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Economic factors help shrink deals down to size in the M&A market

Economic factors help shrink deals down to size in the M&A market

When the buyout bubble burst last year, not all restaurant-related deals were washed away.

Instead, the deals—still driven largely by the same private-equity firms behind the shopping spree of recent years—now take into account the limited access to capital, weak performance throughout the restaurant industry and the slumping economy. In other words, acquirers no longer are searching for large buyout targets with huge price tags, but rather distressed companies that appear to be sound investments.

“It’s a good time for the right investment, but you have to be cautious,” says M. Steven Liff, managing director at Sun Capital Partners Inc., a Boca Raton, Fla.-based private-equity firm and head of its Los Angeles office. “You have to be really cautious about what will happen over the next year. Will [the environment] continue to deteriorate? You don’t want to buy a company and then six months out you have half of the company you purchased.”

Private-equity firms, which pool billions of dollars from wealthy individuals and other investors, such as pension funds, typically to take over companies, have themselves recently taken a hit. Large companies such as Blackstone Group and Carlyle Group, once hailed for their deal-making prowess, have buckled under the hefty amounts of leverage heaped onto their balance sheets during the buyout boom and exacerbated by the meltdown of the credit markets.

Similarly, several private-equity firms that orchestrated some of the largest restaurant deals of the past years also are facing pressure.

“Anyone today who is long on restaurant assets that are above the quick-service space will probably not be having a good time,” says David S. Lobel, founder and managing partner of Sentinel Capital Partners, a New York-based private-equity firm that has invested in restaurants for some time, including Church’s Chicken, Taco Bell and Old Country Buffet parent Buffets Inc.

“People jumped into the sector in a big way,” he adds, referring to the buyout frenzy that started in 2003 and was at its peak even through most of last year. “They bid up prices to huge levels, prices no one had seen. … Those deals are most likely under a lot of pressure.”

According to sources, the bonds and loans that were used to finance last summer’s blockbuster $3.2 billion buyout of Outback Steakhouse’s parent company have plunged so far in value that they are considered distressed investments. The buyers in that deal included Bain Capital Partners and Catterton Management.

But all is not lost, many private-equity firms say, especially for the players that work mostly in the middle market, where deals are under $1 billion in value and most hover around the $100 million mark. Instead of focusing on the traditional company buyout, private-equity firms this year and next are likely to zero in on bankruptcy deals or offer up infusions of cash to help fund growth or ease a company’s debt burden.

For example, DDJ Capital Management LLC, a Waltham, Mass.-based investment firm, recently purchased casual-dining operator Avado Brands from bankruptcy. Also, Freeman Spogli & Co. ponied up $45 million to boost the liquidity of El Pollo Loco, which is owned by another private-equity firm, Trimaran Capital Partners.

The environment could spur deal making for firms that focus on underperforming companies or turnaround situations, such as Sun Capital Partners Inc. Since 2003, Sun Capital, currently a $10 billion firm, has been active in the restaurant space. Recent purchases include such brands as Smokey Bones, Friendly’s and Boston Market. Other investments include Bruegger’s, Fazoli’s, Garden Fresh, Real Mex, Restaurants Unlimited and Souper Salad, where it holds a minority investment. Restaurant holdings account for about 13 percent of Sun Capital’s portfolio.

Some of Sun Capital’s investments, particularly in the retail sector, already have come under pressure. Wickes Furniture Co. and Lillian vernon Corp. both filed for bankruptcy in February. Sharper Image Corp., which Sun Capital does not own or operate, but invests in through its separate securities fund that acts a bit like a hedge fund, also filed for bankruptcy protection last month.

Sun Capital, however, is regarded as a turnaround expert, and its buyout funds have boasted annual returns, before fees, of more than 40 percent each year since co-founders and co-chief executives Marc Leder and Rodger Krouse started the firm in 1995, said Richard Hurwitz, vice president of communications.

The firm is used to owning struggling companies. About 45 percent of all of the companies the firm has acquired had negative earnings before interest, taxes, depreciation and amortization, or EBITDA, Hurwitz says.

The restaurant environment is a “big challenge,” Liff says. “We’re no different than the restaurants we don’t own.”

Yet, some could argue that Sun’s companies are indeed in a better position, having already faced extreme financial pressures. Each company acquired by Sun Capital has a 100-day plan to operate against and is required to submit weekly or monthly reports, along with management’s discussion on the results.

“We are more hands-on, but we don’t micromanage,” Liff says. “Restaurants are a business where you need to do 500 things right every single day. … We’re good at the blocking and tackling.”

