PE’s Quiet Obsession

Good morning and happy Sunday.

Private equity firms are hungry for franchises, and not just in the food biz. So what's behind PE's insatiable franchise appetite?

Amid the many seismic economic events of last year — the loosening of interest rates, the barnburner stock market run, a nascent revival in dealmaking — it's understandable if you failed to notice one meaty if unglamorous trend on Wall Street: Private equity's love affair with franchising. 

You may recall asset manager Blackstone shelling out $8 billion, including debt, for Jersey Mike's Subs in November. Months earlier, in April, competing PE firm Roark Capital finalized its $9.5 billion acquisition of Subway, Jersey Mike's bigger rival, setting up a competition of buyouts and BLTs.

For Blackstone, it was merely the latest in a year of splurging on food franchises. In February, it was an equity investment in Arkansas-based drive-thru coffee chain 7 Brew Coffee, and four months later, a $2 billion deal for fast casual chain Tropical Smoothie Cafe.

In the latter case, the seller was another PE firm, Levine Leichtman Capital Partners.

Blackstone's history of wheeling and dealing in franchises, it should be said, is not contained to the realm of food — for example, the world's largest alternative asset manager owns a majority stake in Servpro, the fire- and water-cleanup and restoration company, acquired in 2019.

And one of its landmark deals netted Blackstone a $14 billion profit by the time it completed its gradual exit in 2018 from the storied hospitality franchise Hilton Hotels, which it acquired 11 years earlier.

The deal, completed not long before the 2008 recession, easily could have been a disaster because of the ensuing economic implosion. But Jonathan Gray, the man who orchestrated the leveraged buyout, saw that $800 million was invested in the hotel chain, reduced Hilton's interest costs by buying its debt at discounts, and presided over an eventual turnaround as the brand pushed into emerging markets and built out its US footprint.

"It should have been a career-shortening moment," he joked in an interview with Steve Forbes last year. Instead, he's now Blackstone's president and COO and has a net worth of $9.5 billion, according to the Bloomberg Billionaires Index. Not too shabby for a potential career-killer.

Blackstone has since continued its forays into franchises in the hospitality sector, teaming up with Miami investment firm Starwood Capital to buy long-term occupancy hotel brands Extended Stay America for $6 billion in 2021 and WoodSpring Suites for $1.5 billion in 2022.

It's a trend that is expected to continue, and here's a look at why.

Buffett of Options

"If you think a business is going to be around 10 or 20 years from now, and that they're going to be able to price advantageously, that's going to be a good business. And if somebody has to have a prayer session every time they want to raise the price a dollar a pound on whatever they're selling, that's not going to be a good business."

Those are the no-nonsense words of Berkshire Hathaway CEO Warren Buffett, speaking to an audience at the University of Notre Dame in 1991 about one business concept in particular: the franchise.

"One of the interesting things to do is walk through a supermarket sometime and think about who's got pricing power, and who's got a franchise, and who doesn't," he added. For instance, Buffett says, if someone goes to the store and has the option to buy Oreo cookies or a knockoff brand that looks like Oreo cookies but "is three cents a package cheaper, [they'll] still buy the Oreo cookies."

The concept of franchising — taking a business with pricing power and licensing its IP, know-how and products to partners who will exercise that power while taking on some of the risks — would become practically synonymous with the Oracle of Omaha after his company's 1997 acquisition of Dairy Queen.

His success in franchising — which extends to other sectors, including residential real estate via Berkshire Hathaway HomeServices — was a precursor to a surge in interest from other investors, especially private equity firms.

The appeal of the franchising model for a holding company like Berkshire or a PE firm like Blackstone is simple. First, the built-in, recurring revenue models of franchise operations bring predictability and stability. 

Risk is also diversified by handing out operational responsibilities and ownership to franchisees — and the royalty-based models that involve those franchisees make the business more easily scalable and less capital intensive, since expansion costs are borne at least in part by the network of franchise owners.

To that end, the International Franchise Association predicted the number of US franchise establishments in 2024 would grow by 15,000 units, or 1.9%, to 821,000 units. The collective output of franchises was also set to increase 4.1% during the year, from $858.5 billion in 2023 to $893.9 billion in 2024. 

While that trails the extraordinary growth in the stock market, that's not the point: It outpaced the economic growth rate in the US, which is what PE firms that invest in franchises, with their institutional investor clients interested in long-term returns, are concerned with. As Buffett put it in his Notre Dame lecture: "I read annual reports, but I don't read anybody's opinion about what's going to happen next week, or next month or next year."

That long-term mindset — which extends beyond the realm of franchise buyouts and investments — has generated higher private equity returns, according to Pitchbook data, which shows the 20-year return on private equity through the end of 2023 beating public equity by five points.

"What private equity is looking for is — they gotta love the brand, they gotta love the unit economics, they gotta love the points of differentiation and positioning and yadda yadda yadda — but what they're really saying is, 'This person that we're going to roll over into this deal: Are they backable?'" Front Street Equity Partners co-founder Jeff Herr explained last year in an interview with Netsertive.

"They have to make sure that if they're investing all this money they have to keep that engine going, they have to build enterprise value in that company so they can flip it to the next guy," he said.

Franchisors, Franchisees and Quid Pro Quo

Private equity's interest in the franchise model — while traditionally vested at the top with investments in franchisors — has also gravitated downstream in recent years to franchisees.

Examples include Orangewood Partners buying Pacific Bells, a top Taco Bell franchisee that runs 270 restaurants in nine states, in 2021. That has allowed the investment firm to tap Taco Bell's growth under parent Yum Brands, which has outperformed other brands in Yum's portfolio like KFC by wide margins.

In the fitness sector, Brentwood Associates in 2019 acquired Afterburn Holdings, a leading Orangetheory Fitness franchisee. Last year, PCRK Group — acquired by Trivest Partners in 2019 — became the largest franchisee of wellness chain Massage Envy when it added 36 new locations.

Multi-unit operators controlled 54% of all franchise units as of 2023, according to franchise marketing data firm FRANdata.

And, franchisor or franchisee, the private equity rush into the franchise model has shown PE capital — and the strategic assistance that follows along with it — has helped brands and operators expedite growth.

One of the best examples of the last decade is probably Wingstop, which Roark Capital took public in 2015 and which has seen astronomical growth ever since. Its share price is up 275% in the last five years and in October, Wingstop reiterated its guidance of 20% same-store sales growth in the US for its 2024 fiscal year.

Flynn Group, America's largest franchisee with 2,600 units across the food and fitness industry, is also PE-backed, with a little over a third of its shares held by Main Post Partners as of early last year. Flynn announced its sixth recapitalization in February, adding new PE sponsors to fuel the growth of its business, which generates roughly $4.5 billion in sales.

"The impact of private equity on the franchise landscape has been transformative, reshaping the dynamics of business expansion and operational strategies," the International Franchise Association wrote in its 2024 economic outlook. "While higher inflation and interest rates increased the cost of initial investment and created higher barriers to entry into franchising, the facilitation of an increasing number of PE firms has injected significant capital into franchise systems to fuel growth and enhance competitiveness."

Indeed, the fever-pitch pace of the activity in the PE sector has driven up valuations, though franchises won't complain. "The landscape of traditional private equity has become increasingly competitive, with Pitchbook data showing over 3,500 PE firms competing for deals in 2023, up from 2,000 in 2015," Shaina Denny, the CEO of petcare franchisor Dogdrop, wrote in November. "This competition has led to rising valuations in the middle market, with median EBITDA multiples expanding from 5.5x in 2010 to 7.8x in 2023."

Written by Sean Craig