Thursday, May 26, 2011

Private Equity & Dunkin' Donuts' Impending IPO

Several months ago I wrote this post describing some awful customer experiences I suffered at a few Dunkin' Donuts franchise locations. The events involved a bungled new product introduction which DD's corporate unit, currently a private equity property, had poorly executed.

Some weeks later, I was informed of this post/comment on a franchise-oriented blog. A bit later, I was directed to this post on the same blog, in which the role of private equity firms, such as Bain, in franchiser buyouts such as Dunkin' Donuts, was discussed. An additional example of private equity behavior in buyouts of restaurant businesses was forwarded to me, as well, in the form of the filing of a suit involving a private equity firm and one of its acquisitions.

I"m not focusing on the detailed dynamics of franchising in this post, nor the particular details described (far better) in that second linked post from the franchising blog.

But what does seem reasonable to assume in the matter of private equity deals is that the private equity group(s) take fees and special dividends out of the acquisitions, further leveraging them up beyond what leverage they already had.

It doesn't take a genius to consider what this sort of cash siphoning by the private equity firm can do to the long term viability of the acquisition, once it has been prepared for an IPO.

Which brings me to Dunkin' Donuts.

In recent weeks, business media have begun to anticipate the return of DD, the franchiser, to public capital markets via an IPO.

Prior to the information I received regarding my post's reference in the franchise blog, I didn't really give much thought to any connection between DD's product launch issues and its franchiser's private equity status.

Since then, I have. Specifically, what the risks are to franchisees of buying into a system, the franchiser of which is vulnerable to takeover by a private equity firm.

Just a few days ago, in the Wall Street Journal, there was a positive article regarding McDonalds commencement of a physical overhaul of up to half of its franchised stores. Being as large and reasonably well-managed as it is, McDonalds seems to be in no danger of being taken private, so its franchisees are pretty safe from uncontrollable damage being inflicted by a new owner.

However, I've learned that this was far from true in the Dunkin' Donuts case. For example, DD, upon going private, engaged in a practice by which they receive extra fees by exercising clauses in franchisees' agreements to essentially take units from current owners and resell them, for more money, to other parties.

Known as "refranchising," this allowed the franchiser, DD, to selectively break up smaller, multiple-unit franchisees who were profitable, but whose stores would be more valuable to slightly larger franchisee groups.

Further, as some of these franchisees who were being, in effect, driven out of business, litigated these moves, resulting fees from the resale of the units became income to the franchiser, or private equity group. Through a process that is rather murky to those of us not in the business, the private equity groups were able to fund such a program from the franchisees' own marketing expenditures, but keep the gains for the corporate unit.

The larger point of all of this is that what has been transpiring at DD under private equity ownership may well be considered activities which aren't exactly "business as usual." Thanks to the magic of IPO accounting, the imminent spinning of DD, the franchiser, back into public hands, seems, well, rather like a pig in a poke.

Given the remarks in one of the franchise blog posts regarding extra leverage being applied to DD during its private equity ownership period, one wonders how capable the newly-independent corporate franchiser will be to fully service its franchisees, its announced expansion into India, and, generally, growth activity, if its laboring under a large debt load.

It's an interesting story for me, as it started with a simple observation of a product launch gone wrong, and ended with my learning more about the mechanics of private equity management of franchisers, just as Dunkin' Donuts is about to go public again.

My own equity portfolio selection process would not see DD as a candidate for some time, if ever. But I wonder how much the average investor, even on the institutional side, really comprehend about what may have been done to and with DD, the franchiser, during its tenure as a private equity-owned acquisition.

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