines the due diligence process, an incredibly important moment in the investment timeline. Having business plans, pitch decks, balance sheets, corporate agreements, promissory notes, cash flow and income statements, and term sheets provides transparency and protects the sell-side enterprise from last-minute changes.
At the same time, it lets potential investors know that the sell-side team is knowledgeable and confident. This can greatly impact the path of negotiations, because the fund managers will recognize that they are dealing with equals.
Step 6: Use Teasers to Attract the Right Kind of Investors
Once a restaurant has conducted a thorough self-study, locating areas of opportunity and mitigating risks, it’s time to start shopping for offers. An investment banker can help write a teaser, a short document that describes why the restaurant will make a sound investment.
The teaser should approach the opportunity from the perspective of the private equity firm, addressing these questions:
- What makes the target an attractive investment?
- How would its assets and intangibles — which include market share, technology, intellectual property, and expert managers, staff members, and workers — contribute to a firm’s growth strategy?
- What aspects of the current operation can be leveraged to produce both long- and short-term value enhancements?
- How would this deal fit in with the firm’s overall strategy?
- How will the funds be used? How will the investment affect future plans and forecasts?
- What gaps in management or the business plan will private equity be expected to fill?
- What are the risks? What risk mitigation strategies can we devise?
- What’s the exit plan?
Private equity firms will then contact the banker and ask for a Confidential Information Memorandum, which will include more information about the restaurant.
The investment period will likely extend for a few more months, but these advance preparations will speed things along. Recently, some private equity firms have been cutting their due diligence timeframe almost in half, from two to four weeks. (This speed-up likely reflects the difficulty PE firms are having making deals, but from our perspective, it’s not in the best interests of either party.) Regardless of the deadline, having these documents ready will make the process easier and instill potential investors with confidence.
The team of external advisors, now experts in the restaurant’s history, operations, and goals, will guide the internal deal team through the buy-side due diligence process, negotiations, and closing.
ABOUT AARON ALLEN & ASSOCIATES
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.