The Restaurant Roll-Up Transaction
The Restaurant Roll-Up Transaction
We examine the process and methodology of roll-up transactions of restaurants that were financed individually with a common general partner.
Structure of a Typical Expansion Model for Restaurants
It is not uncommon for a new restaurant to be financed through a limited partnership, raising capital from high net worth individuals who will be looking for an annual cash return and eventual return on investment through capital gains. The general partner (“GP”) contributes funds for its GP interest, usually 1% and some percentage of the LPs’ interest. The GP provides the management, accounting, and training of staff and managers to the individual limited partnerships. The limited partnership, holding one store, distributes cash flow but has no rights to the use of the name unless conferred by the GP, as the trademark of the restaurant is commonly owned in a separate entity. Future stores are built with a combination of debt and equity and are controlled by the same GP. The limited partnership pays a fee to the entity owning the trademark and uses the name and logo of the restaurant for such fee.
In this structure, the GP maintains control of the name and the operations of the restaurant without having to own more than 50% of the entity. In this structure, the LPs are commonly paid a high percentage of the cash returns until a certain payout threshold is met, after which point profits are shared 50/50. The typical ownership structure is depicted in Figure 1.
Limitations to the Individual Store Financing Model
This model of expanding new locations has the benefit of low cost capital, not diluting the founders of the company, avoiding excessive leverage, and providing income to the investors. The model also has some important limitations.
- Since the free cash flow from the individual stores is typically distributed to the partners, there is limited cash flow to fund any expansion.
- The ability to raise equity capital is severely limited since the business and operations of the limited partnerships cannot be used as collateral.
There is a point of diminishing returns to utilizing the LP structure to grow. Even if future growth is anticipated to be slow and steady, increases in the cash flow at the store level will not be available and trying to satisfy the limited partners return expectations will be difficult. Any industry that utilizes this structure usually reaches a point at which growth becomes constrained. The fact that only a fraction of cash flow generated can be reinvested in the business will inhibit expansion, financing, and the ability to acquire as a method of growth. If all of the LPs own the same percentage of each partnership, an unusual condition, the analysis becomes one of relative contribution to the new entity (“Newco”). This is an easy analysis other than for the stores that are losing money or are not yet profitable and the value of GP fees and trademark entity. When proportionality does not exist, all entities need to be valued to determine their interest in Newco. Regardless of the circumstance, the valuation considerations and methodology we use are detailed next.
As is the case with all going concern valuations for operating companies, there are three valuation approaches, some or all of which are used for determining indications of value based on the facts and circumstances as will be discussed in this section. The approaches are the Income Approach, Market Approach, and Asset Approach.
The Capitalization of Earnings method under this approach involves capitalizing (dividing a sustainable level of cash flow at a capitalization rate) a single period of free cash flow by a rate that deducts an expected long-term growth rate. In order to implement this method, careful analysis of the historical financial statements should be conducted in order to exclude the effects of any nonrecurring amounts of income or expenses. A normalized level of cash flow should also reflect potential changes in minimum wages, rents, deferred maintenance, and required franchise remodeling, just to name a few. Future demand drivers of restaurants include surrounding demographics, consumer tastes, disposable income levels, and brand recognition. This method is most applicable to companies that face predictable and constant growth, such as single location restaurants in a mature growth stage. For most restaurants considering a roll-up transaction, it is likely that the existing limited partnerships have reached a mature state in which future cash flows are relatively predictable. Thus, this method can likely be utilized for roll-up transactions.
The Discounted Cash Flow method involves the discounting of expected future net cash flows for a predictable period into the future and a terminal value (based on either capitalizing earnings or applying a multiple) at an appropriate risk adjusted rate. This method is most applicable to restaurants that are new, have expectations to open additional units, or in a location that is expected to experience a significant change in economic condition. In a roll-up transaction, a Discounted Cash Flow method may be necessary for newer locations that may experience a varying level of revenue and net cash flow prior to reaching a stable level.
Under either of these methods, the discount rate can be determined either by the build-up method or by using the Capital Asset Pricing Model (CAPM) by utilizing data of publicly-traded comparable companies or SIC code data. As discussed in the following section, careful consideration should be given to select companies with comparable concepts and metrics.
The Market Approach, also known as the Guideline Company Approach, involves the determination of indicated values derived from either developing a group of companies in the same or similar line of business or those with similar risk characteristics.
