PE and China franchising: Eat what you cook

Former investment banker Justin Kennedy opened his first store as PizzaExpress' Greater China franchisee in 2001. It was located in Hong Kong. While keeping a hungry eye on the mainland market, Kennedy's instinct was to take it slowly: the Chinese weren't quite ready for a premium slice of pizza.

Five years later, PizzaExpress launched in Shanghai but the pace of expansion has been conservative. There are now 13 stores in Shanghai, one in Shenzhen and 12 in Hong Kong.

"Many people with a franchise think, ‘I've got an amazing global brand that works well in Europe or the US, so I can open stores like crazy in China and Chinese consumers will queue up to buy my products'. That assumption doesn't hold," says Kennedy. "The first challenge of operating a foreign brand, however strong it is in the US, is in China it's brand new and you're starting pretty much from scratch."

PizzaExpress' UK-based management team - and Cinven Partners, its PE owner - were not so patient. Last May a wholly-owned outlet opened in Beijing. Two months after that, PizzaExpress was sold to Chinese PE firm Hony Capital for EUR900 million ($1.5 billion). The new owner planned to acquire the 26 franchised restaurants in China and open 15 more every year.

This is not an isolated incident of PE targeting fast dining. Last year RRJ Capital teamed up with Jollibee Corp. and acquired the license to operate Dunkin' Donuts across most of Greater China. They want to open more than 1,400 stores over the next 20 years. EQT Partners bought a majority stake in China F&B Group, local franchisee for Dairy Queen and Papa John's Pizza, while CVC Capital Partners bought local chain Da Niang Dumplings and plans to expand it nationwide.

These are China consumer plays, looking to leverage the appetite of an expanding middle class for a convenient, affordable and high quality dining experience. Franchising is an efficient way to achieve scale at short order. The model is proven in China, but it does not come without risk - whether the PE investor is working with partners to roll-out restaurants as a franchisee or sub-licensing to local operators as a franchisor.

Quick formula

Restaurant franchises have been present in China for about 20 years. A majority of the top 100 players in the catering sector - which are dominated by local brands - follow a hybrid model of self-owned stores combined with large franchisee networks. This is deemed necessary to stay competitive in a fast-growing market.

China's catering sector generated revenue of RMB2.79 trillion ($445 billion) in 2014, according to the China Cuisine Association. While the high-end segment has struggled due to a government crackdown on corruption that has curtailed spending by officials on entertainment, the quick service segment remains robust. Revenue rose from RMB243.8 billion in 2008 to RMB546.5 billion in 2013 and Frost & Sullivan projects compound annual growth of 16.4% through 2018.

Though well-known franchisors globally, the likes of KFC, McDonald's and Starbucks have to a certain extent eschewed the model in China. Rather than distribute products through a third-party licensee, who is bound by strict guidelines on how to operate and pays the franchisor an initial fee plus royalties, these companies own and operate restaurants directly.

This is in part a function of their early arrival in a market. When KFC set up shop in 1987, foreign companies were obliged to operate alongside local partners. It was only with greater acceptance of the wholly foreign-owned enterprise (WFOE) structure that KFC switched to self-owned outlets. Yum Brands has around 6,700 outlets in China. More than 90% are directly controlled - including all 4,800 KFCs - compared to around 10% in the international markets.

McDonald's, with more than 2,000 outlets, took a similar approach at first, although in recent years it has adopted a hybrid franchisee model.

For some brands, there is reluctance to commit the time and resources required to build up market awareness and achieve scale. The difficult early work is therefore carried out by a franchisee. For example, Mei Da Coffee secured the exclusive license for wholesale and retail operations under the Starbucks brand in Beijing and Tianjin in 1998. H&Q Asia Pacific acquired a controlling stake in Mei Da soon afterwards and took Starbucks from one store to 60 before exiting to the parent company in 2008.

"PE firms prefer to invest in restaurants where it is easy to standardize the product offering and scale up, such as quick service and fast casual restaurants," says Roger Liu, PwC's private equity deals leader for China. "It's rare to see a PE firm to buy a China franchise license from a global company and then operate the restaurants itself; instead it may consider investing in a successful third-party franchise operator."

A good operator

In partnering with Jollibee on Dunkin' Donuts, RRJ has aligned with an experienced operator. Jollibee already has restaurant infrastructure in China, although this came through the acquisition of other established chains rather than the own-brand expansion that characterized its rise to prominence in the Philippines. Jollibee bought the Yonghe King noodle shop chain in 2004, the Hong Zhuang Yuan rice porridge restaurants business in 2008, and then added the San Ping Wang noodle chain.

