Why Restaurant Chains are on the Menu of Private Equity Groups
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In the movie "Midnight Run," Robert DeNiro plays a bounty hunter who tracks down Charles Grodin, a fugitive accountant. Bringing him back to justice after his capture, DeNiro tells Grodin of his desire to open a coffee shop and end his career chasing bail jumpers. Grodin warns against this, pointing out that almost all restaurants eventually fail.
Despite sound financial advice such as that from Grodin to DeNiro and other solid empirical evidence, many private equity firms continue to purchase restaurant chains. The most recent example is the $296 million buyout of 96 Benihana's (NASDAQ: BNHN) restaurants announced in May 2012 by Angelo, Gordon & Co., a private equity firm that specializes in alternate investments. What a private equity buyer looks for in an investment does not reflect Gordin's sage advice, nor the dreams of DeNiro for his coffee shop.
While all businesses have the same goal of making a profit, much of the gains for private equity owners come from what can be taken out rather than what is put into an acquired entity. About half of the profits for private equity firms are from the dividend payments extracted from businesses that are owned. This generally comes from larding on as much debt as the company can absorb, then distributing the proceeds to the private equity owners rather than utilizing the funds to expand operations or make improvements.
As such, the predictable cash flow of a restaurant chain is very enticing to private equity groups. To service the debt, there must be a strong and consistent current of cash flowing from operations. A restaurant chain provides this as the operating margins can be very strong. As an example, McDonalds (NYSE: MCD) has a robust operating margin of 31.59%.
Intrinsic for increasing the cash flow and bolstering the operating margin is significantly reducing expenses. Slashing staff is always one way to lower costs. Buying a restaurant chain also offers the ability to lower costs through the synergies of greater purchasing power and more efficient buying. Owning 96 Benihana restaurants will allow for Angelo, Gordon & Co. to negotiate better deals at lower prices for needed goods and services than DeNiro would have been able to with his lone coffee shop.
It is also for the very reason that Grodin advised DeNiro not to open his coffee shop that makes established restaurant chains so attractive to private equity buyers: the high mortality rate, particularly in the early years. When a private equity group buys an established restaurant chain such as Benihana's, it knows that it has a customer appeal that is documented by years of audited financial statements from being a publicly traded corporation. Someone else took the risk of Benihana's going under its first year of operations. The goal of Angelo, Gordon & Co. is now to make the operations as profitable as possible. In the short term, cutting expenses as much as possible while increasing revenues works for raising the profit margin.
For a private equity group, that overall goal of higher profitability most likely entails selling the restaurant chain for the longest green possible, as soon as possible. DeNiro was looking forward to keeping his coffee shop for life, easing into retirement with his own place to hang out and make a few bucks.
Burger King (NYSE: BKW) by contrast, has been transformed through a number of permutations having both major corporate and private equity owners over the years, ranging from Diaego (NYSE: DEO) to TPG Capital, Goldman Sachs Capital Partners (NYSE: GS) and Bain Capital as it has fluctuated from being publicly traded and privately held. Diaego sold Burger King as part of its move to focus on beverage operations. Goldman Sachs Capital Partners cashed out after Burger King's initial public offering (IPO) . Goldman Sachs Capital Partners has continued to finance restaurant operations, making a "strategic growth investment" in May 2011 in Apple American Group LLC, the largest franchise group of Applebee's, a nationwide casual dining chain with over 2,000 units.
The appeal of restaurant ownership for private equity groups continues unabated on a global scale. It was recently announced that 1,000 Burger King restaurants will be opened in China owned by Catesian Capital Group LLC, a private equity firm. As the middle class expands around the world and grows more affluent, there will be more meals eaten at restaurants. Casual dining and fast food establishments such as Applebee's, McDonalds and Burger King will be the initial entry point for many, providing the cash flow and profits that entice private equity groups into buying restaurants to later sell for gains in the future, rather than the lifelong dream that owning a coffee shop was for DeNiro.
Fool blogger Jonathan Yates does not own any of the stocks mentioned.