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There’s been a lot of investor interest in the restaurant industry as of late, and for good reason: even when economies around the world struggle, consumers continue to dine out. And even though habits might change and trends might shift, the global restaurant industry remains a force. Still, with so much Venture Capital, Private Equity, and commercial loans flowing into the space, restaurant due diligence is increasingly important. Rigorous due diligence helps buyers and institutional investors understand the full picture of an investment – its risks, forecasts, and factors impacting its performance — before the investment is made.
There is an art to executing successful M&A and the biggest advantage is in being thoroughly prepared to demonstrate to a potential partner exactly why a given deal makes strategic and financial sense. Thorough due diligence can challenge the investment thesis and the assumptions on which it is built (i.e. the upside of the investment as well as its risks). In essence, it’s an examination of where the asset is strong, and where it’s weak (in terms of financial, legal, commercial, and operational standards) and, further, determining how it could grow down the line. Those with specialized expertise in the industry will offer a different perspective, exploring unique angles that others may or not find without that knowledge (for example: how its enterprise value can be increased through improving products, facilities, enhancing profit margins, etc.). They also might note some common due diligence findings that others wouldn’t be as familiar with.
Evaluating a single-unit restaurant across all its functional areas (from menu to store design to marketing strategy) is quite involved, but the level of complexity multiplies as the number of locations increases and geographical spread widens. Our restaurant due diligence work has focused on middle-market institutional investors and chains with units spanning multiple continents and, in most cases, several different brands spanning categories, cuisines, countries, and operating models. The questions that need to be worked through for these multi-unit, multi-region, multi-concept companies are complicated, and require a considerable amount more calculus than the diligence undertaken by those with just one unit, of course.
WHAT IS RESTAURANT DUE DILIGENCE?
There are several types of due diligence, including commercial, operational, legal, and financial, which are generally conducted prior to an acquisition. Each concentrates on different audit criteria, but with a similar goal: to determine if an investment is worthwhile, and identify facets of a business that can be addressed to ultimately increase the company’s enterprise value. There are unique considerations for each industry – below, we will focus on the foodservice sector.
Due diligence serves to help an investor understand the impact, risks, and forecasts of a particular industry and provide a clear and comprehensive view of a target company through the holistic lens of value creation. Due diligence helps an investor understand, holistically, the market potential, risks and value creation opportunities of an investment.
Growing a target company is not always as easy as “just as water” – though it can appear so prior to proper due diligence. If your firm is looking to make an investment into a restaurant concept (or you’re a restaurant operator looking to take on private equity funding), here’s some of what you should understand about the exercise, though every target will have its own unique set of circumstances:
WHAT DOES RESTAURANT DUE DILIGENCE ENTAIL?
Essentially, thorough due diligence serves to answer a number of questions for investors looking to acquire a foodservice operation (including an examination of the chain’s historical performance, review of the current operation, and how forecasts for the future state). Those questions include – but are certainly not limited to — the following:
- What political considerations (regulations, policies, taxes, labor laws) should be taken into account?
- How are macroeconomic factors impacting the restaurant company? How might they in the future?
- How have societal shifts (remote workers, changing family sizes, more solo diners, etc.) impacted the business? What other emerging consumer trends and dining behaviors will become more important (and less) over the holding period?
- How can value be unlocked through expansion into new markets, or created throughout post-acquisition, or via bolt-on acquisitions?
- Can the current operational structure support future expansion? Will some holes (to supply chain, organizational chart, etc.) need to be filled – and if so, at what cost in terms of CAPEX and expansion delays?
- How will technological advancements impact the target going forward? Could value be added to by increasing use of technology (in terms of mobile ordering, ERP, back-office systems, automation process improvements)?
- How does the target plan to expand? Is it familiar with the costs in uncharted/foreign expansion markets? Will it be able to hire the same types of employees and have access to the same ingredients, contractors, supply chain, product and operational standards that have been utilized at other locations?
- What else could go better or worse? What other factors could impact investment assumptions or risks?
- How do the KPIs of the target company compare with industry benchmarks, and other comparable concepts?
- How do service standards, traffic, sales, and marketing efforts compare to competitors?
- Are the restaurant’s food and labor costs in line with industry standards? If it’s going to expand, will it be able to maintain those costs as a percentage of sales?
- What potential changes would enhance the guest experience and drive revenue?
- How well-institutionalized is company culture, operational systems, and best practices currently? How replicable are these systems moving forward, and are they sturdy enough to support the expansion aspired to in the investment thesis over the holding period?
- How have facilities been maintained (what are R&M schedules, condition of fixed assets, etc.)? What might need to go into post acquisition plans in order to bring locations up to par?
