Episode 147: Mike Esposito of Franchise Equity Partners on Box Economics and Multi-Unit Franchise Investing

Episode Transcript   

Shiv (00:11.249)

All right, Mike, welcome to the show. How's it going?

Mike Esposito (00:13.804)

Right.

Shiv (00:14.981)

Excited to have you on. So why don't we start with your background and franchise equity and then let's go from there.

Mike Esposito (00:20.696)

Sure. Well, first off, thanks a lot for having me. Really appreciate it. I'm sitting here in New York today, which is where we're headquartered. I'm Mike Esposito, I'm one of the co-founders and co-managing partners of franchise equity partners. We launched in 2021. Prior to that, I was at Goldman Sachs for almost 30 years as an investment banker in the financial services area. I ran the Global Financial Institutions Group.

While at Goldman, I had a little side hustle, which is I owned a bunch of Jersey Mike's stores, and it kind of opened my eyes up to franchising and kind of paved the way for franchise equity partners. So we focus on multi-unit retail investing, typically as a franchisee, and we focus on five verticals: restaurants, automotive dealerships, beverage distributors.

Heavy equipment dealers, and other consumer business services. As I said, we launched in 2021. We have about $2 billion of assets under management. We've been backed by HPS Investment Partners, which is a subsidiary of BlackRock. And at this point, we've got about 2,000 storefronts across the various verticals I mentioned.

Shiv (01:39.569)

Yeah, it's interesting because a lot of investors that come on the podcast are more focused on technology or tech-enabled services and this is different, right? So walk us through your investment philosophy. Like what types of assets? I get the franchises, but give us some more details, like what stage of business are they in? Is it geographically focused? Like help us understand that.

Mike Esposito (02:00.205)

Yeah, and let me just back up 'cause you hit on something that kind of—

We found be really interesting about this whole sector is that there's a lot less organized private equity competition across these different verticals, particularly across the franchisee investing universe. We do see some competition in restaurants, but we don't really see anybody playing across the space. And I think there's a couple of reasons for that. First and foremost, private equity people—

Shiv (02:19.368)

Totally.

Mike Esposito (02:34.155)

You know, don't like to have to give up control or power to brands. And at the end of the day, as a franchisee, you're not the brand owner. And you've got to be comfortable with that, that somebody else is controlling a playbook and controlling how to develop a brand. I also think that in a lot of these situations, they're family-owned businesses.

And so family-owned businesses oftentimes has some nervous feeling about private equity also. We try to look like a family office. We can invest for a very long period of time.

We can invest as a passive investor, as a minority investor. And we really tried to set up our capital, be very differentiated relative to typical private equity. That's worked for the families, but importantly, it's also worked for brand owners. And so we've gotten into a bunch of systems where there's no private equity. And so, like in the auto dealer world, in beer distribution, there's no private equity, there's very little, and heavy equipment dealing, and we've been able to get into all three verticals. So I think there isn't a lot of competition and yeah, that is definitely one of the reasons that we like it quite a bit.

Shiv (03:46.961)

Yeah, I just—to touch on that, I think it's an interesting angle, right? Because one of the things a lot of firms struggle with is deal flow and really distinguishing themselves. And at the same time, there's so many middle market firms that chase the same assets. And meanwhile, there's all of these companies. Like I have a bunch of entrepreneur friends and people that run businesses that are not a private equity focused type of industry, but they're good businesses. They're profitable and there's modest growth and they're just good businesses to own and run. And yet institutional capital doesn't always back those kinds of companies. And so I can see that being a bit of a blue ocean for you guys.

Mike Esposito (04:26.731)

Yeah, no, absolutely. We've definitely found it that way. There—as I said, just not much competition in it. And they're big industries, they're consolidating industries. You know, for us, we found it to be a bit of a different return profile. You know, as you said, a lot of investors, as traditional investors, are focused on tech.

You know, clearly there's been this AI boom that's happening, which has drawn a lot of investment capital. We're definitely old economy businesses in a way. We're brick and mortar businesses.

