Imagine operating a single restaurant. The food keeps bringing them in, and prices are relatively stable. Consumer confidence is high, unemployment low, discretionary income rising and people are going out more. Now multiply these variables as if we operated a chain of restaurants, and you will find small changes in any of these variables are multiplied exponentially and take a longer time to adjust for a restaurant chain. By looking across the industry, we can see that big changes may just be beginning, and we can join the change now.

Restaurants continue to see investment money pouring in. Papa John’s and Jack in the Box are just two of many franchised restaurant chains undergoing due diligence for acquisition. Focus Brands, Inc., owner of Carvel, McAlister’s, Jamba Juice, Auntie Anne’s, Moe’s Southwest Grill, Schlotzkey’s and Cinnabon, bought Jamba Juice in September 2018 for approximately $200 million. On Oct. 29, Focus Brands issued $300 million in additional bonds under its securitization facility with an interest rate of 5.184 percent. The bonds are securitized by royalties and revenues from the other chains under the Focus Brands umbrella. Undoubtedly, unit economics support this financial engineering of debt, but it seems relatively easy to fund big spends for acquisitions. Is this special to the restaurant sector?

Big acquisition spends are not only prevalent for healthy companies but also distressed companies. Taco Bueno Restaurants, Inc. filed Chapter 11 on Nov. 6 for its 140-unit company store and 29-unit franchised Mexican units. The reason it filed was because of falling earnings and underperforming restaurants. But Sun Holdings, a multi-concept franchisee listed as the eighth-largest franchisee in the United States, is the stalking horse bidder. Sun acquired the outstanding debt of $130.9 million for about half price and will inject $10 million into operations, and convert its debt claims into ownership of the company. Sun is doubling down on the franchised business.

Similarly, Papa Gino’s and D’Angelo’s filed Chapter 11 on Nov. 6 for their 141 company-owned branded locations, and was franchising 37 locations. It had once been as large at 370 units. A stalking horse bidder, Wynnchurch Capital, acquired the senior debt of $18.5 million and the second lien position of $34.2 million. Wynnchurch has agreed to provide debtor in possession financing of $13.8 million. There is another $39.9 million in mezzanine financing held by Hartford Insurance Co. and Brookside Mezzanine Fund.

Is there more capital available than good ideas and strong restaurant operators? Why are knowledgeable people placing bets on restaurant chains rather than home builders, car manufactures and other industries? This abundance of capital has resulted and continues to result in the ongoing consolidation of Big Restaurant, franchisers and large franchisees able to leverage their assets and G&A costs. Family offices and private equity are increasing their investment in this sector because of the low barriers to entry and expansion. It allows retirees to buy franchises on credit, and consolidate their holdings to expand. Is there still more upside than downside?

We can find the answer by looking at where we have been. The U.S. economy is experiencing the second-longest expansion in our lifetimes, after recovering from the greatest recession ever. We are still feeling the effects of economic stimulus, low interest rates, tax cuts, government deficit spending. This economic caffeine is about to be diluted. We can see it in the sales trends. We can see how to adjust to change by looking at the trends.

We are feeling good, and perhaps need to adjust to the rising headwinds. Top-line revenues may appear to be rising, but that may be due to new delivery models. Some restaurants pay Grubhub and Doordash a high percentage of sales to deliver their products and increase volumes. Companies which build deliver and technology into their business increase their profits exponentially. The digital technology allow owners to gain knowledge regarding their customers by analyzing data coming from scan-to-pay systems, order-ahead applications, consumer-facing technology and delivery arrangements. The better companies will know their customers better through the use of technology. They will use social influencers to drive customers from the internet to the store fronts.

Increased labor costs and management attention will also challenge restaurant growth, however, there are apps for this as well. Franchisee enterprise systems often can predict and manage labor schedules for franchisees. On resale and financing, technology is one of the strongest selling points, so it pays to invest in technology. Restaurants have even gone as far as to provide platforms for their customers, relying on Facebook and LinkedIn. But even technology cannot hold back the tide of increased labor costs and responsibilities. Technology cannot eliminate competition through value meals, value pricing and giveaways.

The structural changes involve structuring how we invest in restaurant chains. Technology that educate the operators how to better cater to customers, and help adjust labor and menus will be in demand. Increases in efforts of the operators to improve the customer experience, as the internet has replaced word-of-mouth referrals. Finally, economic adjustment is needed, to build equity in the business to hedge against the over-leveraging of hard assets. You need that equity there when you need it, and you need to start building it now.

Reprinted with permission from the December 27 issue of The Legal Intelligencer. (c) 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.