PE and VC investors are also supporting Chris Tay, who previously headed up Taiwan food conglomerate Tingyi Holdings' China casual dining business, on YPX Cayman. The company started out with self-owned restaurants but is now creating sub-franchises with individual operators.

YPX is intended to serve as a platform that can operate several brands. The first of these is Taiwanese dumpling chain Cloud 9, which Tay bought in 2010. The Taiwan-based assets were sold and YPX received $5 million from Qiming Venture Partners to start a greenfield operation in mainland China. A Series B round worth $15 million came in 2011, led by Taiwan's Hotung International. There have been two more rounds, of $11.5 million and $25 million in 2012 and 2014, as the Cloud 9 network grew to more than 40 outlets in different Chinese cities.

YPX only become a franchisor late last year. It is targeting 225 Cloud 9 outlets by, of which 100 will be franchise stores and 125 directly-owned.

"About 99% of brands in the world need franchisees to put up all the money to open stores. The idea is the franchisors don't have to come up with their own capex. But for me to do franchised stores isn't so much about whether the franchisees have money or not. It's because I can't reach far in the China by myself. My franchisees are locals in their respective provinces and cities. They are more in tune with the local market and they can cater different needs, and thus do a better job than I can," says Tay.

The franchising process is described as a snow ball effect. For the franchisee, building up a network of restaurants is cash-intensive at the beginning, but once the business reaches a certain scale it becomes very cash-generative. The initial fee is negotiated and the royalties paid to the franchisor are usually in the region of 5% of monthly gross sales. Some franchisees operating foreign brands also have to pay material fees, whereby they are obliged to source certain ingredients from the US franchisor or from approved suppliers in China.

The PizzaExpress Hong Kong franchisee, which now pays royalties to Hony, obtains most of its fresh ingredients locally but has to import items such as cheese and mustard sauce from approved overseas suppliers. The RRJ-Jollibee venture, meanwhile, pays royalties and material fees to US-based franchisor Dunkin' Donuts.

PizzaExpress' Kennedy targets a return on invested capital of around 30% for each store. The Hong Kong operation is already funded through internal cash flows and Shanghai could soon become self-financing shortly after nine years of operation. When the franchise was first launched it was difficult to secure loans because banks saw the restaurant business to be too risky.

"Hony's team spent a lot of time looking at our brand development and growth strategy. They have seen how we operate in China, and how it compares to others who might take a more aggressive approach. I think they understand we're doing things differently," says Kennedy. "One difference is we are focused one building the brand at the same time as we build our restaurants rather than adopting the ‘build it and they will come' approach."

Levels of comfort

Not every private equity firm is comfortable franchising out to third-party operators. Actis acquired a majority stake in Chinese hotpot chain Xiabu Xiabu in 2008. At the time the company had 40-60 outlets, some directly-owned and others franchised. All the franchised stores were soon bought back and the chain grew to more than 300 outlets before being sold to General Atlantic in 2013.

According to Andreas von Paleske, head of consumer at Actis, the PE firm generally prefers its restaurant chain portfolio companies to follow a self-owned store model. "We believe this gives us more control over locations, quality of operations, the management of the brand, and interface with consumers," he says. "The value of our investment is dependent on the strength of the brand and the quality of the operations backing it, which ensures repeat consumption."

The private equity firm typically expects each new outlet to be cash-generative within one or two years. It is suggested that, to achieve the same earnings growth through franchised operations, companies would need to open a much larger number of stores, and success hinges on finding franchisee partners with the requisite capital and skill-sets.

"That is why some of these players have pursued the owner-operator model when entering certain new markets," von Paleske adds.

McDonald's and KFC provide own staff training at every store they open in China. However, running such large operations they are not immune to risk. In the last year both companies have suffered from reputational damage after allegations that suppliers had provided expired meat to restaurants. Given the size of their China businesses, weaker sales have an impact on the bottom line globally. In the quarter ended March 2015, Yum saw net profit fall 9% year-on-year to $362 million as China sales dropped 6%, with same-store-sales decreased by 12%. KFC alone witnessed a 14% decline.

Burger King - which is currently owned by 3G Capital - faces a different challenge, industry participants say. It is spread relatively thinly, with approximately 200 restaurants nationwide, which makes it difficult to establish meaningful relationships with landlords and secure optimal locations.

