Why Private Equity Firms Are Investing in Franchises Franchise Friday with Jeff Dudan & Pat Galleher

As an operator for the majority of my career, I thought private equity had always been a thing. But in reality, private equity really came to its current form in the mid-90s. Can you talk a little bit about how private equity evolved and what purpose it really serves? To help business owners release capital, unleash some wealth, and then also help companies grow?

Yeah, that's a great question. I mean the original, you know, private equity today is, is more about strategy and helping business owners and families grow their businesses with, with, we call it, other people's money. You know, back in the early days, in the early 90s when KKR and some of the firms first started, it was all about financial engineering and the sum of the parts being worth more than the whole enterprise. And that really has changed over the last 10, 15 years. It's all about strategic vision, helping the founders put the right KPIs in place, put the right players on the team, and helping the current management from their experience, you know, put the right strategies to work that are going to help them grow, you know, 50 to 100% over the next three to five years. So, so private equity now is much more of a partner than an owner. And a vast majority of the deals that were involved with the private equity firm after the first 90 to 120 days is really just, you know, part of the board and helping from a vision standpoint and you know, putting the right parameters in place on a day to day basis. So a lot less scary than it was 20 years ago when I, when I, when I did my first IPO in 2000 and then I did a private equity deal in 06. You saw the private equity firms that were more about financial engineering really got annihilated during the 0809 recession. And the firms that lasted and are really flourishing today, like the Riverside Company and Princeton Equity and Susquehanna and those firms are really all about helping current management grow the business and not replace management and not change the strategy. So that's where our process, where we narrow it down to eight final Private equity firm really self selects and aligns management with the potential buyers. So by the time we get to loi stage, everyone's pretty aligned with where they think the business going to go.

All right, let's deconstruct something. You said, you said that they were people that were looking at it for the sum of the parts, right? So there's the, was it RJ Reynolds that was featured in Barbarians at the Gate where there was a leverage buyout and then they, they wanted to deconstruct the company, buy it at a low price, deconstruct it, sell it for a sum of its parts and then basically make money on that. And it was called Barbari at the gate. And how they tried to hold them off, I don't know. You know, it was a big thick book. I never got to the end of it. So I don't know what happened there.

But you know, that, that, yeah, that really, you know, especially in the sub 500 million prize value, we, we don't see anyone, especially in the franchise industry. I mean no private equity firm, firm is paying 10 to 15 times cash flow to, to deconstruct the company. It's all about growth. It's all about strategic fit. And it's all about how can that private equity firm add value from a marketing standpoint, from a finance perspective, you know, how can they assist the current management team in getting that, you know, getting that company to the next level? So, you know, the barbarian of the gates and then those type of episodes in private equity, they still do exist, just not especially out in the franchise space. Right.

And also the antagonist or protagonist and Pretty Woman.

No one's buying Bluestar Airlines anymore to separate it out. So those are great movie lines and movie plots, but that's no longer the current private equity environment. Great.

When I think about private equity, I kind of think about it as a ladder, right. You've got some people or some firms that are going to operate in the lower market and they're going to be, they're going to have a certain size fund, they're going to invest in certain size businesses, maybe a platform company that's healthy and maybe they're willing to pay a good multiple for it. But then their goal is really through organic growth, through strategic partnerships and through accretive acquisitions to take that business and add on to it. And basically one plus one equals four or five. Because when you move it up to the middle market and there's funds that say, I can't write a check less than 30 or $50 million, those companies are going to be writing bigger checks. And ultimately the, the higher the EBITDA is or the cash flow minus certain things, then the larger the multiple genuinely is. So, so it's kind of this game of, of, of taking an asset and then figuring out how to enhance the asset for its benefit and for the benefit of any of the other assets that are put with it. And that's how extra capital is generated. And then of course, there's always some, there's always a bigger Fish that if you can build it in the middle market and you build it to a 50 or 100 million dollar EBITDA business, then there's going to be somebody else at lat levels that's looking to make those types of investments. Is that something that most business owners that you engage with understand the concept of or is it even important for them to do so?

