Franchisor consolidations after COVID-19

For some time now, the world of franchising has seen a craze for consolidation, resulting in families of franchisors in the same or related industries. But once COVID-19 passes, things will be different. Consolidations will continue in an opportunistic way, but will be moderated by a recognition that consolidation can be risky.

I. The history of consolidation

Franchise systems can be attractive targets. The most desirable franchise systems have strong financials such as healthy and predictable revenue streams, cost controls, corresponding profitability, superior debt to equity potential, and great return on investment (ROI). Franchise systems also typically come with positive drivers for expansion, including a proven business concept and model, a growing market, few or manageable regulatory hurdles, a strong trademark, healthy relations with franchisees, untapped potential (such as new markets and technological efficiencies), and a good and stable management team. Attractive targets also sometimes provide synergies with other already owned businesses.

The acquirers of attractive franchise systems are commonly private equity (PE) firms. Other common acquirers are strategic buyers, who are looking to buy others in their industry.

II. Types of consolidations

Both types of acquirers – PE firms and strategic buyers – can eventually amass a “franchisor family,” and many have done so. The synergies that derive from such consolidations are a natural force that drives this result.

The consolidations, however, are not all the same. The four circumstances detailed below indicate the different types of consolidations and the perceived potential to achieve greater profitability through synergies.

• Acquisition of direct competitors. Some acquisitions are of franchisors that compete practically head-to-head. While management may draw appropriate distinctions among geographic footprints, customer bases, marketing strategies and more, the essence is that these are the same type of business and, therefore, are perceived as being capable of deriving the most synergy from a consolidation. Think of affiliated car rental or real estate brokerage businesses operating under different brands. The synergy often derives from efficiencies of eliminating or combining overlapping functions, such as the merger of two similar departments into one, or the enhanced purchasing power of buying for two systems instead of just one.
• Acquisition of indirect competitors. Some franchisor families compete only indirectly. They are arguably in the same industry segment (eg, restaurants), but, because of the different product offering (chicken vs pizza), delivery method (eg, dine-in vs take-away), or other characteristics, they are most appropriately perceived as only indirectly competitive. In a market generally best defined broadly (eg, as the restaurant industry, the automotive repair industry, or the hotel industry) these segmented businesses are only indirectly competitive because they provide different product or service offerings. Such businesses, when consolidated, offer synergies that can be significant, but not as potentially significant as those that compete directly.
• Acquisition of complimentary franchisors. In consolidating franchisors, some acquirers prefer collaborating franchisors which offer complementary businesses, instead of direct or even indirect competitors.  For example, the owner of a franchise system that services residences would acquire franchise systems that can service other homeownership needs. When consolidated, these businesses offer synergies that can be almost as synergistic as those that are indirectly competitive.
• Acquisition of unrelated franchisors. There are also many buyers of franchisors that do not seek the synergies associated with “franchisor families.” These buyers are often opportunistic and see value even without maximizing synergies. While there can be some synergies as a result of owning multiple yet diverse types of unrelated franchisors, those synergies are likely to be less than those associated with the directly competitive, indirectly competitive, and complimentary types described above.

III. Reasons for consolidation

Increased or enhanced economies of scale, and greater synergy, can be achieved by
putting several franchisors under one roof. Doing so provides opportunities to pool resources. And one of the main indicators of an ability to pool resources is the degree to which the combined franchisors are similar. The more similar the franchisors, the greater the ability to pool resources, the greater the economies of scale, and the greater the synergies.

IV. Consolidation increases risk

Consolidation and the synergies it provides can be, and often is, a winning strategy. The desirability for synergistically positive results has led to unprecedented waves of consolidation, including through auctions that have been called “feeding frenzies” and at which franchisors sell for high multiples of EBITDA. But, along with the synergistic rewards comes risk.

These risks have come to the surface with COVID-19. Entire industries have been decimated, including many in which franchising is commonly used. Some examples are restaurants and bars, hotels, amusement and entertainment venues, travel planning, car rentals, personal service businesses, and fitness clubs.

Franchise families that compete directly and indirectly typically have less diversification than franchisor families made up of complementary franchised businesses or unrelated businesses. During pandemic-related shutdowns, a portfolio that had complementary franchisors or franchisors in diverse industries had some losses mitigated. Of course, the mix matters and exceptions exist: for instance, portfolios containing a mix of restaurant types found their dine-in restaurant losses mitigated by take-out restaurants.

V. Lessons for the post-pandemic world

The post-pandemic world will no doubt offer many opportunities for greater consolidation of franchisors. There will be sales of failed franchisors, fallen franchisors, bankrupt franchisors, and insolvent franchisors. Those PE firms with “dry powder,” and strategic buyers with adequate cash, will gain market share and greater synergies by buying up prior competition. The temptation to acquire industry competitors will be significant – especially if the price is right.

But COVID-19 has illuminated a risk that previously lurked in the dark. As we move forward, diversification and correlation concerns will move to the forefront. Sponsors will look across the portfolio to understand how a new acquisition might make investors especially vulnerable during a crisis; for example, investors with directly competitive franchisor portfolios might consider acquisition of unrelated franchisors in order to diversify and, thereby, mitigate risk at the cost of lower synergies.

This vulnerability analysis is not just theoretical.  New crisis-like market conditions can be readily imagined, such as another COVID-19 wave, the arrival of a new pandemic, or even industry-focused headwinds, such as the effect on auto repair franchises due to the growth in electric vehicles.

Buyers should ask whether the extra reward that comes from the economies of scale and synergy of consolidating same or similar types of franchisors is going to be worthwhile in light of such increased risk. This analysis may also lead some owners of consolidated franchisors to not only conclude that further consolidation in a non-diversified manner is too risky, but also that the current portfolio is too risky and that some divestiture of same or similar businesses needs to take place.

VI. Our final thought

The appetite for franchisors, and the synergies that they bring to the table, will clearly continue. This will likely mean a return to traditional M&A activity, but next time with a greater understanding of the need for diversification or at least the risks of running an industry-concentrated portfolio.

If you have any questions regarding this development, please contact the author or your DLA Piper relationship attorney.

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This information does not, and is not intended to, constitute legal advice.  All information, content, and materials are for general informational purposes only.  No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.