Season 1, Episode 26: Arbitrage in buying and selling franchises



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Welcome to the Restaurant Boiler Room, episode 26. I'm your host, Rick Ormsby, managing director at Unbridled Capital. Today in the Boiler Room, arbitrage when buying and selling franchises, creating passive income in a business sale from 10-31 investments, Papa John's and Pizza Hut commentary for Q4, innovation and election year sales thoughts for restaurants in 2020, and some Unbridled Capital year-end deal closing announcements.

The Restaurant Boiler Room is a one-stop shop for multi-million dollar merger and acquisition activity and financial complexities affecting the franchise restaurant industry. We talk money, deals, valuations and risk. Delivered to the front door of franchisees, private equity firms, family offices, large investors and franchisors on a monthly basis. Feel free to find our content at Unbridled Capital's website, at

Now, let's enter the Boiler Room. Our first topic for today is arbitrage when buying and selling franchises. And I am using an actual example, but kind of using it in a theoretical way here, about what I saw recently. We helped a franchisee, a second-generation franchisee sell his business recently.

I know he made a ton of money in the transaction, and it wasn't just a kind of a buy-and-flip type of an attitude. This is someone who intended to be with the business a long time, but when he saw the prices associated with the MNA market being so strong right now, he asked us to do a valuation of his business, and then we kind of ... Eye-popping results at how high the prices had come. And he decided to sell, and the transaction's completed. And he's kind of had some generational change, I think, his in his wealth.

But I'm going to use this scenario to kind of go through an example of arbitrage, of what family offices, private equity folks, and franchisees are experiencing as they consolidate and roll up franchise investments. Okay? So let's take the example of a KFC restaurant.

And let's say, for now, that the KFC restaurant does $1.2 million in annual revenues, and the real estate's attached with it. It's probably got average operating margins, but since it's a one-unit KFC operator, let's say, that's sitting in the middle of, let's call it Iowa, somewhere. They probably aren't the best operator. Maybe they have Pre-GNA, EBITDAR margins in the 16 to 17, to maybe 18% range, which is three or four percent lower than maybe the national average for KFC, and many franchises like it.

And they have a piece of real estate that's kind of sitting around in a small town, and they're operating. In that kind of scenario, since it's a very slim market for selling that store, many franchisees could only realize maybe a million, to 1,000,002, to 1,000,004 in the sale of their business and real estate at one time.

It obviously depends on more than just the sales, EBITDA and real estate values and all kinds of things go into when determining a valuation. But let's just say, because of the lack of marketability, and the fact that there's not that many one-unit KFC buyers, or other franchise buyers across the country anymore, that the marketability is otherwise pretty low.

So they sell the business to, let's call this person Joe Smith. And Joe Smith buys this KFC, in this example, for 1,000,002. And again, it's 1,000,002 in sales, but he buys it for 1,000,002, and he gets the real estate alongside it. And then let's say Joe Smith goes to the neighboring town, and he sees another one-unit operator, and he can do the same thing. And he buys this same, let's say it's the same sales volume. Let's say it's 1,000,002. And let's say buys that one for 1,000,002.

And then, and then let's just say he does that four or five or six times, and he ends up with a business that he's paid, let's say he's got seven units, and he paid, let's call it $8 million. Okay? For those seven units.

And let's say his business is doing now eight and a half million dollars in sales. Okay? And he's sitting there operating this nice little business. He can put an area coach in place, can probably remove himself from the day to day four o'clock in the morning phone calls when things are going wrong. Not entirely, but a little bit, because he's got a little bit more scale. And let's say he's a good operator. Joe ends up pushing the margins up to maybe from 16% to 20%, just because he's fresh, he's younger, he's newer. He hustles, he's got the benefit of a better management because he's got a bigger business.

He does all this. And Joe then comes to Unbridled Capital and says, I want to sell it. Right? And so, because he's got the benefit of scale, and his business is now appealing not just to a neighboring franchisee who doesn't want to pay a lot of money, but to a larger audience across the country, Joe's business itself might be worth $5 million, and his real estate could be worth as much as 10 or $11 million, now.