- Could (and should) the chain’s design be improved upon? Can CAPEX be better optimized?
- How are food safety risks being mitigated? How is inventory tracked and recorded? Are the proper systems in place for inventory and supply chain management? Is there high yield of ingredients? What sort of post-acquisition improvements be made (including centralized production or food preparation)?
- In a Pareto analysis, which are top and bottom contributing locations? Why are these locations better- or worse-performing? How may these patterns, anomalies and outliers factor into more granular modeling of investment thesis assumptions with regard to revenue and cost drivers?
- What changes have been made to capital expenses and operating costs (food, labor, utilities) recently? Are these changes sustainable? How will this impact P&L cost structures?
- How are yield, throughput, bottlenecks, and other operational shortcomings impacting performance? What will be required to fix those and what would ROIC be over the course of holding period?
Restaurant Legal Due Diligence: the process of collecting, understanding and assessing all the legal risks associated with a restaurant investment
- Does the target have full rights and ownership of the operation? Are there any exclusivity agreements in place?
- What are the company’s contract administration systems? Are there contractual obligations in place that could present a risk or impairment?
- Is the chain subject to any legal liabilities or liens? Are there any related parties issues?
- Are there any franchise or license agreement issues?
- What is the company’s legal organization structure (i.e. which subsidiary entities are owned by which parent companies, where is each incorporated, and what does the ownership of each one look like)? Are there any hidden majority or minority investors buried in the organizational structure of the company?
- What sorts of trademark and intellectual property issues might affect the company?
- Are some groups of employees within the company represented by unions? If so, is the union contract up-to-date and inclusive of scheduled wage rate changes, work rule limitations, guaranteed benefits, and other issues that may alter the costs of the business or be subject to litigation?
- Are there pending discrimination claims against the company? Is there a history of such claims in the past?
- Are there any disadvantageous contractual terms the target is subject to?
- Does the target suffer from an inordinately high proportion of injuries, or workers’ compensation claims?
- What other legal liabilities or vulnerabilities exist, and what protections from breach of contract and misrepresentations should be factored into the term sheet negotiations (including callbacks, carve outs, errors and omissions coverage, etc.)?
Restaurant Financial Due Diligence: an analysis and validation of a target company’s past financial performance and health, to determine a view for the future and ensure there are no missing pieces.
- Have the financials being used been audited? If not, when was the last external audit of the target?
- What is the company’s current liquidity, debt, credit and financing structure? How will this look moving forward?
- Is there any considerable debt on the business? Can the target afford to take on additional debt?
- Are there changes that could be made regarding lease agreements?
- How have forecasted budgets compared to actual performance?
- What are the target’s projections for performance over the next several years?
- Could the capital expenditures for the last several years be further improved upon?
- Have the owners of the target company attempted to sell it before? If so, what happened?
COMPREHENSIVE DUE DILIGENCE REQUIRES EXPERTS WITH DEEP KNOWLEDGE OF THE RESTAURANT INDUSTRY
A comprehensive restaurant due diligence effort requires a knowledge of emerging consumer dining behaviors and trends, industry benchmarks and key restaurant industry ratios. Just as a restaurant chain wouldn’t use its in-house counsel to navigate a Private Equity or M&A transaction (opting isntead for someone well-versed in finance), an experienced and specialized advisor can enable investors to make more informed decisions concerning the investment’s potential and the company’s vision. In fact, a 2016 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.”
In other words, specialized partners already experienced in working with institutional investors on due diligence will be able to better understand the dynamics of the industry and a company’s performance within it. Due diligence is about much more than simple market analysis. A true partner will have deep industry experience across categories, cuisines, ownership types, and geographies, bringing well-demonstrated abilities in terms of understanding both the internal and external factors impacting a restaurant business. Ultimately, such a full, transparent view will help better inform and ultimately provide validity to not only the investment thesis, but also the financial returns.
OTHER RELEVANT CONTENT:
- A Look at Global Restaurant Investment Banks
- The Most Active Restaurant Private Equity Firms
- Private Equity Deals Make Their Mark On the Middle East Restaurant Industry
- A History of Restaurant Initial Public Offerings, 2000-2017
- Global Restaurant Commercial Lending Trends
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ABOUT AARON ALLEN & ASSOCIATES:
Aaron Allen & Associates is a leading global restaurant industry consultancy specializing in brand strategy, turnarounds, commercial due diligence and value enhancement for leading hospitality companies and private equity firms. We’ve led more than 2,000 senior-level strategy engagements across 100 countries and 6 continents. Collectively, our clients post more than $100 billion, with locations totaling tens of thousands.