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PUBLIC, PRIVATE, PARTNERSHIP?

by Dr Callum Floyd,
last updated 25/08/2017

Dr Callum Floyd discusses the impact of private equity and listed company ownership on franchisors and franchisees

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Most franchise companies start in private ownership. They’re often founded by an individual or a small group or partners, and in many cases never even planned to become chains. But the success of an individual business can lead to the opening of a second or third, and before long someone will realise the opportunities that franchising can offer for rapid expansion.

Financially a franchisor’s business, if structured correctly and with full market penetration, can develop a considerable earnings platform and become a valuable business asset. What happens then? Well, some franchisors will continue growth and development of the company through private ownership and look (based upon their own capacity) to consolidate the business or seek expansion opportunities like international franchising or acquisition opportunities.

But others will take things a step further and look at what outside investment can bring. This may be initiated by the franchisor or be the result of an approach from a Private Equity or Public Listed company. For the franchisor, there may be the desire to sell anything from a minority stake to all of their shares – often for a good valuation. From a Private Equity or Public Company perspective, there will be the motivation of a strong potential investment return.

History illustrates strong interest from Private Equity and listed companies to buy franchise brands. And while some companies go straight to Public Company ownership, Private Equity investment often occurs first in franchising. Private Equity often happens first because the franchisor isn’t sufficiently large or prepared to publicly list, or Private Equity interests see strong investment potential in the business. This is not to suggest Private Equity is small: Roark Capital, which specialises in franchising in the USA, has many billions in assets while others are larger still.

What’s the difference?

Private Equity involves individuals or non-listed ‘private’ companies investing in the shares of privately-owned companies, or, sometimes listed companies they intend to take private.

Publicly-listed companies allow individuals to buy or sell shares via a share market, like the NZX in NZ and the ASX in Australia.

Private Equity

In NZ, Private Equity examples include Waterman Capital’s recent ownership of both David Reid Homes and Guthrie Bowron franchisors, and, Australian Allegro’s current involvement in the purchase of Carpet Court in NZ.

Private Equity is typically focused on generating clear investment returns over a three to five-year period, but can hold much shorter or longer. Sometimes, a Private Equity company may buy a publicly listed company and take it (eg. Burger King) private, and then relist it again at a future date.

More often, Private Equity will buy a franchise system with the intention of growing it for either private sale, or ideally taking it public with greater associated value (based on an earnings multiple).

Mike Pero Mortgages is an example of the transition from founder-owned, to Private Equity to Public Company listing. A Private Equity investor (George Gould) purchased 90 percent of Mike Pero’s 1990-founded 35-franchisee strong franchisor business for $13.5m in March 2004 – valuing the total business at $15m. Three months later, the company successfully listed (it was oversubscribed) with a valuation of $25m.

Both owners sold 40 percent of their revised holdings as part of the IPO, leaving Gould with 54 percent and Pero with 6 percent. That provided both with combined shares and cash proceeds of the IPO totalling $22.5m (Gould) and $2.5m (Pero), respectively. In investment terms, the IPO process was very successful for Gould, netting circa $9m on an original $13.5m investment, while Pero’s total proceeds and capital was $16m.

Today, Mike Pero Mortgages is no longer listed as a separate company. In fact, just two years later in 2006, it was taken over and delisted by two companies - and is now owned by only one of those companies (Liberty Financial). While bearing his name, Mike Pero is no longer a shareholder or director of the Mortgage business. However, he does share ownership with Liberty Financial in the separate Mike Pero Real Estate Company.

Public Listing

There are, of course, different routes and different motivations that lead a franchisor business into being publicly listed.

Single brand examples of listed companies include Burger Fuel, Cash Converters and McDonalds. Well-known diversified multi-brand examples are Veritas, owner of the Mad Butcher and Nosh until recently, and Retail Food Group, owner of 12 food & beverage chains (and other related businesses), including Brumby’s and Michel’s Patisserie.

The most romantic route is, of course, the individual franchisor taking their own brand public. Here the company, like McDonald’s in 1965, or Burger Fuel in New Zealand in 2007, establishes a newly-listed company that is not only branded the same as the chain but the founders or key owners continue to maintain both high levels of ownership and management input into the business.

Sometimes, by contrast, an already-listed company hunts and purchases an established franchisor business, as Veritas did in 2012 with the 35-store Mad Butcher chain. Other examples in New Zealand include Retail Food Group separately purchasing the New Zealand operations of Esquires in 2011 and The Coffee Guy in 2012.