So Joe has created a situation where he bought a business for, what did I say? 8 million bucks? And he has a business now that might be worth 16 to 17 million, potentially. Let's just say it's 15 to 16 million. And while he has accumulated these stores, he's obviously bought them with debt, and paid some of the debt down. So even though he bought them for $8 million, he might only owe 6 million on them, and he sells them for 15 million. And Joe walks away with 9 million bucks.

In that particular situation, that's called arbitrage, right? You can buy fragmented, smaller businesses for a lower price and a lower multiple, and a lower cap rate on the real estate, from sometimes an unsuspecting sellers. And then you can consolidate, and you can build a larger system that is appealing to a larger audience.

You can improve the margins, you can do several things like that. And then, all of the sudden, you've got a business that you can sell for double the money. And that's, whether it's Joe who starts off with one unit and sells eight, or whether it's family office XYZ, who starts off buying a platform investment of 13, or 15, or 25 units, and then grows the same way in chunks of three to five units, and all of a sudden has a 70 or 80 unit business. The same kind of principle holds.

And this is how, not only these individual's firms, private equity firms, family offices, all the whole lot are getting returns. They get, obviously, a yearly return on the capital that they have invested. And then if they look to monetize the prices in a sale, they get the benefit of higher multiples through a bigger audience, through the selling of a consolidated and larger business. Okay? Pretty cool, huh?

Okay. Our second point is 10-31 investments. So in creating passive income, we had another transaction I thought it was really cool. So it's an example of not just selling someone's business, but thinking about using someone's real estate to create generational wealth and passive income in the sale of a business.

Okay? So in this particular case, we have a franchisee who owns 10 restaurants, let's say. And in these 10 restaurants, let's just say, theoretically, he owns, I don't know, let's call it all 10 of the real estate underneath these restaurants. So when we do the valuation, we look at the valuation of the business, and obviously the valuation of the real estate too. In this particular case, the franchisee, instead of selling the business and real estate to one buyer, they decide to sell the business and keep the real estate. And in this case, Unbridled Capital helps them find a buyer for the real estate who's a separate buyer than the buyer of the business.

If we go forward in this example, the buyer then, pardon me, the seller then sells the real estate to a separate party, and does what's called a 10-31 exchange. Where, in a certain short window as defined by the IRS, you can do a like kind exchange, and you can take the money that you get from the sale of the real estate, and you can place it in another real estate, like kind real estate investment, without having to pay the taxes on the exchange of the selling and buying of those real estate assets, if that makes sense.

And so what effectively ends up happening is, you sell, you get a big check for the real estate portion of the restaurant sale. You flip it into a 10-31 investment. You then borrow, reasonably, and rationally, and responsibly borrow some money on really attractive terms to increase your investment potential, and the pool of money you can use to go out and buy other like kind properties. And then you buy those properties on the 10-31 exchange, and put in, and have leases with those tenants.

And they're triple net leases, so you don't have to take care of insurance and property taxes, any maintenance on the facilities. And then you're sitting there collecting rent at may be a 10% return, and then you have 10% rent increases every five years. And so it's a pretty nice way ... I see this really happening a lot with younger sellers of businesses. A lot of the older sellers of businesses are just looking to sell and get out, and want to monetize the whole thing and pay the taxes on it and be done it. But some of the younger folks who maybe might be in their forties or fifties, are looking at creating lasting generational wealth that can cover their family's expenses with reliability and predictability for the next 20 years. And they are choosing, in many cases, to do this kind of a strategy.

I'll take an example of one store here. Okay? So let's say again, you have one, I mean, call it, I don't know. Call it a Taco Bell. You got one Taco Bell doing a 1,000,004 in sales. You sell the business and the real estate, okay? And let's say we value the real estate at 8% rates, and a seven cap rate. Or call it a six cap rate. Well, in this case, call it a seven cap rate.

So if you take 1,000,004 in sales, and you multiply it by 8%, you get $112,000 in rent. And if you divide that by a seven cap rate, you get about 1,000,006 valuation for the real estate in this example. Okay? So let's say you sell the real estate, whoever the buyer is, for 1,000,006. And you sell the business, I mean, just throw a number at it. Let's say it's a million dollars for the business.

