Another Investor Enters Brick & Mortar – Will Likely Regret It

Last week Fishbowl Marketing was acquired by Symphony Technology Group. I’m always a little leery of private equity ownership because many of these funds use financial engineering to steal their IRR instead of digging into the operations and making improvements at a more fundamental level. Classic example is Golden Gate Capital stripping the real estate off Red Lobster.

But Fishbowl made a good move years ago in buying Mike Lukianoff’s analytics company. Mike was one of the first people I heard of doing legitimate data science in the brick and mortar space. Many retail executives will tell you they’re using “big data” or “data science” but that’s just verbal masturbation to make it look like they know what they’re doing. So because of Fishbowl’s willingness to involve themselves in real data science by aligning with Mr. Lukianoff, they’re probably making a good move by partnering with Symphony.

Though with all respect to Fishbowl, I’m not sure it will be a (relatively) good deal for Symphony.

Start with this question:

Why are there so few private equity (PE) investments in brick and mortar service providers, particularly restaurants?

Our observation is two-fold, and we’re not shy about providing data to back it up

1. Merchants are really unsophisticated and thus sales cycles are forever long
2. Merchants are really broke because they don’t run their businesses well so solution provider revenues are low

On the whole, this truism is bad for the industry. It means external sophistication continues to pass it by because growth is hard to come by. Think of it like this.

The US restaurant industry is huge. It’s $700B in sales, employing over 14 million people – 10% of the workforce. Yet you’d struggle to find 10 restaurant technology companies that meet the PE threshold of investment interest ($10MM annual revenue).

[bctt tweet=”Think about it: here’s an industry that’s the 2nd largest employer yet you can’t find 10 tech companies that earn $10MM in revenue…” username=””]

What does that say about the sophistication – and thus potential – of the industry?

This is a list of tech companies that might reach this revenue minimum. (I’m going to ignore payments companies because they’re ultimately not constrained to brick and mortar like a restaurant marketing tool might be.)

• Compeat
• Crunchtime
• Ctuit (might be a little short)
• Delaget
• Fishbowl
• Hotschedules
• Tillster (previously EMN8)
• Xformity/Altametrics

For a list of companies that received tens of millions in funding to reach this level of PE-acceptable revenue, see the below

• Grubhub/Seamless
• olo
• OpenTable
• Shopkeep, Toast, Revel (likely losing millions/tens of millions of dollars annually)

But even when one of these rare companies reaches $10MM ARR, are they really a good bet for PE? Or is this image an accurate depiction of placing bets here:

In other words, is getting that 25% IRR easy to achieve when the end customer is ultimately really unsophisticated or are you better off going somewhere else?

Let’s look at Hotschedules for an example.

TPG executed the classic PE rollup in January of 2013, combining Hotschedules with a handful of other software providers (Schoox, Macromatix, and Red Book) in the space. The theory for the rollup is pretty straight forward: take a bunch of software companies with similar customers in the same space and get them to cross-sell to each other. Provide working capital and lever the acquisition with debt, scale it up, and exit in 5 years, hitting that 25% IRR mark.

Let’s start with a basic rule of thumb to figure out if TPG is making their lives easy by taking on this acquisition.

A quick and dirty way to calculate IRR is to use a multiple-on-money (MoM) number and divide out the length of time to get IRR. For example, if I buy a company for $100, and it takes me 2 years to double it to $200 (where I then sell it), what’s my IRR?

So I would take $200-$100 = $100. This is a 100% gain from the initial $100 investment. It took two years to achieve, so it’s roughly an IRR of 50%. However, we need to add a fudge factor for compounding (because money has value over time), which is usually a 20%-25% discount.

For this example, we’d say the IRR is 75% of that 50% number, or about 40% IRR.

With that, let’s reexamine TPG’s rollup. Our guess is that the 4 companies prior to acquisition were earning a combined $50MM in annual revenue (Hotschedules reported annual revenues of $10.6MM right before acquisition and with the exception of RedBook they were likely the only asset doing > $10MM ARR). Now, four years later, the asset is earning somewhere around $75MM in annual revenue.

Maybe.

I assumed a 10% compounded annual growth number for the business then I added a 30% EBITDA margin because “good” companies have margin + growth = 40%.  But on Linkedin Hotschedules shows fewer than 500 employees. If we assume they cost $100K/year and add a 30% EBITDA on top of it, Hotschedules might only be pulling in $60-65MM ARR.

And one could argue this 40% number from some pretty public bumps in the process.

The rollup was first branded as Red Book Connect. New management was brought in. Then new management left. New management was brought in again, and the whole asset was rebranded to Hotschedules in early 2015. New management then left again.

Troubles aside, if we assume 50% leverage and an exit in January 2018 with topline revenues of $75MM and 40% EBITDA margins, that’s a 18% IRR over 5 years on MoM of 2.2x. Not very good.

Now TPG, being a very clever PE firm, will find creative ways to hit their IRR or MoM goal, whether that’s from financial engineering or adding “strategic” value that improves the exit multiple.

But the point is that it takes a LOT more work to hit respectable IRR numbers in brick and mortar.

While the market appears greenfield, it’s greenfield for a reason.

I would expect TPG to exit Hotschedules before January of 2018. It wouldn’t appear that their revenues are high enough for an IPO, so they will look to push the asset to another PE firm. When that happens, other PE groups – including the ones currently active in companies like Crunchtime, Delaget, Compeat or Fishbowl – will learn just how well Hotschedules performed.

Looking at the numbers, our guess is the active PE investors in this space will need to borrow some of TPG’s financial engineering magic to pull of a win.

At some point it’s wiser to make bets on businesses serving sophisticated customers where you can leave your magic kit at home.