There are also many franchising and licensing chains locally whose ultimate owners are a publicly listed company – eg. Contact Rockgas (owned by Contact Energy), SuperValue (owned by Woolworths) and Placemakers (owned by Fletcher Building). It’s not just franchisors that are publicly-listed, either – some franchisees are listed, like Restaurant Brands, which is the NZ master franchisee/licensee for KFC, Pizza Hut, Carl’s Jr. and Starbucks.

Advantages and disadvantages

There are many potential advantages and disadvantages of Private Equity or Public Company scenarios, for franchisors and franchisees alike. Here we focus on the public listing scenario, because of the breadth of potential issues – both positive and negative.

The Pros of Public Listing

There are many franchisor positives – provided the company is solid, and performance is predictable and improving. For the franchisor, a great advantage is the higher valuation multiples often associated with publicly traded companies. This means the franchisor (assuming attractive listing criteria) may be able to sell some of their shares in the business lucratively and, potentially, raise additional capital to retire debt or fund expansion. Arguably, the newly-listed business may also benefit from increased brand equity due to a greater public profile and new insights from market analysts (assuming they’re big enough to warrant coverage). But probably one of the biggest benefits that could be argued is the better governance and planning, and potentially better management, that should be associated with a publicly listed company.

From a franchisee viewpoint there are also potential positives, although it is debatable how well these have been realised in some of the above examples. The listing may deliver needed capital for improvements in infrastructure and support, better governance and planning for the system, and greater brand recognition. Public listings often also promote growth initiatives that should, in turn, help improve franchisee returns.

The Cons of Public Listing

There are also potential disadvantages associated with a public listing. From a franchisor point of view, first is the often considerable cost, both monetary and in terms of time, of preparations for a public listing. On an ongoing basis, there are much higher ongoing governance and compliance costs (eg. directors, advisory, auditing, etc) and the pressure of regularly reporting consistently-improving company results. The latter, in turn, often leads to a short-term, rather than important long-term, focus with resulting problems for franchisors and franchisees.

For franchisees, other potential disadvantages include:

- The original franchisor dilutes their holding and influence. This can also increase uncertainty at a personal level. Management attention may be diverted to the business of being listed rather than operations.

- There may be a drive for increased franchisor margins and cost-cutting of support services, both at the expense of franchisees.  

- The culture can become more legalistic than relationship-based, leading to a heavier-handed approach. This is bad for franchisee relations and satisfaction.

- Bad investor sentiment can impact end-user customer sentiment. Customers may be less sympathetic to a perceived large (public-listed) versus small private company.

- Uncertainty of future ownership and emerging diversification.

- Emerging diversification, or the franchise brand being one of many, can lead to a lack of sufficient focus and resources.

The most obvious challenge for franchisees is a situation where the franchisor company gets bought by a diversified company that neglects and fails to invest in the brand, system and franchisees. This is what Tom Potter, the 1987 founder of Eagle Boys, claimed happened after he sold a majority stake in the business to NBC Capital in 2007 and was removed as a director and CEO. At its peak, the company had 340 stores in Australia; by 2014, franchisees asserted NBC Capital had stopped print and media advertising since purchasing the business and store numbers had halved. Administrators were finally appointed for the franchisor business in 2016 and Pizza Hut purchased the business with intentions to migrate many stores to their brand.

The conclusion and promise

To date, in New Zealand anyway, the promise of public listings or ownership by publicly listed companies to investors and franchisees has unfortunately often not delivered to expected levels – particularly for franchisees.

At a private level, New Zealand franchising has delivered some wonderful success stories, with many franchisor companies growing an impressive network, profit base, and positive stakeholder base – particularly franchisees. However, New Zealand is yet to see a large-scale franchise operation grow from private ownership to publicly-listed ownership and then truly take performance for the original owners, franchisees, and investors to another level.

I believe this is in part due to the size of New Zealand, whose scale limits the potential value of a domestic franchisor, and our proximity to outside international markets. I believe it is also in part due to the nature of the franchise model itself, in that franchising reduces the constraints normally associated with limited capital that make public ownership so attractive in other areas.

This is not to suggest it can’t happen or it won’t happen. The challenge remains for a strong NZ-founded franchising brand to publicly list their operations, raise capital and use that capital to assist successful international development – all whilst continuing to improve the investment and support model of their existing franchisees. As companies like McDonald’s and Coca-Cola have proved, it can be done ­with outstanding long-term returns for the franchisor, franchisees and investors alike.

 

This article was first published in Franchise New Zealand magazine Year 26, Issue 1

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