It's part of when, when we take on a new client and during the process of onboarding a new, a new mandate, you know, we really spend a lot of time with the client trying to understand do they want to be the platform, do they want to be part of a platform. If you become part of a platform like Empower brands or neighborly or Authority brands in the franchise space or an UNL niche brands, you know, that's a different second bite of the apple. You know, our, our client's going to get, you know, shares or roll forward into a diversified portfolio of franchisors versus just being, you know, a single franchisor investment. So there's a lot of benefits to becoming part of what we call a franchisor aggregator. But there's also, you know, you're, you're diversifying your upside and your risk by you know, your firm isn't going to be the sole determin future value on the next exit. So but there's been, you know, the great thing about the franchisor space is, you know, even KKR and KKR owns Neighborly now. And you know, 10 years ago KKR had no interest in the franchisor space. So you're seeing much the largest of the large private equity firms invest in franchising. Blackstone has an effort now. You know, they've made some, some big acquisitions in the franchisor space. And you know, so you've seen, you know, all the way from the smallest private equity independent sponsors all the way up to the Blackstones and the KKR Susquehanna's, you know, putting real money behind the franchise industry.

What is it about the franchise model that they like so much?

Predictability? You know, we, you know, we, we always term it internally is, you know, a lot of our clients are recession resistant and pandemic resistant. So we have a lot of clients who did very well during the 08092010 recession as corporate refugees as they got laid off at the, you know, some of the big GE and some of the big firms, they went out and bought franchises in residential services business. You know, low cost, no lower, lower initial cost franchises and bought themselves new jobs making 150 to 250,000 a year. So we've been able to prove to the private equity industry that, you know, through the recession of 08 to 2010, a lot of our clients did extremely well. And then during the pandemic, you know, once again, franchisors did extremely well, excluding restaurants. But franchisors and residential services specifically did incredibly well during the pandemic because more people were staying homes and they wanted to spend money on new fences and new roofs, new siding, new carpets. So, you know, you know, franchisors have proven time and time again to have high predictability of royalty streams and future cash flow. And there's very low capex at the franchisor level. So your free cash flow from EBITDA to free cash flow is a very high conversion. And so the ability to service debt. And the lenders love franchisors. So it's really proven to be a great industry for private equity to get behind.

If I'm an operator listening to this, you've just started speaking the language of finance and you helped us, I believe we were one of your first deals in franchising with my business advantaclean back in 2018 through the year and then closing January 1, 2019. What was apparent to me that was not apparent before is that finance is really a foreign language. And no matter how intently I listened, if I didn't have the underlying fundamentals of finance, how, how the businesses are being evaluated, what the ratios are, how private equity firms evaluate risk inside of a brand, what they give weighted credit to, what they take credit away from, and really, you know, navigating that to your extent, if you don't speak the foreign language of finance and you're an operator that's been doing painting or restoration or one of these things, and you're going to get into a room and think that you're going, it's, it's like dropping in Portugal. And you, you haven't spoken a word of Spanish your entire life. You know that the Octopus is great. You love the coast. I mean, there's things that, you know, you'll recognize words occasionally like bathroom, but at the end of the day, you, you don't have a chance. So, you know, talk to me a little bit about, you know, some of the, some of the do's and don'ts. If you're, if you are a franchisor or if you're a direct business or if you're even a franchisee, which I'm going to want to talk to about what's happening in the boxes, as we say in the franchise industry, going through the brands into the boxes and the consolidation that's happening there. But I mean, right off the bat, what are some of the do's and don'ts that you can give value to our listeners here? Because we have a huge audience. I've found out in franchising with brands and with business owners. So what do we stay away from?

