ON THE RECORD

Private equity investors have recently been more bullish about the restaurant industry. to what do you attribute this enthusiasm?
Private equity firms – and investors generally – were historically very skittish about investing in restaurants, because there is a high failure rate for new restaurants. However, that is really only the case in start-ups. Once you have an established chain with an established business model and operations, it is fairly uncommon for restaurants to fail, and people have started to realize this. Also, restaurants tend to generate cash and don't consume a lot of cash in their operations, which is attractive for private equity funds investing in a leveraged environment. In the current economic cycle, prices for publicly traded restaurants are improving, so there are also opportunities for multiple arbitrage by buying privately held restaurant businesses and taking them public.

What is Castle Harlan's approach to investing in the restaurant industry?
We have been active in the industry since 1988, when we made our first investment in Morton's steakhouses. From one point of view, investing in restaurants is no different than investing in any other type of company. They first have to meet our overall investment criteria, such as having differentiated products or services, a sustainable competitive advantage, predictable cash flows, and history of demonstrated success. Differentiation is a little harder to define in this industry, but it is in every one of our investments. With restaurants, we are competing with everyone else in the food industry, so if someone is looking for a particular kind of meal, we have a differentiated strategy and have a differentiated product. Morton's was the premier steakhouse in the US when we acquired it. McCormick & Schmick's is the only nationwide, fresh, premium seafood restaurant chain. Perkins is renowned nationally for having the best breakfasts. So we always look for a point of differentiation.

Which specific areas within the industry are particularly in demand right now?
It has shifted a little bit. Private equity deals, over the last several years, tended to be concentrated in casual dining, where you don't have to dress up but can still have a sit-down meal. That has shifted a little more toward restaurants that offer a higher end experience and are a little more pricy. In private equity and in the stock market, people are beginning to capitalise on a more high-end experience than in past. If you look at the public markets, high end retailers – such as Tiffany's or Nordstrom's – are tending to do better, and you may be seeing that factor in the restaurant sector as well.

What level of interest are you seeing from corporate investors and hedge funds in this space?
restaurant company may buy another chain as a new growth vehicle. You see that from time to time, but not nearly as much as you used to. Corporate America is not diversifying into restaurants as much as it is getting out of restaurants. We haven't seen much activity from hedge funds; part of this may be because it can be tricky for hedge funds to invest in restaurants, because management is particularly crucial in this business, and because it is difficult to turn around distressed restaurants.

where do you see the market going in the next 12 months?
The sector is doing well because the economy is doing well. Rising gasoline prices can be a problem in that if people are spending more money to fill up their gas tanks, then their wallet becomes a little lighter, and they might not eat out as much. The spike in energy prices is also putting a squeeze on margins for a lot of companies, and our companies are adopting better practices to save on electricity costs. However, year after year, the percentage of dollars spent on food in restaurants versus groceries tends to go up, driven in part by so many women entering the work force. So even if the economy has troubles, you're going to see more food dollars go into this sector.