What is the specific challenge for smaller, older legacy owners, and why this is ushering in larger franchise operators?
Fast Food franchising took off starting in the 1950s. In those days, franchisors wanted “mom and pop” operators to be the heart of their franchise systems. They reasoned that these small owner/operators would personally work the business at the store level getting the most out of each store location. Franchise agreements were drafted in such a way as to restrict franchisees from developing and expanding rapidly. Specifically, the franchise agreements did not allow private placement/syndicated partnership financing, public financing and conventional commercial lenders, who did not understand the fast food model so were not lenders to this market. The result: expansion could only be achieved by using cash generated by the operator’s existing restaurants or the operator’s own resources. It takes a lot of capital to develop a new location so development was very slow by any individual franchisees. The 1980s ushered in a new era in franchising. Franchisors started to rethink their strategy of expanding with “mom and pop” operators, and instead, started to focus development using larger, well-financed, multi-store operators.
Today, Franchisors are all about reinventing themselves to address the concerns of the next generation of customers, the Millennials and their children. Millennials are focusing on eating what they perceive to be healthy food that is sourced in a humane and environmentally friendly way that they can obtain quickly with a minimal amount of hassle. As a result, Franchisors are demanding that their franchisees reimage their existing stores and expand and develop new stores filling any perceived location gaps and new growth locations.
The cost of reimaging an existing location can be very costly - $250K up to $1MM or more per location. Developing a new store can be upwards of $2MM. Older, legacy franchisees look at the amount of money required and must think if they have the energy and time to recoup this new investment. Add to this mix that, in many cases, the legacy owners’ children are not interested in the family business. And finally, there has been a substantial increase in the multiples being paid to obtain existing stores. Larger, well financed franchise operators are fighting each other for the change to expand quickly. This can be accomplished by buying older legacy operator locations.
What happens with vacated real estate left behind by some 90,000 or so closures? Will COVID open the door for entrepreneurial-minded growth, like fast casual in the Great Recession? Or will the biggest bigger? Or something else?
Larger, well financed operators are taking over the fast-food model. Franchisees that want to buy out existing operators are being approved by franchisors, but part of the cost is a requirement to sign a development agreement. These development agreements require the acquiring operator to agree to develop more stores within certain designated areas within certain periods of time. Vacated real estate left behind by failing operators will be quickly repurposed into new restaurants to satisfy the development agreements that the large franchise operators were cajoled into signing.
Will there be a shift from private equity financing to family offices funding large franchise deals?
The issue I see most often with private equity financing is a lack of goal alignment between the ownership parties. Hedge funds like quick serve restaurants. Or rather, they like the large cash flow generated by quick serve restaurants which they see as a source of leveraging. The more cash generated, the more credit that is potentially available to the business to borrow and ultimately use to buy them out. The typical private equity firm want to be in and out of the business within 4-7 years. The owner/operator, on the other hand, looks at the business as its long-term cash cow. They want to run the business indefinitely.
Thus, the disconnect. The private equity firm wants out in the short term while the owner/operator is in the business for the long term. And there lies the problem. The private equity player forces the owner/operator to buy it out at a substantial profit using the borrowed funds resulting in the business being over levered and a perfect candidate for failure when the market has a downturn, and it no longer has cash or the ability to borrow to sustain itself. It is forced to sell.
Enter the family office. Family offices are, by their nature, typically “long term money”. Family offices usually are looking for investments that pay yields over a long period of time. This allows for the goal alignment that is lacking with private equity. I believe that family offices will become a major source of funding for quick serve restaurants moving forward.
What makes the current landscape so unique compared to 2008–2010?What are some major differences operators need to consider, especially growth-minded ones?
The world collapsed in 2008 and again in 2020. However, in 2008 the financial system collapsed causing major disruptions to business and consumers alike. In 2020 that is not the case. To the contrary. Financial institutions were much stronger going into 2020 than 2008, partly as a result of legislation that was enacted forcing financial institutions to carry more reserves and take other conservative measures to ensure they would not collapse in a future calamity. In 2020, governments around the globe created instant and substantial liquidity to their economies and at the same time doled out money to support their consumers. As a result, consumers have substantial accumulated wealth and have decreased their debt. Add in the pent-up demand of having nothing much to do or spend on over the past year and the result is a booming economy.
Operators are looking to acquire existing restaurants and build new locations. This is pushing up the price of existing stores. Since quick service restaurants (QSR) has held up so well during the pandemic, the value of its real estate has increased, particularly to 1031 buyers who are concerned that the tax laws are going to change increasing capital gains and perhaps eliminating the Section 1031 exchange vehicle. This is increasing the cost to acquire and develop new stores further eroding the ability of smaller operators to compete.
What is the potential of “centralized kitchens”? Why are they seen as a potential fix to some of the current roadblocks for restaurants?
Millennials like convenience. Quick serve while fast is not as convenient as quick serve plus delivery of the food to their door. GrubHub, Door Dash, Uber Eats and others all are trying to find a model to address this want. Problem is, no one has yet found a way to make money at it.
A possible solution is “centralized kitchens.” Most of the delivery services go to a specific restaurant and pick up a specific order and deliver to a specific house. Then they do it again. Someone must pay for this service – either the restaurant or the customer or a combination of the two. The problem is that the cost of this very personalized service is expensive, too expensive for the restaurants who cannot easily pass the cost back to the customer and too expensive for the customer who does not want pay a delivery charge equal to or close to the cost of the meal.
With a centralized kitchen – which is a single location that houses multiple food concepts; kitchens, a driver for one of the delivery services can go to one location and pick up several meals from different restaurants for different customers at the same time. This is a huge time saver for the delivery service as it allows them to make only one stop at the centralized kitchen to serve multiple customers, thus reducing the delivery cost.
Could this create unfair competition and encroachment issues for franchisees?
I would not classify it as unfair competition since anyone could open a centralized kitchen and anyone could rent space at the centralized kitchen (provided the franchisor agrees). Encroachment, that is another issue. Franchisees are very sensitive to the same restaurant concept opening too close to its existing location. If franchisors allow operators of a central kitchen location to sell to a market where there is already an established, full restaurant that is owned and operated by someone else, I guarantee there will be claims for encroachment. In addition, it is probably very feasible for a centralized kitchen to be able to service areas much broader than the usual “protected area” granted to a particular restaurant. So, a centralized kitchen could theoretically encroach on more than one operator. I suspect this is an issue that will ultimately be resolved as franchise concepts figure out how to add this “delivery service” to its menu of options.
What changes are expected to stick around after COVID? And what will separate the winners and losers?
Prior to COVID, drive-thru was about 70% of gross sales for QSR. During COVID, drivethru plus online ordering plus delivery were 100% of gross sales. I expect these trends to all increase over pre-COVID. Dining room traffic will continue to fall as a percentage of gross sales. The other trend that started pre-COVID and will continue is that large owner/operators will be the winners with smaller and mom and pops fading from the scene. Large operators have access to capital which allows them to obtain and buyout smaller players as well as develop new locations. This is being facilitated by the franchisors who are favoring the larger operators.