You know, we like to say that we're the businesses that Amazon hasn't been able to get to. So you have to go to a gym to work out. You know, these people still want to go to a car dealership to see their automobile. You have to get your taco from a local taco place. And so there's good reasons why these businesses exist, but they've been a little bit undisruptible. And we like that.

Mike Esposito (05:33.709)

And they tend to be economic resilient.

And they tend to have very good cash on cash returns, which is another thing we liked about them. So, you know, a lot of things you see transacting in private equity can often trade in the 10, 15, 20 times EBITDA level, particularly where there's this rush of capital into it. And we just don't see that in the things we transact in. You know, we're sub-10 times, and as a result, they have a very good sustainable cash on cash return.

Shiv (06:05.178)

Yeah, yeah, I think that's a powerful differentiator, especially when you're thinking about value creation and growing these investments over time. But help us understand the profile a little bit more. So I get the model. What characteristics do these businesses need to have for you to consider them worthy of investment?

Mike Esposito (06:21.964)

Yeah. So we kind of have probably a two or three tier filtering screen for us. You know, as you pointed out, we've got a niche strategy. So one good thing is that on that, is that every day we come in the office, every day we go out and hunt for something, we know very clearly what we're looking for. And people in the market also know for these types of assets where to come.

And so that focus has really helped us quite a bit. And so we see a huge amount of deal flow.

When it comes to traditional multi-unit retail, we have this multi-tier filter. So I think it starts with the category and brand. So I'll speak about this in the context of food, but it's applicable to anything else, whether it be automotive aftermarket, whether it be gym space, whether it be early education, all of which we're in. But I'll speak about that in terms of food. So we start with the brand, and you know, brand matters a lot when you're a franchisee.

You know, you're a taker of the model, you're a taker of the brand, and so you want to find a brand that's got good momentum where they're looking, where we can partner with the brand, and we spend a lot of time not only studying the brand but then getting to know the senior leadership from the brand, and you know, we really want to try to find systems where they're looking for partners.

When it comes to brand momentum, you know, we're looking for things that generally have decent AUV growth, meaning unit volume growth.

Mike Esposito (08:04.148)

So it kind of starts at that level. You know, ideally we're looking for things that are unique, that are differentiated, whether it be the food, whether it be the service model, whether it be some of the optimization of how they actually produce things. So you know, it starts with the brand, it starts with the quality operation, the growth, and then the partnership mentality. And then we look at box economics.

For box economics, you know, we're looking at things again like AUV growth, but we're looking at margin structure. You know, one of the things that's really difficult in multi-unit retail, particularly in the franchisee space, is that a lot of times margins are really thin. And we are very sensitive to margin because at the end of the day, margin is what allows you to survive shocks. You know, for us, we're generally looking for things at the store level that have margins in excess of 15%.

Mike Esposito (09:03.952)

And ideally north of 20%. And a lot of concepts, probably 80% of concepts, get cut off right there because they don't have that.

Shiv (09:14.02)

Yeah, can you expand on the box economics and the AUV growth side? Just help us understand how you're evaluating these franchises. I get the margin component, I get that on a per unit basis, how much are they moving in terms of revenue? What's their gross margin, their overhead, and all of that? But what are some benchmarks that you're looking for within those types of metrics?

Mike Esposito (09:37.773)

Yeah, so when you think about the margin, there's several components to it. Many, many categories, but I'd say maybe three to spend some time on. And again, I'll talk about this from the food concept, the quick service restaurant concept. You know, first is obviously food cost, and that gets coupled with labor. And generally the two of those together—

We're ideally looking for things that have a fifty percent or so relative to revenue. So fifty percent cost of labor and food costs. Now food costs can be volatile. So if you look at what's going on right now, meat and burger and beef prices have skyrocketed.

