Private Equity firms have been snapping up restaurant chains at an astounding rate in recent years. It makes sense, considering the industry is cash-generative, offering a continual source of new concepts that can be scaled and eventually sold, generating lucrative returns. And while those in the financial and banking sectors often perform the due diligence on those deals, a firm with extensive restaurant experience and a deep knowledge base can deliver insights that otherwise might be passed over by a generalist advisor.
In fact, a recent Harvard study found that “private equity deals led by partners with prior operational experience, particularly in the restaurant industry, show greater improvement in inspection results than those led by partners with financial or banking resumes.”
Through our extensive experience conducting restaurant commercial due diligence engagements in the past, we’ve found that the same findings continue to crop up again and again, no matter how different the restaurant companies themselves might be. Below is a roundup of the most common restaurant commercial due diligence findings.
EBITDA is Often Overstated
Naturally, it’s in the seller’s best interest for EBITDA to be high: the higher the EBITDA, the higher the total valuation, the more cash for the seller. But while the EBITDA of a restaurant chain might be financially accurate, it won’t necessarily be operationally sustainable.
So, if EBITDA has jumped significantly in the lead-up to a sale, don’t necessarily expect that level of profitability to continue throughout the entire holding period. An industry expert can validate the sustainability of handsome efficiency gains in the 18 months prior to a term sheet being established. Budget allocations that would likely be the first line items a business might cut to increase EBITDA in the short-term include:
- Training (both development and implementation)
- Man-Hours (cutting back on staffing, or leaving certain positions vacant)
- Repairs & Maintenance
- Sudden Reductions in Food Costs/COGS
- Below-Market Compensation (companies might underpay employees with the promise that wages will rise once a new owner steps in)
Unfilled key positions and a lack of marketing or training materials might result in a temporarily higher operational performance (and, by extension, a higher valuation), but once those positions are filled or the marketing or training ramps up, EBITDA will decrease, resulting in an unexpectedly steeper J-curve.
Another important piece of the EBITDA puzzle is shared overhead, which is often difficult to quantify — particularly in the case of a multi-brand system selling-off a brand or business unit. An investor looking to buy a company that shares office space, staff, and a marketing budget — among other shared resources — with five other companies will need to account for whether those allocations have been fully isolated and replacement costs forecast and extrapolated.
CAPEX Requirements are Often Underestimated
Not all companies being sold are in a position for investors to “just add water” and have the business build itself. The thought of making additional investments throughout the course of the holding period can sometimes be overlooked when seeing the potential of the target company. Often, there is a mistake of investing too little in the beginning, rather than laying a proper foundation in the early stages of an investment which can then help expedite growth and enhance the value on an accelerated basis.
It is often the case that additional investments and enhancements to infrastructure are requisite to enable the improved performance. Even sophisticated restaurant operators can sometimes lack the systems and visibility into true costs. While new unit opening costs, for instance, may be accurate in aggregate, less visibility into the detailed cost structure can lead to faulty assumptions in the financial modeling (particularly in aggressive case scenarios). This cost includes more than just the building materials and direct labor. Executive planning time, meetings with real estate agents, soft costs of development and engineering can all add up, but may not be included in the CAPEX budgets for previously built locations (though they were incurred, and absorbed elsewhere in the budget).
While not all investments are treated as a “turnaround”, there are plenty of opportunities to transform a business – including making fundamental operational changes, or adding new products or profit centers. Below are some areas that require CAPEX investment, but can increase a company’s value over the holding period:
One of our key recommendations for investors, come the post-acquisition phase, is to create a plan and develop a prototype for a new unit before expansion. Focus on the existing business in the first year, taking the time to conduct industrial engineering studies to fully quantify and incorporate performance enhancements, to improve staffing models, eliminate operational bottlenecks, etc. It would be better to open six new locations that are operating at their highest and best potential in the second year, rather than two locations in the first year that are sub-par and perpetuate an inefficient design. Not all chains pay attention to industrial engineering, but it’s an investment that pays off, especially as a chain is preparing for rapid expansion.
Infrastructure & Technology
Technology requirements to support growth are often underestimated. The infrastructure supporting a 10-unit chain will be different than hat supporting 20 units, or those managing a multi-brand portfolio or expanding into new markets that are less understood or have less historical performance to benchmark against. Similarly, investments into ERP systems, executive dashboards, and back-office systems help investors gain real-time insight into a business. Some of this will be be identified in the due diligence phase (to the extent necessary to make assumptions), but granular-level plans will be needed as part of post-acquisition initiatives.
Institutionalization of the Business
While common in well-established companies, materials including comprehensive training, technical specifications/documentation, and integrated inventory systems are not always standard in middle-market companies. Development and implementation of these systems and tools increases consistency, availability and accuracy of data.
New Profit Centers & Centralized Enhancements
Many operators underestimate the cost of developing new profit centers. Adding delivery capabilities, for instance, might boost revenues, but requires considerable investment (delivery vehicles, packaging, technology and software, training, updated marketing collaterals, etc.). Unlocking value within new profit centers can potentially yield a return that will more than offset those costs, but a thorough understanding of CAPEX and OPEX impact should be performed by industry specialists in the due diligence phase.
An Overly Rosy Picture of OPEX Gains
A comprehensive restaurant commercial due diligence engagement requires a knowledge of emerging consumer dining behaviors and trends, benchmarks against competitors, comparisons to key restaurant industry ratios, and much more. Restaurant investors often factor huge efficiency gains into their models without realizing how unrealistic those projections might be. A restaurant chain’s historical EBITDA will be a much more accurate representation of company performance than the EBITDA immediately prior to sale.
The same systems and same people won’t yield larger efficiency gains overnight. It takes time to find, assimilate, and replace management, and investors all too often underestimate the intensity of the post-acquisition transition period.
On the lookout for low-hanging fruit, private equity firms might look to what they can do right now to boost company performance. We recommend that those in the quest for short-term gains don’t lose sight of longer-initiatives, which will likely yield even higher returns. Rather than immediately remodeling a store, for instance, adding a fresh coat of paint or cleaning up a group of stores can still lead to short-term gains, while planning the mid- and long-range initiatives on a concurrent path.
Utilizing an Industry Specialist Pays Off
The commercial due diligence process should assess everything from transaction-level granularity (including a trailing 36-month analysis), industry-specific KPIs and benchmarks, company culture, and corporate governance. The rigor of fully assessing a business from top to bottom (how it has performed historically, its current state, and where additional value could be unlocked or could be created) requires more than just face-value analysis when connecting granular data and modeling to the greater investment assumptions. Determining how to gain efficiencies in terms of cost optimization, revenue-building potential, entering new markets or adding new products is especially powerful when done it in a way that’s relevant for the specific company within its operating market.
Specialists can bring important insights generalists may miss in terms of global trends and factors impacting the business (both internal and external) and will therefore explore unique angles that others might not. In addition, they can better communicate with the industry target — speaking the lingo, knowing how back-office and point-of-sale systems work, and offering an understanding of the terrain and outlook. Understanding the market’s history and potential can deliver added context and confidence in the findings, recommendations, and performance scenarios that will ultimately be modeled out.
Increasingly valuable, we’ve found, is the combination of local know-how and global understanding. With globalization affecting everything from supply chain to customers to competitors, there are important insights generalists may miss that a specialized partner can catch – helping to ensure an investment will be one that can yield powerful returns.
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 have helped restaurant companies around the world drive revenues, increase profits, and enhance the guest experience through improved marketing, messaging, and menu engineering. Collectively, our clients post more than $100 billion, span all 6 inhabited continents and 100+ countries, with locations totaling tens of thousands.