Hedge Funds Set Table For Restaurant LBOs

Hedge funds don’t have too many friends in buyout land. But they may be partly to thank for the latest crop of asset-rich restaurants to come on the market.

Facing pressure from hedge fund activists, officials at Friendly Ice Cream Corp. and Applebee’s International Inc. have both said they would consider the possibility of sales. Another restaurant chain under pressure from a hedge fund, Wendy’s International Inc. has also been the subject of auction-block rumors. The deal flow promises to further whet the appetite of buyout shops for restaurant chains, which often produce steady cash flow and feature undervalued real estate assets.

“Over the last five years there has been significant interest in investing in restaurant concepts,” said Glenn Kaufman, managing director of American Securities Capital Partners, a New York-based private equity firm that owns Potbelly Sandwich Works, a private Chicago-based chain of franchisees. “People have discovered that restaurants, when well-executed and well-run, can be very attractive brands.”

Indeed, part of the attraction is that the company-owned property can be sold and leased back, making it possible to leverage these companies up to as much as 10x EBITDA. In addition, say insiders, buyout firms have the opportunity to sell company-owned restaurants to franchisees, also called refranchising, which generates cash on a one-time basis, and potentially drives up a restaurant company’s value.

“The revenue stream of franchising income is more valuable to a buyer than just restaurant operating profits,” said David Pittaway, senior managing partner of New York-based Castle Harlan Inc., a buyout firm that’s been investing in restaurant chains since 1988 and owns Morton’s Restaurant Group and Caribbean Restaurants. Pittaway added that bond investors would accept a lower return on investment in providing leverage for these deals. “That means you can pay a higher price to the franchisor,” he said.

No one is tying the potential sales of Friendly’s and Applebee’s directly to the hedge fund activists—Sardar Biglari in the case of Friendly’s, Richard Breeden in the case of Applebee’s. But both companies recently engaged investment banks to explore strategic alternatives, just as pressure from the hedge funds was reaching a boiling point.

Biglari, who is chairman of the Lion Fund, a San Antonio-based hedge fund, and the company’s largest shareholder, issued a letter to Friendly’s shareholders earlier this year, critical of the company’s direction and chairman Donald Smith. In the letter, Biglari suggested that refranchising would be a way to reduce the number of company-owned restaurants and allow management to focus on improving operations. Biglari argued that a franchisee can manage a restaurant more efficiently. With the cash generated by the deals, Biglari said he wants to pay down the company’s “enormous debt,” which would improve the stock’s value.

Smith countered with his own letter, posted to the company Web site, saying the board had offered Biglari two board seats to avoid a costly proxy fight, but Biglari had refused. Smith charged that Biglari wants to control the board and “redirect corporate assets for purposes other than for the continued growth of Friendly’s.”

With the announcement that the company would consider selling itself, shares soared to over $15 each, up from a 52-week low of $7.43. Meanwhile, the company’s largest franchisee, Kessler Family LLC, which operates 46 franchises, announced in mid-March that it is exploring purchasing the company. Friendly’s, which has 316 company-owned restaurants and 205 franchises, has recently improved its performance. In 2005, the company sustained a $27.3 million loss, but saw net income swing to $4.9 million last year. EBITDA came in at $47.1 million, according to financial disclosures posted on the company’s Web site.

Meantime, Applebee’s has been resisting tactics by a hedge fund activist of its own. Richard Breeden, founder of Greenwich, Conn.-based Breeden Capital and former chairman of the Securities and Exchange Commission, is seeking four seats on the company’s board. In March, Breeden rejected an offer from the company to expand its 12-member board to 14. Applebee’s then said it would consider a number of alternatives, including a recapitalization of stock, a leveraged buyout, or a sale to a strategic buyer before the end of June.

Breeden, whose fund owns 3.9 million shares of Applebee’s, or just over 5 percent of total outstanding shares, is calling for the sale of “non-earning assets like real estate,” and wants to see the company-owned restaurants get sold to franchisees. In October he charged that poor decisions regarding the allocation of capital to company-owned restaurants and real estate holdings were yielding low returns. He said high administrative costs and “undesirable governance and compensation practices” were all impacting share price. Officials from Applebee’s declined comment.

Applebee’s is the largest single-concept casual dining restaurant in the nation, and three-quarters of its 1,942 restaurants are franchises. System-wide domestic comparable sales declined in 2006, as its core customers—those with moderate incomes—got hit with rising fuel costs over the same period. Winter storms in some regions of the country also cut into customer traffic in recent months. The company recently announced it would close 19 of 24 underperforming restaurants, ten in New England and the remainder in nine other states.

Applebee’s, which has a market capitalization of $1.8 billion, does not publish EBITDA. Operating cash flow in 2006 was $174.6 million. On Feb. 20, its share price approached $27 per share, but quickly dropped to below $26, due in part to the severe winter weather. It remained well above the company’s 52-week low of $17.29.

Hedge fund activism is nothing new in the deal-glutted restaurant business, which last year saw The Carlyle Group, Bain Capital, and Thomas H. Lee Partners purchase Dunkin’ Brands, one of the largest franchisers in the world, for $2.4 billion. In March 2006, Wendy’s International Inc., expanded its board from 12 to 15 seats to accommodate the demands of Nelson Peltz, chairman and chief executive officer of New York-based hedge fund Trian Partners. Wendy’s, with 6,673 restaurants, including 1,465 that are company-owned, has a market capitalization of just under $3 billion, and generated 2006 EBITDA of $220.7 million.

In September, Wendy’s International spun off Tim Hortons, a Canadian-based chain, to shareholders. In November, it completed a sale of subsidiary Baja Fresh for $31 million. Its long-term strategy is to sell off about 500 company-owned restaurants to franchisees, said David Poplar, the company’s investor relations director. Peltz’s fund and Highland Capital Partners, a venture capital firm based in Lexington, Mass., each owns more than 5 percent of the company’s shares. Rumors that the entire company is up for sale were denied by a spokesman. “The new board has approved the current strategic plan which calls for a stand-alone Wendy’s company,” he said.—Joyce Crane