A tasty proposition

In May, two of the US’s most iconic restaurant chains wound up in the hands of private equity firms.

First came Golden Gate Capital’s $2.1 billion purchase of Red Lobster from Darden Restaurants, followed a week later by Sentinel Capital Partners’ acquisition of TGI Fridays alongside TriArtisan Capital Partners.

While M&A activity in the restaurant chain industry has remained relatively flat since 2011, private equity funds are claiming a larger slice of the pie. Private equity transactions accounted for 35 percent of all restaurant chain M&A in 2013, up from 27 percent in 2012, making private equity the largest buyer type last year, according to a recent study from investment ban-king firm JH Chapman Group.

One reason for the increased interest is the overall improvement in the US economy.

“You have an underlying macro-economic trend working in your favour these days, with unemployment coming down, albeit slowly, and income growth going up, albeit slowly,” says Anthony Polazzi, managing director at Sun Capital Partners. “Those two things both provide some tailwinds.”

Sun Capital has been investing in the restaurant sector for over a decade, and has 10 restaurant chains in its current portfolio.

“With leverage being available the way it is, and with the economy performing the way it is, it’s not surprising to me that there would be a lot of interest in the consumer sector, like restaurants,” Polazzi says. “We saw the same dynamic in 2006–2007.”

Another reason private equity activity in the sector is heating up is the renewed popularity of initial public offerings for restaurant chains.

“IPOs in the restaurant sector have very strong performance, so that’s driving some interest in the sector,” Polazzi says.

In April, Brentwood Associates portfolio company Zoe’s Kitchen claimed the first restaurant IPO of 2014, pricing at $15 per share before closing 65 percent up at $24.72. Brentwood had reaffirmed its confidence in the sector the previous week, acquiring 21 additional Taco Bell franchises for portfolio company K-MAC, one of the largest Taco Bell franchisees in the US.

For Brentwood, the fundamental characteristics of the restaurant chain model help to make investing in the sector such a strong proposition.

“With restaurant chains, you have more of that customer frequency, which is important for driving sales,” says Brentwood managing director Rahul Aggarwal. “If you have a loyalist or a big fan of your concept, they can dine with you multiple times a month.”

Like any business, however, restaurant chains do come with their own particular risks.

“For these restaurant chains, if you have 100 stores, it’s 100 businesses that you’re trying to operate,” says Polazzi. “The ability to get execution across the chain on a strong level and invest to drive that execution is what makes it both a tough business to operate – but also one that, if you get it right, has a lot of real upside.”

Other issues such as commodity prices and weather can have an adverse impact on business, says Aggarwal.

“There’s a lot of escalation right now going on in commodities, partially driven by escalation in beef and cheese prices,” he says. “[But] now that we’re through the weather, I think everybody’s optimistic that the commodity stuff is going to improve.”

And while some bricks-and-mortar retailers are losing market share due to the rise of online businesses like Amazon, the restaurant sector remains on steady ground, according to Aggarwal.

“Until Amazon figures out how to drone a hot meal to your house, we’re going to be OK in the restaurant space,” he says.