Eighteen months ago that was chicken. And so you have to think a lot about end commodity risks that you're taking. You know, one of the great things about Taco Bell is that there's actually not a lot of protein, whether it be chicken or beef, in the taco, and it's a lot of filler, which is a lot less volatile in terms of cost. And so Taco Bell is one of those systems that has a circa 50% prime cost, i.e. labor and food, but also importantly, it's not as exposed to the commodity cycle. So that makes it, from a box economic standpoint, really attractive. And then beyond those two costs, food and labor—

Mike Esposito (11:07.074)

—we're looking at the "all other," and I would say the biggest driver there is rent. And you know, that's the other key, is that in part it's how efficiently can you take a big unit volume down to the bottom line. Part of that is food and labor, but then box format matters a lot. So standalone stores are expensive, inline stores are cheap. And so—

Mike Esposito (11:35.023)

You know, to the extent we can find systems that have very good unit volume that can be done in an inline format, that makes things very attractive. You know, in today's markets, some names that come to mind that have that kind of very attractive situation is somebody like a Dave's Hot Chicken, even Wingstop today, which has had some issues in the last four or five quarters.

Very good box economics because again it's inline. Jersey Mike's would be another one that fits that mode. So when we think about box economics, those are some of the key things that we're looking at in terms of profitability measures.

Shiv (12:11.27)

Yeah, so I guess it just sort of—to reflect back, so it's basically what you're saying is that there's commodity impact on the cost of food, and then there's the actual rent and the overhead that goes along with maintaining the location. And so certain locations, if they take up less square footage—like there's a metric, revenue per square foot, I'm sure you guys look at that, right? On a revenue per square foot basis, if you have an inline store versus a standalone store, it's just more efficient. You're moving more product, you're moving more revenue, and you're able to be way more efficient with your operations.

Mike Esposito (12:43.532)

Yeah, so you know, I think there's always a bit of tension between franchisee and franchisor. Franchisors don't have to live directly with the cost of a build, and say, look upon a standalone store as branding. McDonald's is probably the best example of this.

Mike Esposito (13:03.458)

But it's maybe not the most efficient way in terms of if you want to grow stores quickly and have good returns on the stores, oftentimes an inline concept is better. It's a trade-off, no doubt about it. Standalone stores do attract more attention, so probably in general, standalone stores have better AUVs. You know, I think where it gets interesting and it matters a lot is in concepts that are driven by the need of a bigger box.

If you look at what's going on in coffee now—this is a great example—and what Dutch Bros and 7 Brew are doing, they've actually got standalone stores. The stores themselves are tiny, but it's all driven by speed of service. It's like the key threshold for them: get people in and out through the line in three and a half minutes. And they've got big pads, but it facilitates the double drive-thru model.

So the point I'm trying to make there is that, you know, from where we sit, we like the best return on investment as possible. In certain instances, the bigger footprint is necessary to facilitate a high throughput model, which creates a lot of value.

Shiv (14:17.967)

Yes, right. So it's always a bit of a trade-off. I guess something that jumps out to me is that because you're investing in so many different types of franchises—quick serve, automotive, beverage, equipment—your investments are susceptible to what's happening in commodities markets, what's happening in supply chains. And so there's just a lot of moving parts versus, let's say, a tech business, where an investor just puts money into software companies and really is just looking at the software code and whether that's legit and how it maps against competitors. So it feels like way more complexity to invest in these kinds of businesses. Or am I wrong? I'm curious your take on that.

Mike Esposito (15:01.87)

Well there's certainly, you know, nothing's free in this world and there's risk in everything one does. But my god, I like—every day I can go and I can see the cash and the cash register in the things we invest in. These are cash flow businesses. There's no uncertainty. You know, given what's gone on in tech—you look at what's happened in the whole software market and the disruption that's being caused by AI—whatever they had in terms of EBITDA is surely shrinking every day. And even when you look at pure tech-oriented growth investing, how many of those businesses in their first five years actually generate cash flow? So, you know, we kind of like it. Yes, there's clearly risks—we've already hit on a number of them. You know, the thing that we think a lot about is over the last 20 years, barriers to entry in these industries have come down dramatically. You know, it used to be you had a handful of choices.