The business side of it, you have to pay taxes on. Right? And so the seller and buyer, through our help, they do a negotiation of the allocation of assets to make sure it works for both sides. And obviously the seller wants to minimize the value of FFNE so that they don't have to pay recapture and ordinary income tax on a lot of the business sale. They'd rather put it in good will. And the buyer obviously has the other mentality, they want to put a lot of the value in the equipment and FFNE because they can write it off more quickly for their own tax purposes.

But for the sake of this example in this million dollar business valuation, the buyer and seller reach an alignment, the seller gets his money and he pays taxes on it at a certain rate. Based on that allocation. He gets 1,000,006 though for his real estate. And instead of paying the taxes on the real estate, he says, huh, I might consider a 10-31 rollover.

And so he takes that 1,000,006, with six months or so to identify and close on a like-kind transaction. He goes and finds a ... He starts looking at other pieces of real estate that he can buy. Maybe it's a Rite Aid in Texas, or maybe it's a Walgreens in Alabama. Or wherever it might be, and whatever it might be. And he also thinks, well, maybe I could borrow 50% loan to value, and borrow another 1,000,006 against that 1,000,006 that I'm going to be looking to invest.

So that's not irresponsible, right? He's got a 50% loan to value, that's pretty, pretty conservative. And so he goes and borrows 1,000,006. He has $3.2 million now to invest. And that 1,000,006 he borrows, he borrows at four-and-a-half percent interest rates over a 25 year period. So incredible term, incredible amortization, fixed rates. The rates are low.

And he targets a 10% return. And he goes and finds an investment at a seven cap. And he invests that $3.2 million at a seven cap, right? And then his return actually ends up being, I don't have the exact numbers here, but maybe 275 to $300,000 a year in rent, is what he gets. Let's call it $275,000 a year in rent. And his payment is only maybe a hundred thousand dollars a year in rent. And so he basically has created a situation where he's got maybe somewhere between 150 and $200,000 in rent coming in a year after his debt service in a triple net lease, that's basically like clipping a coupon or taking a check.

And if he can do this over the course of four or five properties, right? I mean, maybe he's building a portfolio that could be somewhere between six, seven, 800, 900,000, maybe even a million dollars or more in income to himself, even after paying back that debt, since the borrowing costs are so low, and the rates are so low.

And he's created a great lifestyle, right? Not only does he have this really nice amount of money coming in monthly. On a total yearly basis can cover all of their needs, probably cover the needs of his children too, potentially. But then also he has this asset that is appreciating, this real estate asset that's appreciating and getting debt paid off against it.

And so at some point in the future, maybe it's 15 or 20 years, after the rent's been raised 10% every five years, at the end of the lease, he's probably got a piece of real estate that's paid off and has a ton of value to it.

And so it's a really neat wealth creation technique for the right person who is okay deferring, taking a big gain on a real estate sale, but instead would be okay creating a lifestyle through passive income over time.

And we're seeing, again, we're seeing this kind of happen more often and more frequently in our deals as a way to protect generational wealth. And also keep, heck, I guess another comment would be, it helps the seller of this business, who ends up becoming a real estate investor, keep a little company open and run some expenses through it, and a healthcare plan, and some of the things that they do from a lifestyle basis to keep their business open and running as well.

Okay, a third piece of today was talking about Papa John's and Pizza Hut commentary for Q4. First comment is on Papa John's. I hear that the garlic Parmesan crust pizza is doing pretty well, and I think the street is generally saying, expecting plus two comps same-store sales for Q4, for the Papa John's brand. And my view is that we're hearing a lot of kind of very quiet optimism on some turnaround with Papa John's. Putting some good things in place. I hear the garlic promise on cross promotion is going really well. They just hired former Arby's president, Rob Lynch as CEO, and there's some positivity there as well.

And so, just kind of an ancillary comment that I kind of feel like. Whether I'm right or not we'll see, but I kind of feel like you're seeing a little bit of an uptick and resurgence of the Papa John's brand, and a little optimism after, admittedly, what's been a bad year-and-a-half or so for the brand.

