New deal: Restaurant IPOs are out, private equity is in

Many restaurant companies looking for new ownership, an injection of cash or a strategic partner to spur growth are looking no further than the growing pool of private-equity firms that are busily buying their way into foodservice.

Apparently fast fading are the days of hasty initial public stock offerings — especially for midsize restaurant companies — as the public market today poses steep regulatory hurdles and costly barriers to entry. Also a factor in the rise of private-equity allies is the fact that IPOs offer no guarantee that they'll raise the volume of funds anticipated, expert sources indicate. They also point out that the equities market has not been especially kind to restaurant companies of late.
For example, two of the three restaurant stocks that went public last year are currently trading well below their initial offering price.

Yet private-equity firms possess obviously deep pockets and are willing to pay high multiples-of-earnings prices for the right investment, according to numerous sources. Last month, for example, a deal was reached to sell Dunkin' Brands for $2.43 billion to a consortium of three private-equity companies, which agreed to pay what insiders indicated was a price perhaps double a typical earnings multiple. And as of presstime, Quiznos Masters LLC reportedly was looking for a buyer for the Quiznos Sub sandwich chain franchisor that was willing to pay about $2 billion.

Dunkin's acquisition by Bain Capital Partners, Thomas H. Lee Partners and The Carlyle Group is considered among the largest in foodservice history.

"There is massive capital overhang right now," said Jack McCarthy, managing director and co-head of the transaction advisory group at Alvarez & Marsal, a professional-services firm based in New York. "There is a load of capital to be invested, and the private-equity funds need to put their money to work. It's the largest amount of capital out there in a long while."

Indeed, private-equity firms bought almost a third of the restaurant companies that changed hands during the first nine months of 2005, according to J.H. Chapman Group, an investment banking firm based in Chicago. Of the deals closed from Jan. 1 through Sept. 30, 21 involved equity firms, compared with 12 in the same period in 2004. That 75-percent increase was recorded despite a 13-percent drop in the overall number of acquisitions, according to Chapman.
What's more, the value of those restaurant transactions is growing ever larger. From last January through October, the total value of the 45 restaurant transactions whose terms were disclosed reached $1.71 billion, up from a total disclosed value of $517 million in all of 2003, according to research from FTI Capital Advisors LLC, a boutique investment bank that works with middle-market companies. FTI Capital is a wholly owned subsidiary of FTI Consulting Inc. of Annapolis, Md.

"In the simplest of terms, money is chasing opportunity," said Raymond Zale, a senior managing director and head of the restaurant practice at FTI Capital Advisors.

Still, Zale cautioned restaurant operators to understand that multibillion-dollar deals are not the norm in the restaurant industry. The majority of restaurant companies are middle-market companies with market capitalizations less than $1 billion, or small-cap companies, with estimated values between $250 million and $500 million, he explained. Most private-equity firms attempt to keep the purchase price at a low multiple to the company's earnings before interest, taxes, depreciation and amortization, or EBITDA.

"The mantra of a strategic restaurant buyer is never pay more than five or six times EBITDA," Zale said, "unless there is outstanding growth potential."

In the Dunkin' Brands deal, for example, the purchase price was almost 12 times EBITDA, according to Sandra Horbach, managing director of The Carlyle Group's consumer retail team, and that premium was based at least partly on the company's growth prospects.

Carlyle was "buying a quality business with great growth opportunities," she said. "You have to pay for it. … The purchase price was driven by market dynamics."

Indeed, some sources say Quiznos — a brand not nearly as time-tested as those in the Dunkin' stable — could fetch the floated asking price of $2 billion simply because of the state of the market. The 4,000-unit chain does boast impressive growth trends, including a 25-percent annual jump in systemwide sales in fiscal 2004 on an increased new-restaurant count of almost 35 percent.

"On the tail end of other large transactions, why wouldn't a seller or a seller's adviser announce a premium number and let the market determine the price?" Zale asked by way of suggesting one strategy for optimizing spin-off proceeds.

But mergers and acquisitions are not all about high finance. Restaurant operators, particularly chains' senior management teams, are just as involved in an auction or a private-equity exchange as the company's investment bankers or consultants.

Jon Luther, chief executive of Canton, Mass.-based Dunkin' Brands, said he was in Paris immediately after the company's owner, Pernod Ricard, had disclosed it was looking to divest the foodservice division of Allied Domecq, Dunkin's former parent company, which was acquired by Pernod for its spirits holdings.

"They had decided on an auction process," Luther said, "which is a bad term, although sometimes it feels like that. We participated in the process of evaluating all potential bidders and providing them with our good story."

There initially were about 40 to 50 potential bidders for the franchisor of Dunkin' Donuts, Baskin-Robbins and Togo's, Luther said. Of that number, 23 actually turned in bids. Dunkin' and Pernod, who worked with JPMorgan as their adviser, narrowed that bidding field down to "eight or nine" finalists, he indicated. Dunkin' gave in-depth presentations to each of the finalists, and they had 30 days to place a final offer.

"It was an interesting couple of weeks," Luther recalled.

Of the four finalists, all were pairs of investors made up of at least one private-equity firm. Kohlberg Kravis Roberts & Co. teamed up with Trimaran Capital Partners, owners of the Charlie Brown's steakhouse chain and recent buyer of El Pollo Loco Inc. Providence Equity Partners teamed with Dunkin's and Pernod's advisor, JP Morgan, while Triarc Cos. Inc., parent company of the Arby's chain, partnered with Apollo Management LP.

Other than Carlyle's Horbach, no representatives of any of the finalists could be reached for comment

Luther said he would have been comfortable working with any of the groups. In addition to his work on the acquisition, Luther and his senior-management "go-to" team were able to leave the day-to-day operations of running the franchisor's three chains to other capable leaders, he said.
"All of the officers got a message when this process began," Luther said. " 'Listen, you're great leaders, don't take your eye off the ball,' and they didn't. They continued to deliver. … It really was a model on how to get through this."

Joe Stein, chief financial officer of Irvine, Calif.-based El Pollo Loco, said it is imperative for any restaurant company that's up for sale to limit the impact an auction could have on the chain's operations. Trimaran closed on its $415 million acquisition of the grilled-chicken chain in November.

"It can be a very lengthy process, so it is best to limit the amount of people involved," he said. "The primary heavy lifting is done by the finance team, legal and, obviously, the chief executive."

In El Pollo Loco's case, according to Stein, the company's former owner, American Securities Capital, had invested in the company for a while and was looking for a return when it felt the time was right, he said.

"Private-equity groups have a life cycle to their funds, and they will require a return at a certain time," Stein said. "Management saw a good market in 2005. There is a lot of money out there right now."

Much as with Dunkin' Brands, there was an auction process for El Pollo Loco, during which a group of bidders emerged before the decision was made to go with Trimaran, mainly because of its experience in the restaurant industry, Stein explained. "The key for us was to find another great partner to help management get to the next level," he said.

Neither Luther nor Stein would comment on any pending exit strategies for their respective private-equity owners. While they both said it was too early to consider just how the buyers would extract their ultimate return on investment, sources familiar with the inner workings of mergers and acquisitions said that most deals do not close until numerous ROI strategies are calculated.

Still, the ups and downs of the market could determine whether Dunkin' and El Pollo Loco float public stock, conduct another sale with private-equity players or get sold to a strategic buyer.

"The market will dictate the exit strategy," Stein said. "There is a lot of money in private equity right now, but if the IPO market is hot, you never know."