In the food space, you had McDonald's and Burger King. In the gym space, you had a bunch of people, but it was really Planet Fitness. And you know, what we're seeing is the emergence of all these new competitors, and there's a lot of liquidity in the private financing markets—both debt and equity—that have financed those. And a lot of people have made money doing that. And so, you know, there are new entrants, and to me that's one of the bigger risks in everything we do. But at the same time, you've got a lot of visibility in the—

Shiv (16:34.107)

Yeah, that's a great point, which is that these businesses by default are churning out more cash than a tech business that constantly requires reinvestment. And you kind of have to balance the investment in that. I guess the other complexity would be things like capex or construction costs and other physical assets that you have to invest into. And so I'm just curious, like when you're deploying capital—because you have to forecast out three to five years out—how will this industry change, or how will certain dynamics in the market affect this particular line of business? How are you evaluating all of that risk and additional capital expenditures and things like that that you'll have to put into?

Mike Esposito (17:20.712)

Yeah, so one of the things we do is a lot of forward real estate development. And I like to say we occupy this world between traditional private equity and traditional real estate private equity, in that we end up building a lot of stores. You know, if we go back to the top of the discussion, AUV growth matters a lot. We find AUV growth to be very hard to predict.

And over a long time—over the last 20 years, if you look at it in restaurants—AUV growth has averaged less than inflation. And so generally speaking, in any of these multi-unit retail concepts, we are loath to forecast same-source sales growth for any extended period of time at anything greater than inflation. And so in order for us to get our returns, we've been getting a lot of it from new store growth.

And so we focus a lot on new unit development and the returns associated with that. And we've done five or six deals. We've gotten into the 7 Brew coffee system, we bought 50 stores, we're developing 250. In Valvoline, we bought 40 stores, we're developing 75. We recently got into the Primrose nursery school system, we bought three stores, we're developing 18. We just announced a deal in Australia in Planet Fitness, where we bought the Master Franchise rights to Australia. We bought 30 clubs, we're building over 70. So we're doing a lot of this. So first off, we've got a data science team, and the data science team has built white space models in all these different concepts, and they're dynamic models. And what we've observed is, you know, you can look at AUV today, but AUV degrades over time as systems build out their footprint. That's in part due to cannibalization—it's in part with themselves. In other words, if I put a Planet Fitness here and then I put one five minutes, five miles further away, I'm going to degrade, cannibalize myself.

But—Economics 101—if it's a good concept, somebody else is going to also build one close. And so you've got the cannibalization effect, both yourself as well as new competitors coming to market. You've got oftentimes brands starting with the best places, best cities, best metros, best DMAs, and they move into secondary and tertiary. So that degrades AUV over time.

Mike Esposito (19:38.315)

And then there are vicissitudes to the brands. And so, you know, we've spent a lot of time thinking about all of those things, modeling all those things. And so we'll take on these three to five year development deals, but we go in eyes wide open about all the different things and we try to quantify it as best as possible. In order to cover our risk, we do this where we can get a 20% unlevered return or better. And so, you know, in really simple terms—

Mike Esposito (20:30.86)

—you know, the simplest way to think about it is EBITDA at the store, less some corporate overhead, divided by your all-in construction cost. We're looking for a 20% plus unlevered return on that. And we felt like if we can get that 20% unlevered return, that we can pretty much cover our risk for all the things I mentioned before. And we've been getting that in most of the places where we've been developing.

Shiv (20:58.929)

God, yeah, that's really interesting. I guess on the real estate side, is that considered part of the same fund, or is that a separate part of the business that you're investing into the real estate behind these franchises?

Mike Esposito (21:10.594)

So it's all part of the same fund. You know, and every system and every concept is different. So a little bit what you're asking is, you know, do we own the real estate or not? So first and foremost, we always want to maximize the value of the operating business, and we find that having the right location trumps everything. So in certain concepts that need to be on Main and Main, food would certainly be this.

Shiv (21:21.167)

Mm.

