Franchising Remains a Safe Bet for Private Equity Investments Post-COVID-19

When the year began, markets were enjoying all-time highs. Private equity investors were being aggressive in negotiations, as they had increasingly been over the past decade. Then came the coronavirus pandemic, which slowed and in many cases altogether shut down businesses across sectors and industries, and the private equity industry is no exception.

“Up until the coronavirus crisis, the market had been strong. There was a lot of capital out there, which was driving up valuations in addition to cheap financing. It got to the point where people were moving down to smaller, more emerging growth purchases because the big targets were being exhausted. It was an aggressive deal environment,” said Erik Herrmann, partner and head of CapitalSpring’s restaurant investment group.

Now, of course, everything has changed. It remains unclear how long many businesses will be forced to close their doors, and the economy continues to slide downward. However, while it’s not closing many deals right now, the franchise industry will likely remain attractive to private equity investors on the other side of this crisis.

“What’s attractive about franchise business models to private equity firms is that they’re much less capital-intensive. If you have a model that’s sellable, meaning you can effectively sign up franchisees, then it’s something you can get exponential growth from with a minimal investment,” Herrmann said. “That’s a key driver of why people find the franchising industry to be attractive from a financial standpoint.”

In addition to franchisors, private equity investors are likely to find franchisee-owned businesses attractive as well. According to Herrmann, “The average franchisee is growing in terms of unit count. If you have the ability to buy into a platform and embark on a series of acquisitions to create value, that’s also attractive from a private equity standpoint.”

However, it will likely take a while for investment firms to start considering their next moves. Herrmann added, “Right now, most people are focused inwardly on their portfolios given the massive disruption we’ve seen across most industries. Any industry that isn’t deemed ‘essential’ is getting crushed. But with that being said, there are going to be interesting opportunities that grow out of this”

These opportunities are still up in the air, given that nobody knows what’s around the corner and the fact that many companies are not expected to survive the coronavirus crisis. But Herrmann is predicting that the biggest changes that the private equity industry will see include risk pricing and financing costs massively resetting. He’s also anticipating some big deals on the other side of this despite the setbacks.

“If you look at massive dislocations in the past, some major investments have come out on the other side,” said Herrmann. “People are generally looking at this and saying that if you have capital, there will be interesting opportunities that emerge after a few months when things settle. But I think it’s very much a case-by-case situation depending on the fund, their strategy and their sector. Some sectors are in for a longer recovery. It might be eight months or so before we get to normalcy in certain pockets of the economy.”

In order for franchisors and franchisees to remain a safe bet for private equity firms on the other side of the crisis, Herrmann recommends closing any gaps and focusing on communication.

“What we’ve seen is that there are varying levels of performance across the country. Some brands are slower to respond while there are others that are way ahead of this,” Herrmann said. “That’s the learning — responsiveness is different from concept to concept. It’s important to have tight alignment between franchisees and franchisors. That will determine how you optimize and survive on the other side of this thing.”