What is the specific challenge for smaller and older owners, and why is this ushering in larger franchise operators?
The fast food franchise took off in the 1950s. At that time, franchisors wanted âmom and popâ operators to be at the heart of their franchise systems. They felt that these small owners / operators would personally work in the business at the store level making the most of each store location. Franchise agreements have been drafted in such a way as to prevent franchisees from growing 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 and therefore were not lenders in this market. As a result, the expansion could only be achieved by using the 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 has been very slow by all of the individual franchisees. The 1980s ushered in a new era in franchising. Franchisors began to rethink their expansion strategy with âmom and popâ operators, and instead began to focus on development using larger, well-funded multi-store operators.
Today, franchisors want to reinvent themselves to meet the concerns of the next generation of customers, Millennials and their children. Millennials are focused on consuming what they perceive to be healthy, human-made, eco-friendly foods that they can get quickly with minimal fuss. As a result, franchisors demand that their franchisees redefine the image of their existing stores and expand and develop new stores, thereby filling perceived gaps and new growth locations.
The cost of reimaging an existing location can be very expensive: $ 250,000 up to $ 1 million or more per location. Developing a new store can cost over $ 2 million. Older franchisees are considering the amount of money required and should consider whether they have the energy and time to recoup this new investment. Add to this mix that in many cases the children of inherited owners are not interested in the family business. And finally, there has been a substantial increase in multiples paid to get existing stores. Larger, well-funded franchise operators are fighting against each other for change to grow quickly. This can be accomplished by purchasing slots from older operators.
What happens with the vacant real estate left behind by some 90,000 closures? Will COVID open the door to entrepreneurial-driven growth like fast casual during the Great Recession? Or will the bigger one be bigger? Or something else?
Larger, well-funded operators are taking over the fast food model. Franchisees who wish to buy out existing operators are approved by franchisors, but part of the cost is the obligation to sign a development agreement. These development agreements require the acquiring operator to commit to developing more stores in certain designated areas during certain periods. The vacant real estate left by the defaulting operators will quickly be reused in new restaurants to meet the development agreements that the large franchise operators have been led to sign.
Will there be a shift from private equity financing to family offices financing large franchise operations?
The problem I see most often with private equity financing is a lack of alignment of goals between stakeholders. Hedge funds like fast food restaurants. Or rather, they like the large cash flow generated by fast food restaurants which they see as a source of leverage. The more cash generated, the more credit the company has available to borrow and ultimately use to buy it back. The typical private equity firm wants to get in and out of the business within 4-7 years. The owner / operator, on the other hand, sees the business as his long-term cash cow. They want to run the business indefinitely.
So the disconnection. The private equity firm wants to exit in the short term while the owner / operator is in the business for the long term. And therein lies the problem. The private equity player forces the owner / operator to buy it out at a substantial profit using the borrowed funds, making the company over-leveraged and a perfect candidate for failure when the market is down, and that it no longer has liquidity or the capacity to borrow to maintain itself. He is forced to sell.
Enter the family office. Family offices are, by their nature, typically âlong-term moneyâ. Family offices generally look for investments that provide returns over a long period of time. This allows for the alignment of goals that private equity lacks. I think family offices will become a major source of funding for quick service restaurants in the future.
What makes the current landscape so unique compared to 2008-2010? What are the main differences that operators need to take into account, especially growth-minded operators?
The world collapsed in 2008 and again in 2020. However, in 2008 the financial system collapsed causing major disruption for businesses and consumers. In 2020 this is not the case. On the contrary. Financial institutions were much stronger in 2020 than in 2008, in part because of legislation that was enacted requiring financial institutions to have more reserves and take other conservative steps to ensure they don’t. would not collapse in a future calamity. In 2020, governments around the world have created instant and substantial liquidity for their savings and at the same time distributed money to support their consumers. As a result, consumers have accumulated substantial wealth and reduced their debt. Add to that the pent-up demand for having nothing to do or spend over the past year and the result is a booming economy.
Operators are looking to acquire existing restaurants and build new locations. This drives up the price of existing stores. Since quick service restaurants (QSRs) have held up so well during the pandemic, the value of their real estate has risen, particularly to 1,031 buyers who fear tax laws will change, increasing capital gains and eliminating may -be the exchange of article 1031. vehicle. This increases the cost of acquiring and developing new stores, further eroding the competitiveness of smallholders.
What is the potential of âcentralized kitchensâ? Why are they seen as a potential solution to some of the current barriers for restaurants?
Millennials love convenience. Quick service while being quick is not as convenient as quick service and delivery of food to their doorstep. GrubHub, Door Dash, Uber Eats and others are all trying to find a model to meet this need. The problem is, no one has figured out how to make money yet.
One possible solution is âcentralized kitchensâ. Most delivery services go to a specific restaurant, pick up a specific order, and deliver to a specific house. Then they start again. Someone has to 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 restaurateurs who cannot easily pass the cost on to the customer and too expensive for the customer who does not want to pay a delivery charge equal to or close to the cost. of the meal.
With a centralized kitchen – which is a unique place that houses several food concepts; kitchens, a driver from one of the delivery services can go to one location and collect multiple 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 a single stop at the centralized kitchen to serve multiple customers, thus reducing the cost of delivery.
Could this create problems of unfair competition and encroachment for franchisees?
I wouldn’t call this unfair competition since anyone can open a centralized kitchen and anyone can rent space from the centralized kitchen (as long as the franchisor consents). Encroachment is another problem. Franchisees are very sensitive to the same concept of a restaurant opening too close to its existing location. If franchisors allow operators of a central kitchen location to sell into a market where there is already an established full restaurant that is owned and operated by someone else, I guarantee there will be encroachment claims . In addition, it is probably quite conceivable for a centralized kitchen to be able to serve areas much larger than the usual âprotected areaâ granted to a particular restaurant. Thus, 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 âdelivery serviceâ to their menu of options.
What changes are expected to persist after COVID? And what will separate the winners and the losers?
Before COVID, drive-thru represented around 70% of QSR’s gross sales. During COVID, drive-thru, online ordering and delivery accounted for 100% of gross sales. I expect these trends to all increase from the pre-COVID period. Dining room traffic will continue to decline as a percentage of gross sales. The other trend that started before COVID and will continue is that the big owners / operators will be the winners, the little ones and the moms and pops fading from the scene. Large operators have access to capital which enables them to obtain and buy out smaller players as well as develop new locations. This is facilitated by franchisors who favor the larger operators.