By most accounts, foreign players from Taiwan and Japan are making the deepest inroads into the local market, with large franchisee systems that leverage economies of scale. Dicos, which is owned by Taiwan-based Ting Hsin International Group, is the leading operator with more than 800 franchisees running over 2,000 stores that serve Chinese-style friend chicken. It is followed by burger chain Hua Lai Shi and Guangzhou Real Kungfu Catering Management, also known as Zhen Gong Fu.

Indeed, Dunkin' Donuts has tried and failed in China before. The brand entered mainland China in 2008 with the opening of a shop in Shanghai. This initiative was led by Mercuries & Associates, the franchise partner for Shanghai and Taiwan, which planned to launch 150 outlets nationwide over a 10-year period. However, in early 2013 it was announced that the remaining 19 Dunkin' Donuts stores in Taiwan would close. This followed reports that the business was losing money.

Another franchisee secured the license for Shanghai and the provinces of Jiangsu and Zhejiang in late 2013 and plans to open more than 100 restaurants. RRJ and Jollibee, which have committed up to $300 million to their joint venture, are covering much of the rest of the country, including Beijing, Tianjin, Hong Kong and Macau.

One factor potentially working against the brand is donuts are seen by some as too sweet for local Chinese tastes, which could impair hopes of achieving a critical mass of demand. "I'm not optimistic about donuts becoming a big thing in China," says one industry source. "Chinese people don't enjoy sweet things like that. We have seen many donut shops in China in the last 10 years. Even Uni-President - with Mister Donut - can't get bigger."

China risk

To mitigate the risk of a foreign brand failing to gain traction locally, some private equity firms target more mature franchisee networks. This is the case with EQT's investment in China F&B Group, while CVC, which is the owner of Da Niang but wants to expand the business through a franchisee model, targeted a business that already had a substantial chain of restaurants.

Founded in 2003, China F&B Group controls Dairy Queen, the largest ice cream restaurant chain in the country, and Papa John's Pizza, the second-largest pizzeria player. It has more than 500 restaurants in total. Once the franchisee achieved certain scale, the US franchisor brought in a private equity shareholder with a view to professionalizing management and improving corporate governance.

"Dairy Queen and Papa John's Pizza in the US like our openness with them, which creates greater transparency. Individual founders tend to have more personal style in discussing issues, and they don't want to talk about the problems they face. Franchisors feel a lot more comfortable with us," says Martin Mok, a partner and managing director for China at EQT. "Secondly, most franchisors do have a development plan. When the franchisee doesn't meet the plan, the franchisor might have second thoughts about franchisee's credibility."

At times it does fall upon franchisees to fine tune the offering to suit local needs, such as changing up the management team, re-launching the menu and altering pricing strategies, and deciding how to structure promotions. Mok notes that a private equity investor can support these efforts.

The idea of a having an established, credible investor participating in the business is perhaps especially important in China's catering sector, where individual restaurants can see substantial inflows and outflows of cash. The risks are well known.

"Many restaurants operators in China rely heavily on cash payment, whether it is to pay salaries to the chefs or buy vegetables from wet markets. Sometimes it's difficult to trace the cash flows if IT and reporting systems are poorly established. It leads to a lot of inconvenience for private equity when conducting due diligence on target companies," says PwC's Liu.

This is where a restaurant chain operator, whether franchisor or franchisee, must strike a balance between scale and control. For the private equity investor, time and money are the key factors in devising a strategy. Set up a network of franchisees and a nationwide roll-out can be achieved rapidly, but the business is reliant on third-party operators. Building a self-owned chain with a local partner constitutes a larger capital risk, given the upfront investment required, but the pay-off could be higher.

It is unclear which path Hony will follow with PizzaExpress, and the firm may well opt for a combination of the two. From Kennedy's perspective, though, opening a lot of restaurants very quickly is not worth the risk. He notes that the Greater China franchisee has yet to close a failed branch, and this is the result of cautious expansion.

"I think that the problems come if you expand too fast and then you lose control of quality and consistency," Kennedy adds. "We're very focused on maintaining tight control of everything we do. It's really important to ensure that every guest leaves with a positive impression of the product, the service and the value proposition in order to build customer loyalty to the brand."

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• Topics
• Consumer
• Greater China
• Expansion
• Buyouts
• Consumer
• China
• buyout
• Growth capital
• Hony Capital
• RRJ Capital
• Qiming Venture Partners
• EQT Partners
• CVC Capital Partners