On the Pizza Hut side, there's a new president in town. New interim president, Kevin Hochman. And I just wanted to personally congratulate him. What a fantastic guy he is. He's a KFC president, he is a smart as a whip and has got some incredible results with the KFC brand. Over five years of same-store sales results in the positive. The brand is really humming along, at better with more health and more optimism, I think, than the brands had in at least 15, maybe 20 years.

And we hope that Kevin does just a fantastic job at solving what can be a complicated puzzle with the Pizza Hut brand, that has a number of dynamic issues involved, but just a fantastic brand with so much legacy, and so much clout, and so much wonderful marketing prowess. So we hope Kevin has the most success, and we wish the best for Pizza Hut for 2020.

Now the next item here is innovation and sales declines, and thoughts for 2020. I just want to make a note. I was reading an article in Barron's the other day. And not that I have seen much from Barron's that tells me that they know a whole lot about the restaurant business. But I'll say that I was reading this article, and it kind of caught me. So one of the comments was that innovation is it going to trump discounting for 2020, and I thought that was kind of interesting.

And what they said was, they said, okay, you've got this beyond meat buzzword in the industry. Burger King's killing it with the impossible Whopper. Dunkin brands is selling a beyond sausage breakfast sandwich. McDonald's rolling out the beyond meat PLT burger. And then we have innovation with the Carne asada, with Chipotle Mexican Grill and Wendy's spicy nuggets, and a massive return of the chicken sandwich, right? With Popeye's. Just killing it with their chicken sandwich.

And then some continued work on innovation in the Yum Brand systems as well. And maybe 2020 could be characterized by a little bit of a flip of the switch away from value to innovation. Value's fantastic and always has to be a message for QSR, especially. But relying only on value is a dangerous place to be. You have to innovate, too. And I think we've gone too far in the pendulum direction of discounting, and not far enough back the other direction in innovation. So maybe that's a fair point for 2020.

And the other point of this article in Barron's, they were talking about how the election season could drag on sales. And I thought, huh, how could that be? And they use some data here to say that in the 2016 election cycle, you saw about a two-and-a-half to three point deceleration in same-store sales growth during the election time. And they said that one of the reasons they believe that happens is because of advertising, because there's much more noise and much more competition for advertising during the election cycle.

And so maybe that's something ... And not just for TV, but for digital advertising and in other areas as well. So maybe that's something to just note, I thought it was interesting to note for 2020. It won't affect us probably immediately, but might as we get into Q2 and Q3.

Okay, so Unbridled deal closings for 2019. And we had a couple of really cool deals that closed recently. One was a 32-unit Pizza Hut deal, CFL pizza, sold 32 Pizza Huts in Ohio, Kentucky, and Indiana. And the restaurants were sold to a new franchisee, who is backed by a private investor. And it was a good transaction for us. I would say that this represents closing rate of Pizza Hut transactions of 91.7% for our company.

We've taken 12 assignments in Pizza Hut, and we sold 11 of them. Pretty darn good, right? And we've sold over 500 Pizza Hut restaurants in the last 18 months. And the quote here was, "We're extremely pleased with Unbridled Capital's handling of our recent Pizza Hut sale. Rick and his team are thorough, professional, respectful, discreet, and always available. They curated a sales process that yielded results that were above expectations, and they handled and navigated the purchase agreement process due diligence, pizza hut approval, especially for a new franchisee and closing. And importantly, they're experts at managing both parts and both parties, and finding solutions to difficult problems throughout the course of the transaction."

And they congratulated us and thanked us for the work, and that was from Andy Rosen, CEO of CFL Pizza. And Andy's a outgoing president of the Pizza Hut franchise association, so it was an honor to work for him.

A couple of other deals, we recently closed 14 KFCs in Indiana and Kentucky as well, for Alice J Slusher, Inc. And we sold them to an existing franchisee, a smaller franchisee in another area of the country. And he's moving his family down to this area to operate the stores. So we certainly wish them the very best as they build this new business, and I think that's exciting.

I'll read you just real quickly. Their quote was, "It was never a question that we were going to hire Unbridled Capital when it came to downsize our business, and Rick and his team have an excellent reputation of getting the best prices and terms for KFC franchisees. And we certainly were not disappointed in this transaction." That's just kind of a snippet. They also said that getting the deal closed required patience, critical thinking skills, determination, integrity, and relationships. And that was from [Kimra Slesher 00:19:52], the seller.