The Comparable or Guideline Company Analysis method starts with a search for comparable companies using a database such as CapitalIQ in order to find publicly-traded companies similar to the subject company. It is important to consider the restaurant’s concept and specific characteristics rather than an all-inclusive list of restaurants that are too dissimilar. Important factors to consider in the selection of comparable companies include the following (i) restaurant concept (casual, coffee/brewery, fine dining, family, fast casual, sandwich, pizza, etc.); (ii) demographics; (iii) average ticket amount per person; (iv) franchise vs. non-franchise; (v) growth expectations; (vi) size; and (vii) geographic locations.
The Precedent M&A Transactions method also involves a search using a database (such as CapitalIQ for larger transactions and PrattStats for private, smaller transactions) for transactions involving comparable restaurants in order to gauge purchase multiples. Larger deals often have EBITDA multiple premiums. In order to implement this method, it is important to consider the date of transaction, as dated transactions may not be meaningful as markets change in response to economic and industry conditions. Make sure to compare the subject company to comparable companies for size, leverage, risk, profitability, and growth prospects. It should be noted that PrattStats database is useful for similar small companies, although may be lacking some of the data necessary for drawing conclusions as information is not as readily available for private companies.
This approach is not generally applicable to going concern valuations as this method does not capture intangible value. However, there is a use for this method when a restaurant location is owned by the company versus leased. In those situations the value of the land, which may be worth more than when purchased, needs to be captured in the value. The approach usually involves treating the land as a sale leaseback transaction wherein the land is sold subject to a long term triple net lease, with the sales proceeds included in the going concern value as a non-operating asset.
Figure 2 shows how all three valuation approaches could be implemented in order to derive the total value of a restaurant company.
As previously stated, assuming that the LPs and their percentages in the individual stores are different, each location will have to be valued separately. For profitable locations that lease their real estate, the Income and Market Approaches will be most commonly used. Unprofitable stores that have the prospect of success will be based on future cash flow. Locations that are unprofitable should be valued on an Asset Approach. For the locations that own real estate, we utilize a combination of approaches wherein the real estate is treated as if a sale/leaseback transaction occurred. Rent equal to long term lease rates is substituted for ownership and then the market value of the land is added to the going concern value as a non-operating asset.
The GP and LPs are treated equally for their ownership in existing stores. What distinguishes the GP and the trademark entity valuation is the continuing value that derives from their income related to future stores. The GP and trademark represent the infrastructure needed to grow. After the roll-up of the locations, the LPs will participate in future growth while under the pre-transaction structure they can only grow based on the revenue and cash flow from the locations they own. That is to say that they cannot open a store in that entity.
In restaurant valuations, the primary valuation considerations and drivers consist of geographic demographics (including average age, number of families, and consumer preference trends), surrounding disposable income levels, the economic conditions of the geographic region of the subject restaurant, the technology and systems in place, and the ability to control costs and eliminate commodity price risk. More specifically, we consider the restaurant concept since each concept has different drivers and faces different risks. The restaurant concept generally determines the hourly sales (table turns) and average ticket amount. As the restaurant industry is subject to consumer trends, such as gluten-free cuisines and having a larger online/social media presence for viewing menus and making reservations, we also incorporate the subject’s restaurant adherence to these trends in our cash flow models.
Obstacles to Getting Full Acquiescence
In order for the roll-up to be successful, most of the LPs must be willing to exchange their cash flow, or most of it, in exchange for the growth opportunities that will exist in the stock of Newco. The LPs initially invested primarily for income and not for capital gains and as a result might be resistant to swapping ownership interests. It is generally necessary to have discussions with the largest investors, at a minimum, to assure that there will be a critical mass of investors willing to change investment strategy.
Unhappy minority investors are always a potential landmine. Those that have no interest in participating should be allowed to sell their interest at the values determined during the valuation process if they choose to do so. The major investors should be given the opportunity to ask questions and to have input into the final exchange ratios. Newco management should consider distributing some of its free cash flow so that the limited partners can have some return in addition to the capital gains opportunity.
The allocation itself and the values ascribed to the individual stores, the GP, and the trademark entity are themselves a potential bone of contention. Therefore, careful consideration of the future cash flows allocable to the GP and trademark entity, such as the selection of an appropriate royalty rate that should be used to determine future cash flows to the trademark entity, is critical to the analysis. As the value allocated to these two entities will not be allocated to the LPs, the valuation of both entities needs to be thorough and defendable.