Mike Esposito (21:38.007)

You know, generally speaking, it's very hard to buy the dirt and own the ground and own the buildings—those properties oftentimes have been in local families for generations, and we found that we end up having to lease the site. In other instances, where you don't necessarily need to be on Main and Main—

We've had a lot of success in buying sites and developing ground up and doing it all ourselves. Certainly in the Primrose nursery school system, early education system, it's a good example where you want to be close to the retail cores, but you don't need to be absolute in the retail cores. And so that's an area where we've been able to buy more of the sites ourselves and develop where.

Shiv (22:21.167)

Yeah, that makes a lot of sense. How do you look at innovation in these spaces? Like, for example, in Quick Serve, there's a lot of talk about restaurants that don't actually have any labor—like down the road, you'll just kind of walk up to a robotic counter and it serves you food. How do you look at those types of innovations and how it impacts your franchises or your plans to actually evolve these franchises over time?

Mike Esposito (22:48.684)

Yeah, so—

You know, innovation is rampant in everything, we're in consumer businesses. And you know, when you look at the last 25 years of these consumer businesses, it's been all about innovation. I'm sure it was true 30, 50 years ago, but certainly the last 20, 25 years it's been absolutely true. And innovation comes in many different forms. You know, when you first mention innovation, the first thing my mind goes to is food innovation.

So for example, Taco Bell is probably the best at this—literally every month they have a limited time offer coming out. One month it's Mexican pizza, the next month it's some drink thing, and they've got a lab that's testing this, not just coming up with quirky recipes, but they're consumer testing it, and they've got a real forward calendar. If you look at what's happening in the beverage space between Swig and 7 Brew and Dutch Bros, you know, they're all really reimagining the whole beverage experience. It's not your mama's Starbucks. It's much more than espresso. It's an energy platform, it's a fizzy drink, dirty soda platform, it's almost like an ice cream parlor platform. So I think—

Like, when I think about innovation, I think it starts there, and I think the concepts that have done well are able to innovate successfully, but do it in a way that doesn't deter from the customer experience in terms of getting through the lines. But then you bring up other kinds of—

Mike Esposito (24:37.558)

—technology. Clearly the app was obviously a big one, and third-party delivery was certainly a really, really big one. You know, what you're talking about now in terms of automating, I think is coming. The in-store piece, people are looking at that, and certain concepts like mixing salads have worked well from a robotic perspective. But I think you'll see more of that. I mean, I think the one disruptive concept out there that's kind of scary is Wonder, where they're really becoming brand agnostic—a ghost kitchen with huge amounts of robotics. And if they can pull that off, that could be the most disruptive thing we could see, because when you think about that P&L I was going through before, you've eliminated labor, you've eliminated the need to be on Main and Main, so your rent is going to be super cheap. And so they're really dealing with some of the most expensive pinch points in making food. So I think that's, to me, the most disruptive thing I can see in food coming out.

Shiv (25:44.794)

Yeah. When you think about these companies, I guess there's obviously the innovation side and then there's the optimization and the financial engineering side. What about organic growth? Do you guys support these businesses in terms of actually growing their footprint or how much they're driving in terms of sales?

Mike Esposito (26:03.372)

Yeah, so as I said earlier, we tend to—not exclusively, but we tend to be franchisees—and there are certain brands where they basically handle all the marketing. So if you think about the big well-known food brands, they're basically doing—

And as a franchisee, your responsibility from a marketing standpoint tends to be grassroots types of things. You sponsor the little league team, you give away some coupons in the local neighborhood, whatever it might be. But the branding itself—digital, social, national brand advertising—it's all done at the brand level. In other systems, that work falls on the franchisees. So for example, we own a business in the Precision Garage Door System, which is a residential services system. It's owned by a company called Neighborly, which is owned by KKR. And we happen to be the largest franchisee in that business, and we're the largest repairer of garage doors in the country. In that business, we're responsible for 95% of the marketing.