And certainly that's true, all those qualities are important. As these deals become more and more complicated, time-consuming, fraught with delays, financing delays as the financing market is changing, and difficult negotiations at times with the corporations that own the franchise rights on these companies.

And then one other closing that I wanted to mention, and I'm really proud of, is 117 Pizza Huts in an eight-state region for Rage, Inc. And we sold those recently to Tasty Hut, LLC, which is a subsidiary of Tasty Brands LP, which is a private equity group out of the California area. And that was an exciting transaction. Tasty Hut is a Burger King franchisee, and now a substantial Pizza Hut franchisee, too. And they represent what we think is just a growing, kind of a meteoric trend in our industry of financial investors coming into the franchise space to buy platform investments.

Much like this 32 unit Pizza Hut deal that I talked about just a minute ago, the same way. Buy a platform investment, and much like I talked about with the arbitrage earlier in the show, come in and get this platform investment, and then build new stores, and buy existing franchisees that are in their surrounding area at lower prices, and build something of scale that could create long-term value for the investors that are behind these funds.

Here's my comment on the 117 unit Pizza Hut sale here. I said this in the release. I said, "In my humble opinion, Bob Geist of Rage is one of the big success stories in America's illustrious history of franchising. As a college kid and assistant greenskeeper at the Wichita State golf course, Bob saw, firsthand, how newborn Pizza Hut would become a global phenomenon. He chose North Carolina to develop because of its various universities, and his team grew an incredible business over 50 plus year, and this legacy should never be forgotten. And it was an absolute honor to represent Rage, and we heartedly welcomed the Tasty brands team to Pizza Hut."

Cool transaction, really. 117 Pizza Huts. Bob Geist, one of the original franchisees, who as a young kid looked across the street off of Wichita State's campus in Wichita State's golf course, and saw on a Friday night how many of these young college kids were lining up to eat pizza and drink beer at the original couple of Pizza Huts.

And he says, heck, if it's working here at Wichita State, it's going to work in a state with a lot of universities, right? And so he chose North Carolina, and built out a business over 50 years, that started from scratch. And that's why I'm so passionate. It's an example of why I'm so passionate about the franchise industry.

And I don't care if it's automotive franchising, gyms, restaurants, I mean, tax practices, whatever it is. I see so much of the American dream that kind of just resonates and kind of bubbles through all of these businesses, real success stories of entrepreneurs who went out there, said what the heck, saw an idea, didn't know that it would work, but jumped on it like a dog and went after it, and made a beautiful lifestyle for their family, and something that involves multiple generations and thousands of people, and changed the lives of many people who participated in these companies.

So I just think a big kudos is due to our industry in general. And I just want to say thank you, from Unbridled Capital to all the people who, over the last couple of years have entrusted us to do business with you. Because we're going to hit the $1 billion mark here, probably round late Q1, early Q2 in the last two and a half years. And that does not happen with fantastic clients who just have a belief in us to help them when it comes to selling and re recapitalizing, and refinancing their business. And I'm just honored for that, and honored to be part of this industry, it's who we are.

And for those of you who listen, who aren't a part of the franchise industry, man, I'm telling you, it is an awesome place to be. It isn't easy. It's easy to do right, once. It's almost impossible to do right all the time, because you're dealing with so many variables. It's a complicated business, but it's a fun business that everyone wants to talk about. It moves quickly, and the people involved in it are first-class promise you.

So thanks so much. And before I go, I just say Merry Christmas and Happy New Years to anyone who's listening here. It's an honor to have been doing this for over a year now. And I'm really thankful to those of you who take the time to listen to these podcasts.

Thanks so much for entering the Boiler Room today. You can find our podcasts on iTunes, Google play, Stitcher, TuneIn and Spotify. If you like these podcasts, please listen, rate and review.

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Please note that neither Rick Ormsby, nor Unbridled Capital LLC, give legal, financial, or tax advice. These podcasts represent opinions that have been prepared for informational purposes, only. We expressly disclaim any and all liabilities that may be based on such information, errors therein, or emissions therefrom.