Investors, both private equity and public, have had a keen interest in fast-casual concepts for the last several years.
There are many good reasons for this focus, including a segment that is on trend with consumer preferences, strong unit-level returns and a host of expansion opportunities. Private equity has invested heavily in the space and has been bidding up valuations. With arguably one of the most successful companies ever presented as a comparable, public investors have snapped up initial public offerings in the space, hoping they’ve bought a piece of the “next Chipotle.” Most of the recent restaurant IPOs have traded to lofty multiples. However, the fundamentals of some of these companies have not met expectations and their stocks have come back to earth.
With the success of these IPOs and their earlier investments in the sector, private equity has made numerous additional investments in fast-casual brands. Rumors abound as to the valuations paid for some of the brands, occasionally paying a multiple of store-level cash flow, ignoring the absence of profitability because of the general and administrative expenses built to enable the brands’ rapid expansion. The bet is that the concepts’ high returns will continue to support expansion, that there is space to expand and that corporate profitability will inevitably follow.
Recent conversations with private-equity firms suggest that at least some of the more experienced ones in the sector are becoming increasingly discriminating and disciplined regarding valuations, as well as concerned about the level of competition in the fast-casual sector. The competition is most evident in finding good locations at a reasonable cost. I have had many conversations with growing companies who are citing an increasingly competitive market for the desired 2,000- to 2,500-square-foot locations and complaining that some well-funded chains are paying up for what is available. If true, this lack of discipline will ultimately result in deteriorating returns on capital with negative implications for valuations.
With money to invest, however, private-equity growth investors are continuing to evaluate opportunities in the industry, and some may be looking to casual dining as an alternative sector for investment. Their focus, however, is not traditional casual dining, but rather “polished” or “next generation” casual dining.
This segment has some of the attractive characteristics of casual dining. In particular, it is on trend with consumers demand for high quality and fresh food, and many of the brands are generating very attractive returns on capital. Because these brands are new and establishing their identity with consumers, they are viewed as authentic to their positioning, something traditional casual-dining chains are struggling to achieve because of their legacy images. Polished-casual restaurants can benefit from a non-chain image because their footprint and décor is often adapted to a specific space. They also have multi-generational appeal. Baby Boomers are attracted because of their healthier, fresher menu offerings, using them as their staple food away from home alternative. Millennials, who use fast-casual chains as their staple, frequent next-generation restaurants for entertainment and special occasions. Authenticity is especially important to this generation, and traditional casual-dining chains, almost regardless of efforts to reposition and improve quality, are viewed as suspect in this regard because of the difficulty in overcoming their brand image that was created through hundreds of millions of dollars of cumulative marketing spending over many years.
Many next-generation casual-dining concepts have focused their development in a single market, creating a powerful brand and a loyal following. Frequently, because there are no prototypes, these concepts have considerable location flexibility that enables them to create a brand without a chain feel. This lack of uniformity adds to the authenticity of the brand. One example worth noting is Matchbox, a six-restaurant brand, five of which are in the greater Washington, D.C., market. Each has its own identity, with considerable, but not complete, menu overlap. They are all high-energy, smartly designed restaurants where generations from Millenials to Baby Boomers feel comfortable.
An example of a polished-casual company that has both moved into multiple markets and attracted an investment from a private equity firm is Barteca Restaurant Group, the operator of Barcelona Wine Bar and Restaurant and Bartaco restaurant. Originally focused in the greater New York area, the two brands now operate restaurants in several markets in New England, Atlanta, and Washington D.C. Barteca arguably has greater appeal to Millenials because of its pricing and live entertainment, and each offers excellent value through the quality of the menu items and service.
Because these companies are private, financial information is not available. However, I am aware of several polished-casual brands that are generating cash-on-cash returns on investment in the 30-percent to 40-percent range, similar to many of the more successful fast-casual brands. The same basic characteristics will need to be present to attract investor interest, namely high returns on capital, the foundation of a solid management team and culture, strong consumer appeal and significant growth potential.
Which segment do you think private equity will target next? Join the conversation in the comments below.