Mike Esposito (27:14.996)

So we've got a chief marketing officer, we've got all kinds of branded strategies, pay-per-click and digital strategies within Google and other platforms. We're coming up with our own marketing campaigns, we're constantly testing and looking at that. And so, you know, it varies widely in terms of that spectrum, in terms of what we're in today.

Shiv (27:41.212)

Yeah, one of the things we've noticed is that there are tech companies that are more savvy in modern ways of driving demand and pipeline, and a lot of these offline businesses don't even do the basic fundamentals of having a local presence, or local SEO, or local paid media, and things like that. And they seem like very accessible and quick value creation levers that can be pulled. And so I'm curious if you see that, especially in all these kinds of industries—like manufacturing or offline, not just quick serve. Quick serve obviously has a whole playbook around these apps where you can order food online and things like that. But I feel like these legacy businesses have never done some of the foundational or basic campaigns that you can run to drive more pipeline.

Mike Esposito (28:31.362)

Yeah, I mean I think some of that, to be frank, is—in this middle market, part of what we didn't talk about, I didn't mention it—you know, we're distinctly a middle market investor. So companies we look at probably are averaging ten to fifty million of EBITDA.

To generalize, in that space, there's probably less data sophistication. We like to say they're pre-moneyball industries. And so what we found is bringing data and data analytics into this can help immensely. We bought, not too long ago, the largest car wash platform in the world in terms of operations in Europe—it's called IMO. This happens to be a company-owned model, and they didn't have a data lake for anything. So we started by building a new ERP system, a new data lake. For a business that was generating 50 million of EBITDA, they spent one million dollars on advertising. There was no chief marketing officer, there was no chief technology officer. So we're reinventing the whole data stack, you know, from the ingestion of data all the way through the customer experience through the app.

We're redoing the whole data stack as part of that, creating the data lake to get information, and then completely changing the pricing, product, and marketing strategy. And you know, some of that was because we've had some experience around these concepts, we've been able to bring it. Obviously a lot of this is we hire the right people to bring to bear to these things. And so we feel like, in that middle market, it's just really ripe for data—

Mike Esposito (30:29.494)

—moneyball-type tactics, and bringing some of these best practices into these companies.

Shiv (30:35.559)

Yeah, I think that's like a huge untapped area, because most of the competition in these markets aren't thinking about these things. Like, for example, even on things like Uber Eats or on these food ordering platforms—there are ad platforms in there and a lot of food vendors don't leverage those. That's a basic optimization to drive more pipeline. And the same can be said for localized SEO on Google Maps. If you have a local business and a lot of companies don't even show up on those types of applications—so I think the value creation levers are just way more accessible. Whereas if you're in a more advanced market where everybody's kind of doing the foundational stuff, then to be competitive, you have to do much more. So I feel like that's a big lever inside these businesses.

Mike Esposito (31:25.942)

Yeah, I mean, we've got, as I mentioned, this data science team. So one of the things we do when we get into these businesses is we try to get as much read on how they're dealing with their estate of marketing. And so one of the things we do is we scrape the Google business profiles—really simple way just to audit how companies are doing. And in some of these businesses we look at, with hundreds of stores, there's no consistency. Hours differ. There's no phone number for the store. They don't link in the Google reviews. It's bad. And so you're right, I think there's a lot of opportunity to unlock value there.

Shiv (32:09.871)

Yeah, a hundred percent. We're coming up on time here, Mike, but before we close off, if people want to learn more about you or get in touch with you, what's the best way for them to do that?

Mike Esposito (32:19.734)

Yeah, so feel free to email me, [email protected]. I'm happy to chat with anyone.

Shiv (32:28.303)

Awesome. We'll be sure to include that and your website and the show notes. And with that said, Mike, thanks for coming on and sharing your wisdom. It's a bit of a change of pace for the podcast to hear from someone investing in these types of businesses, and I think there's a lot of great takeaways for all kinds of companies. So appreciate you coming on and sharing all this.

Mike Esposito (32:45.219)

Thank you.