Sun Capital’s expertise is highly regarded at the 275-unit Bruegger’s chain, one of the private-equity firm’s first purchases in the restaurant sector. Jim Greco, president and chief executive of Burlington, Vt.-based Bruegger’s Enterprises Inc., says Sun Capital is filled with “very bright, very down-to-earth” people. Since being purchased in 2003, Bruegger’s has turned around its operations and in January was able to boast 15 consecutive quarters of same-store sales growth.

Working with a private-equity owner is like working with any “knowledgeable investor,” Greco says.

“They ask questions, have a new perspective and have separate experiences that they bring with them,” he adds, “and yes, sometimes that can lead to changes. But if the business isn’t doing well, change is probably what’s needed.”

Sun Capital says it will sell Bruegger’s when the time is right and will continue to source opportune deals in the restaurant sector.

Given the level of capital Sun has as well as its banking connections and track record in the industry, deals often find the firm. But at other firms, the hiring of a veteran restaurant executive to help find deals and consult through the due diligence process has become a trend.

At TowerBrook Capital Partners LP, restaurant operator Anthony Wedo has joined the firm to help source deals in the restaurant sector. Wedo, a foodservice veteran with 25 years of industry experience, has worked at such brands as KFC, Boston Market and Einstein Bros. Bagels.

TowerBrook says it is actively seeking transactions in any sector of the industry, and with $2.5 billion under management, the firm will look at companies that record between $20 million and $100 million in EBITDA.

“There are always great deals to be had in the restaurant space,” Wedo says. “The industry has gone through these cycles in the past, and the [current challenges] are indeed cyclical issues.”

Wedo describes the current merger-and-acquisition environment, with its lowered buyout multiples and more stringent financing, as similar to the majority of the past 30 years.

“What has actually been the anomaly has been the last three years,” he says.

TowerBrook Capital, which is based in both New York and London, isn’t the only firm to bank on a former industry executive’s expertise and contacts. One of Goldman Sach’s private-equity divisions has worked with James Boyd, an operator with experience at Quiznos and Popeyes, and LRG Capital Group, just this month created a new hospitality capital group to be headed by Shah Bahreyni, a veteran of independent restaurants like Boca Steak & Seafood, Toast and Sabella’s Italian Market, all in California.

“The private-equity sector has a lot of supertalented people,” Wedo says. “But the insights I can provide after 25 years in the industry are pretty unique.”

The use of a restaurant veteran could also go a long way to soften private equity’s reputation as flippers or financial engineers. It’s a reputation that some firms are eager to shake.

“Private equity is a large industry … and when people say there is fear, they are thinking about the more notorious people in our industry,” says Greg Feldman, founding partner at Wellspring Capital Partners, which owns Dave & Buster’s, Checkers and Rally’s. “We are on the other hand builders, and builders with management.”

Wellspring, which is based in New York, currently is looking to sell itsDave & Buster’s chain, which Feldman says has more than doubled its EBITDA in the two years since the restaurant operations were purchased for about $375 million in early 2006.

Feldman says private-equity firms often get lumped in with hedge fund activities, but in reality are very different types of investors. While a hedge fund may typically “agitate for change” at a company it invests in, private-equity firms typically complete “friendly deals” with the support of shareholders and management.

The personality of a private-equity firm is just one aspect restaurant operators should pay careful attention to when considering deals, experts say. In this cautious environment, operators need to be even more careful who they partner with and why, says Steve Carley, chief executive of El Pollo Loco, a 389-unit fast-casual chicken chain based in Costa Mesa, Calif., that has been owned by two different private-equity firms.

“It’s not one size fits all,” he says. “You want a partner that has a longer-term perspective, not one that is in the buy-and-flip mode. They also need to understand the cyclical nature of the business, more so now than ever.”

He adds that restaurant entrepreneurs looking for funding need to remember that giving up equity is the same as giving up control. While private-equity firms are still the go-to for funding, even in this environment, repercussions are part of any deal.

“Startups can’t forget that,” he says. “If you sell a big piece of your company, and if things aren’t going well, the controlling shareholder has the right to make changes, and that often includes management changes.”

Still, the level of financial expertise most private-equity firms possess can definitely come in handy, Carley says, even though monthly or weekly meetings can be difficult and time-consuming. Operators will benefit from the discipline, he says.

In addition, the “freedom of movement” operators are given by any private-equity sponsor is directly proportional to the concept’s financial performance and its ability to meet targets, Carley says.

It is Sentinel Capital’s Lobel who says it best when describing the relationship between a private-equity owner and a restaurant executive.

“If we invest in a company, and the management team demonstrates that they are in need of close supervision, we unhappily provide that service,” he says. “But if they thrive on autonomy, and they are not in need of close supervision, we are very happy to subject ourselves to be supervised by them.”

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