Well, one thing is I would never share your internal financials with a private equity suitor before. We've actually evaluated them and gone through and cleaned them up. And that's one of the number one mistakes we see is we'll take on a client, we'll put together their new P and L that includes adjustments for one time expenses and say you hired a new CFO and you, you spent 100,000 with the recruiting firm to, to find the CFO. That's a non ongoing operational expense that, that we eliminate in the P and L that we put together. And then two, we create a maturity curve on sold but not yet open and locations that are going to open less than, let's say a two to three year maturity curve. And we'll, we'll run that out and create an embedded EBITDA based on all the locations sold but not yet to maturity levels. So when you hear a franchisor got 20 times EBITDA, it's probably because it's 20 times their initial EBITDA. But the buyer, the private equity firm hasn't, has, has paid 12 times EBITDA based on the, that pro forma adjusted EBITDA that we've presented to them. So, so you just got to be very careful. It's very hard for us to convince a private equity firm that's already seen that you're at five million of ebitda, that you're now seven and a half. Once we've done all of our work, it's much better off if they've never seen your internal financials at 5. So that, that's a big mistake. And then, you know, I, I think having, making sure that you have good legal advice. We see too many emerging franchisors trying to save money on their, their first FDD and franchise agreements and, and not really spending the time and effort and money to get their FDD and their documents right up front and then being too open to making changes to the franchise agreement just to get a franchise fee. You know, on those first 10 to 20 units. We, we see a lot of messy franchise agreements in the initial. The kind of the first 20 units of most systems because they're, they're desperate or eager to start making progress on the franchise development side.

So many mistakes are made. As, as you're aware, I was a participant in building a franchise sales organization called Fran Devco. And through the course of that, during that was my Covid project, right. I had sold my business and yet all day to be on zoom, and I was on Zoom 12 hours a day during COVID It was unbelievable. But interviewing companies to, for representation by our franchise sales organization and more often than not they had had some success. Their program may have stalled out, so they're trying to find a solution to relaunch or reinvigorate their franchise sales. And they would send us their documents and they had given the entire, entire state of Texas away to a franchisor. Their territory model. I believe I've seen, I have seen some franchisors basically cap their outcome to 50% or even 25% what it could have been because of the construction of their program. And then unfortunately they had success. So now they had 20 or 30 or 40 franchise owners out there. All the good territory was gone. They didn't have performance incentives in there, like I say, or, or things that would force consolidation or encourage people to spend the right thing. So you, you look at these, at these documents and now they've got to reel it back in. But that's really not that easy in franchising a deal's a deal and they've got to go through a cycle of renewals and stuff. So they, they took what could have been a five to seven year journey and they've just made it the 12 to 15 year journey really to get the value out of it. And I, I'm not trying to over dramatize it, but it's, it's true. I mean the, the genius attacks that people have in creating their franchise program without getting proper guidance or strategic disclosure documents. Not, I mean you can get a legal disclosure document from a lot of franchise attorneys, but they're not necessarily going to be strategic. And I think at home front brands, one of the things we did was before we ever went to market, we brought in the chief legal officer who had been at Servicemaster, he'd been at servpro, he'd been at Valvoline, and his property service experience really helped us. There was things that we were able to put into our documents, I think for the benefits of the franchisees and the franchisor that I just didn't have visibility into. So, you know, really good, really tight. They've been, you know, they've, they've held up and they've aged extremely well. And I think, you know, but again, this was my second time around or probably more like my tenth time around by then with all the brands that I helped or participated in in 2019 and 22. But, but for many people it's like, you know, I think that's, that's a critical advice is if you're still young in your franchise journey or if it's just starting, proper strategic advice from somebody who's actually built a brand or actually helped somebody sell the brands. Because there's lots of people giving advice out there, but I will tell you, probably 95% of them are going to take some money from you and give you, you know, some sort of a templated deal. So it's hard, it's, it's actually hard to get the good advice early in franchising. I think it's one of the challenges in our industry.

Yeah, you know, far too many brands, you know, have made very poor decisions when it comes to area developer agreements and oh yeah, just to get some quick cash in in the first couple years of the franchi or journey. And then those area developers, you know, sit on them and don't, don't do anything to produce additional royalties and you know, then you got a, you got a great brand sitting there and you know, no ability to push new locations or new territories being sold in those areas. And it just really is a limiting factor and it does hurt the, the future enterprise value of, of those brands. So I'm always very consistent when I'm speaking to emerging franchisors about getting the territory or protected territory on a four wall location franchise. Make sure you're getting that sizing correct because you don't want to sell out all the good white space and not get the royalty benefits from that.