Fundamentally Sound: There's Still Room For Deals--If You're Willing To Buck The Herd
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Fundamentally Sound: There's Still Room For Deals--If You're Willing To Buck The Herd

What a difference 12 months can make!

One year ago, the debt markets were flush with cash, the merger and acquisition marketplace was lively with new deal announcements, and operating companies were aggressively pursuing new unit development opportunities. Today, we have a very different story, although an historically recurring one.

The challenges of the current consumer and capital market environments are new only to the youngest of industry participants. Collectively, how the overall market behaves under these circumstances will shape the pattern of the next cycle; but on a micro level, individual strategic decisions made today will separate the winners from the spectators.

First, what type of behavior are we experiencing in today's environment? Clearly, there are a number of opportunistic investors who are very active in today's environment. But most investors have become paralyzed by an aura of doom and gloom.

The degree to which individual industries are interconnected and global markets intertwined is no doubt cause for concern. However, collective behavior in a downturn completely overshadows business- and industry-specific fundamentals. Additionally, the extreme polarization of the investment thesis is mind-boggling. One minute, valuations are approaching all-time high levels, and in the next blink "the United States is going out of business," or so one investor claimed.

Have market participants become so influenced by short-term economic rhetoric that they miss the more relevant long-term strategic assessment? The general herd is scared, and outside of a few contrarians, most investors are looking for a reason, any reason, not to pursue opportunities and instead sit on the sidelines. Unfortunately, by the time the economic storm passes, so too have many attractive opportunities.

Many investors are hampered by yet another institutional player: the debt investor. In general, equity investors typically rely on significant debt capital to achieve leveraged returns. With many debt capital providers still battling their own internal procedures and risk/reward parameters following the current credit crisis, we will have to see more stability in cash flow lending for significant transaction activity to resume. On a more global scale, institutional debt and equity investors continue to manage huge amounts of capital and must eventually put such capital to work. In our current economic environment, many equity sponsors have decided to postpone investments until the debt markets return to "normal" activity levels.

We now understand what is happening currently, but more important, why do we see this behavior? A couple of factors desensitize the investment process today. The first is that in recent years, institutional investors (e.g., private equity) have driven most of the M&A activity in the U.S., particularly in the retail and restaurant industries; rarely is personal capital funding deals of more than $50 million in enterprise value.

The second factor is that institutional investing is somewhat of a young person's game. Key players are often young and highly educated, but do not have the depth of experience that comes with riding the peaks and valleys of industry cycles. Understandably, a downturn in the economy can be somewhat crippling.

Both of these factors lead to more fear-based collective behavior, rather than to the entrepreneurial spirit that has driven our industry over its history. When you picture an institutional investor today, don't picture Warren Buffet. In part, his success has been earned through experience. For some, sticking their neck out in this environment is a frightening experience, yet it can provide a compelling edge over those who are sitting on the sidelines.

Overall as an economy, we have become more focused on short-term events and have strayed from disciplined long-term investing. Historically, winners in a downturn have remained disciplined and strayed from the collective behavior that often defines the trough of the cycle. Their courage and moxie have long been the recipe for success in this country. We're not referring to reckless investing or investing solely in turnaround situations, but the ability to look past short-term downturns and focus on solid industry and business fundamentals. Economies have cycles. This is not new news. Experienced investors fundamentally understand this.

In the restaurant industry, dining out frequency has been on the rise since the advent of the restaurant. Although customer counts may be off in the last 12 months, there is no inherent change in consumer behavior or loss of value over the long term. Over the last six months, we have increasingly seen a change with strategic acquirers becoming the dominant force in the restaurant M&A marketplace, which we would expect. These managers and operators understand the industry environment better than passive investors, and they see an opportunity and with many institutional funds sitting on the sidelines.

Those with the courage to invest in challenging markets where there is increased opportunity and less competition will certainly achieve greater rewards in return for little added long-term risk. Many of these acquirers are not stifled by the current debt environment and are using their strong balance sheets and large sums of outside equity capital to get transactions closed. Their thesis is that the financing markets will return, and they can recapitalize the investments to optimal debt-to-equity ratios for return purposes. In the current environment, well-capitalized strategic and institutional investors with confidence in the return of the debt capital markets value this differentiated approach.

Six years ago, those who saw a silver lining in the interim clouds over the world's second largest burger brand, Burger King, bought into a storied, but promising investment in the midst of a post-9/11 economy and mediocre financing markets. To those of you thinking such prowess is afforded only to the most urbane of investors, like Bain Capital, Goldman Sachs, and Texas Pacific Group, this is not that case. Many savvy industry operators and small franchisees assessed the business fundamentals in the face of short-term weakness and opted to see the long- term value of a stable worldwide brand. Both classes of investors have been rewarded handsomely.

In due time, debt investors will move beyond the current credit crisis with the help of a revitalized consumer, and the debt capital markets will return to providing the security needed for traditional leveraged buyout investing. The financial pundits will declare the recession over and the masses will feel safe to return to mainstream M&A activities.

Until then, we think it is reasonable to expect that the majority of investing groups will take an early summer vacation and potentially reevaluate the situation in the fall. In the interim, we will see fewer deals close. They will be deals made by smart and tested veterans who have a keen sense for unlocking the hidden value of stable business.

Dean Zuccarello, CEO and founder of The Cypress Group, has more than 25 years of financial and transactional experience in mergers, acquisitions, divestitures, strategic planning, and financing in the restaurant industry. The Cypress Group is a privately owned investment bank/advisory services firm focused exclusively on the multiunit and franchise industry for more than 17 years. Contact him at (303) 680-4141 or at

Published: September 15th, 2008

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Multi-Unit Franchisee Magazine: Issue 3, 2008
Multi-Unit Franchisee Magazine: Issue 3, 2008

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