Faster food: PE and restaurant franchising

Of the 14,000 restaurants McDonald's has in the US market, fewer than 1,500 are directly-owned by the company. The franchised percentage falls from 90% to 44% in the high-growth markets where McDonald's is underpenetrated and sees the potential for significant upside. Mainland China is a case in point: the company has 2,400 restaurants and directly-owns about two thirds of them.

It represents a logical evolutionary path for emerging markets. McDonald's comes in, invests in establishing the brand and quality standards, and then in time rolls out store ownership to third parties, taking royalty payments and sometimes extraneous fees for additional services. This is also the only way to really achieve scale in a business. If McDonald's wants to substantially increase its footprint in China, the costs and liabilities of a primarily directly-owned restaurant network would amount to a big burden.

And such is the size and challenge of the China market, McDonald's also needs additional capital and local expertise if it is to realize its ambitions. This is the rationale behind the move to spin out a 20-year contract for the master franchise rights in mainland China and Hong Kong into a separate entity and sell 80% of it to a local strategic player, CITIC Group, and two financial backers, CITIC Capital and The Carlyle Group. As part of the deal, 1,750 company-owned restaurants will be refranchised.

Private equity is no stranger to Asia-based franchises to quick service restaurant businesses headquartered in Western markets. In Australia, Japan, Korea, Hong Kong, Singapore, Malaysia, India and Indonesia, restaurant chains ranging from McDonald's to KFC and Burger King to Dunkin' Donuts have fallen under PE control at various points over the last 20 years or more. Whether launching a greenfield roll-out or a brownfield turnaround, GPs like restaurant businesses that are cash generative and relatively straightforward to scale. At the same time, franchise-led models are not without risk.

Both McDonald's and Yum Brands - owner of KFC, Pizza Hut and Taco Bell - have now restructured their China businesses in ways that give them the flexibility to raise additional capital and pursue growth. Yum Brands, which directly controls 5,847 of the 7,300 restaurants in its China network, chose to spin-out the operation into a separate listed entity and bring in Primavera Capital and Alibaba Group's financial services affiliate as investors.

While the McDonald's partnership plans to open 1,500 outlets in China and Hong Kong over the next five years, Yum China has an ongoing target of 600 gross new builds. They also intend to invest more in menu innovation, improving restaurant experience and offer enhanced digitally-enabled services, such as mobile ordering and payment systems for food collection and delivery.

The question is how much difference these new set-ups can make to brands that have shown signs of stagnation in China. McDonald's and KFC took a hit after it emerged in 2014 that suppliers had provided sub-quality meat to restaurants. But their market share was under threat before then from local chains as well as groups from Taiwan and Japan. According to Euromonitor International, Yum Brands and McDonald's had market shares of 23.9% and 13.8%, respectively in 2015; three years earlier Yum was on 40%, while McDonald's achieved 16.5% in 2013.

With any franchise restaurant operation, success comes down to striking a balance between scale and control. A self-owned chain constitutes a larger capital risk and it might not be practical once a business reaches a certain size, but it means the master franchiser can keep management teams on a tight leash and have fewer qualms about transparency and quality. A network of franchisees allows the creation and maintenance of a huge restaurant network, but much rests on the skills and reliability of individual operators.

For McDonald's and Yum in particular, which are looking to penetrate deeper into China's tier-three and tier-four cities, having the right people on the ground to secure prime locations in these markets and set up the supply chains to keep restaurants in business is invaluable.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Consumer
• Greater China
• Buyouts
• China
• Asia
• The Carlyle Group
• CITIC Capital
• Primavera