While private equity and franchising have a chequered history, executed properly, there can be ample benefits for incoming brands
“Greed is good”, is the phrase that made legendary the part of Gordon Gekko, star of Wall Street, the 1987 blockbuster that marked an era in the history of corporate America. Who did not want to be that almighty being, dressed as a modern emperor, and played by Michael Douglas after watching that movie? I did, and if I had to bet, I’d say you did, too.
Beyond fiction, though, the truth is that since the year 2000, the global investment capital industry has made a concerted move towards emerging markets, as economic growth in the region boomed in relation to that of the developed world. And beyond China, India and Eastern Europe, Latin America represents an opportunity yet to be discovered. Brazil, for example, received about two-thirds of private investment in the region in the last decade. However, few know, for example, that in that same decade Peru was the first Latin American country in private capital investments in relation to its GDP, and the 13th worldwide; while Chile was the 21st and Colombia the 24th.
“Beyond China, India and Eastern Europe, Latin America represents an opportunity yet to be discovered”
On the other hand, only a handful of the 50 largest private equity firms in the world in assets under management have set foot in our region. Our countries certainly represent a great opportunity for the world’s private capital pools and their managers, especially since the majority of the regional players do not have much domain expertise and, therefore, are unable to create value through true active investment, and this just means more risk. Today our nations enjoy a legality that has been increasing transparency in the way business is done; an essential component for good governance.
And whether we talk about buyout strategies, venture capital or even growth equity, the key issue here is to create value. That is value beyond simply improving the operating profit or EBITDA of a company through financial engineering, which is not creating value. Value is created through active investment; this is the process of changing effectively the direction of a business or to build one. And in the case of a young or mature company, both share a common challenge: scaling in conditions of uncertainty and with limited access to capital, which is a challenge that’s not foreign to the franchise industry. In this sense, another shared factor faced by these industries is risk. The challenge here, I am convinced, is to learn to manage it instead of just measuring it.
The rise of private equity
The reality, however, is that there aren’t enough success stories in Latin America in order to draw a road map for the food and beverage, retail and B2C services categories, which are the most obvious franchising categories. There is, however, the necessary information on investment capital in the American franchising industry to project its success in the Latin American market. And from it, we can learn that risk is good only when it is calculated and that specialization pays, that financial engineering is more useful in Excel than in the streets, and that the size of the investment vehicle is inversely proportional to high returns.
Inefficient markets can be highly attractive to those who have what it takes to capitalize on them; that is, more than “simply” money. On the one hand, private equity would give our regional systems access to new sources of capital, deep expertise in management and corporate governance, and a global network. On the other hand, this access could undermine the fundamentals of the franchise system: its culture, still developing in our market, is highly vulnerable. This risk, I think, is latent not only to many franchisees who once felt part of a “family” and now feel they are simply a “number” but to many franchisors who simply aren’t prepared for, after 20, 30 or 40 years at the head of their small empires, giving up control and to start reporting to professionals in other disciplines who know little or nothing about their particular business.
“Global investment firms are part of a process of consolidation of the American franchising industry”
In recent years, the appetite of large and medium-sized U.S. and global private equity firms has increased dramatically. And why is the franchising industry so attractive to the private equity industry? Well, there are several reasons. The maturity of the franchise sector in the American market, its proven business model, its long-term relationships with franchisees and its recurring revenue streams make institutional money want to flock into it. This is not only in the lookout for greater profitability but for more transparency since due diligence processes around professional franchise systems are significantly simpler. Nowadays, global investment firms are part of a process of consolidation of the American franchising industry, which shows us an interesting path for the future of the Latin American industry; a highly fragmented one. And while the current process of professionalization in the industry should take Latin Americans 15 to 20 years, I think this is effectively the path.
Two worlds collide
The first step on this path, however, is to understand the potential dynamics and synergies between these two fantastic and complex industries in front of us, franchising and private equity. In the last decade, the Latin American capital market has witnessed a special appetite for restaurant chains, retail stores and services suppliers in an unprecedented boom of M&A operations. And amid this maelstrom, many finance experts have realized that selling grilled chicken, clothing and accessories, or basic and higher education, was not so easy. After billions of dollars invested, it became clear that things don’t work on the street like the way they do in Microsoft Office. Surprise! And if you are going to play the game with someone else’s wallet, I suggest you ask yourself questions such as: what is the real scalability level of the concept? How much is the potential and minimum critical mass of the system in my key markets? What processes do I need to develop and adapt to ensure consistency in the consumption experience throughout the chain? With which categories should I build the foundations of my portfolio?
These are some of the questions that will allow you to evaluate the merger or acquisition of a business not only in past and present terms but also in future terms. It is clear that what matters is money, but money has a price and it is not always the same. What type of financing should I aspire to? When should I look for leverage?
Finally, what is the history of complicity in the American private equity and the franchising industry? The reasons for capital pools to use the franchise system are obvious: the franchise allows a business to grow rapidly while avoiding the dilution of its founders and investors. On the other hand, franchise chains usually have the type of cash flows that are attractive to private and institutional investors. And what is the history of these industries in Latin America? Well, certainly, one yet to be told. And this is the opportunity, to be the stars of this story that, even without it having started, it has already purged more than one makeshift business. Because franchising or private equity do not have to be exclusive strategies; they are, rather, complementary and synergistic mechanisms.
“Franchise chains usually have the type of cash flows that are attractive to private and institutional investors”
However, I also believe that the discovery of this opportunity as a lucrative leverage vehicle for the franchising industry is a double-edged sword. On the one hand, access to capital can help a brand grow rapidly and offer its founders deserved exits. On the other hand, private equity is, by definition, short-term capital and, as such, requires quick departures and decisions that may not always put forward what is best for the system and its franchisees at the present time. At the end of the day, it is about the risk you are willing to take to achieve your goals, and how well you know the tools at your disposal so that you are one of those who create value instead of destroying it.
THE AUTHOR
Fernando López de Castilla, CFE is the founder of Grupo Nexo Franquicia – a Latin American franchise consulting and international brokerage firm.
