The tight lending climate and the uncertain economy are leading to new unions between emerging growth brands and some private equity firms.
The relationships offer smaller brands access to capital that remains out of reach, and cash-flush PE players breakout growth opportunities that larger chains can’t furnish. But the road to marital bliss is not a given.
During a recent conference in Seattle hosted by the law firm Davis Wright Tremaine, or DWT, experienced operators and investors shared advice younger companies on the hunt for financing should consider before stepping beyond the more traditional support of family, friends and government loans.
“There’s a misunderstanding and a lack of awareness about how private equity actually works,” said Riley Lagesen, an attorney with DWT. “Private equity isn’t inherently bad, but it’s important to understand the space before you get into it.”
The recession has produced a number of dynamic restaurant concepts, many of them already tailored to adapt to today’s economic climate, said Lagesen.
“And there’s a lot of capital out there that hasn’t been deployed,” he added.
Over the past year or so, recent deals include investments by KarpReilly LLC in the then-five-unit Burger Lounge of San Diego; investment firm GrowthPoint Restaurants injected $1.2 million in the then-three-unit Mendocino Farms sandwich concept, based in Los Angeles; Gemini Investors took an equity stake in the 14-unit Garbanzo Mediterranean Grill concept of Denver; and TSG Consumer Partners took a majority stake in Portland, Ore.-based Stumptown Coffee Roasters, with fewer than 10 locations.
Pros and cons
Lagesen, who moderated the session, said his clients are approached frequently by investors who call themselves private equity, “but there are a lot of pretenders.”
For an emerging brand, partnering with private equity can bring a restaurant operator’s tiresome days of raising capital to an end, allowing them to focus on building the business. Private equity funds with deep experience in the restaurant world, specifically, also can offer know-how that many young entrepreneurs may lack.
On the other hand, private equity funds have varying demands, expectations and liquidity preferences, and restaurant operators need to have a clear understanding of how such pressures will impact their business.
Some restaurant operators are wary of bringing on a private equity partner — and with good reason, said Jon Owsley, a partner in Catterton Partners, which owns Noodles & Company and Cheddar’s, and recently sold the First Watch breakfast chain.
“The restaurant space is like church: Many people go there, but few people understand it,” he said.
While a few larger private equity players, like Catterton Partners and KarpReilly, will invest in smaller emerging restaurant brands, other operators may look to companies like Nourish Capital, based in San Francisco, which targets early-stage growth companies — preferably in the fast-casual segment and with two units or more — filling that gap between friends and family, and larger funds, said Brad Klapper, Nourish’s managing partner.
Klapper emphasized, however, “If you’re building a big brand, you need to have the right capital structure.”
One of the first steps a young company should consider is consolidating its investor base to allow for a cleaner transaction.
Private equity funds aren’t interested in dealing with cleaning up a chain that has different family and friend support groups for each unit, including investors with different ideas about valuation.
“Invariably, you’ll come across small groups that will try to hold you at gunpoint, trying to get a better deal,” said attorney Marc Williams of DWT.
That’s why young companies early on should include provisions in their corporate or investment structures that allow for consolidations or the roll-up of entities in the event of a larger deal.
Those provisions should also establish a clear appraisal or valuation process, which can prevent deal-killing battles later on, said Williams.
Private equity players each have their own criteria for investment opportunities, but, Lagesen noted, “if it’s a great company, there’s flexibility.”
M. Laird Koldyke, managing partner with Winona Capital Management, recommended that small emerging chains “claw their way” to 10 units before seeking a private equity partner.
“You’re really not ready for prime time until you have 10,” he said, “though there are guys who will finance getting to 10.”
Koldyke said most private equity partners would look for companies with a 20 percent operating margin from inside the restaurant, excluding general and administrative costs, for example, but expectations vary.
Chris Reilly, co-founder of KarpReilly, owner of The Habit Burger Grill, Z’Tejas Southwestern Grill, Cafe Rio and Burger Lounge, said he looks for companies that focus on one brand, not multiconcept operations.
Reilly said he might look at a franchised brand, but in that case, only chains that work with established multiunit franchisees, not single-unit operators.
Other investors said the key factors they look for are the scalability of the brand and whether it has a proven record of working across different geographic markets.
Meanwhile, perhaps the most challenging question operators need to answer for themselves is how much equity they’re willing to give up.
Russ Bendel, chief executive of Habit Burger parent company Habit Restaurants LLC, said restaurant operators should make sure they understand what their role might be after bringing on a private equity partner.
“Will they bring in an outside CEO?” he asked.
For companies on an accelerated growth curve, Bendel added, “you really need to invest in infrastructure.”
Greg Dollarhyde, chief executive of the eight-unit Veggie Grill chain, based in Santa Monica, Calif., agreed, saying restaurant operators need to do their due diligence about any investors they are thinking of bringing on.
He recommended talking to other operators who have already taken that step to fully understand the expectations and demands a private equity investor may have.
“I find it annoying that people will spend money on a consultant to determine whether their son should go to private school, but not on whether they should take on a private equity investor,” he said.
Owsley of Catterton said it’s important for both sides to do their research and to talk about the future.
“Spend time together,” he said. “You’re getting married. You want to hold hands and jump into the pool together.”
Added Koldyke: “And the divorce laws aren’t in your favor.”