It is and it isn’t…
Former McDonald’s CFO, Harry J. Sonneborn, is even quoted as saying, “we are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent.”
The story goes that in the 60s, when Ray Kroc was trying to grow the business its CFO, Sonneborn, came up with the idea that it was easier to get new financing from the banks if they structured McDonald’s as a real estate business instead of a restaurant.
A real estate business with a balance sheet full of real assets and steady rent revenue has a much lower perceived risk than a restaurant that is exposed to a wide range of operational risks. Thus, as a real estate business, McDonald’s had access to lower interest rates and higher leverage ratios.
Contrary to what Sonneborn said, the real estate business is only one of McDonald’s value generators. It is a smart way to maximize the company value creation and squeeze all value possible out of a restaurant operation.
In fact, McDonald’s corporation is the combination of three different value generators: the restaurant business creating value by selling fast food; the franchise business creating value by allowing other restaurants to use their brand, products and production system; and McDonald’s REIT (real estate investment trust) creating value by collecting rent from the restaurants and appreciation of land value.
But make no mistake, if McDonald’s were acquired by a private equity firm their first action would be to spin off the real estate business and sell it. Which was already publicly suggested by several important McDonald’s shareholders like Larry Robbins from Glenview Capital and Bill Ackman from Pershing Square Capital.
Selling McDonald’s real estate portfolio to a diversified real estate fund would create value because it would reduce its perceived risk. Even though McDonald’s REIT has a diversified portfolio of real estate assets they are exposed to only one client. Because of it, part of the restaurant business risk affects the real estate business elevating its discount rate and reducing its cash flow value. If the same assets were under a real estate fund with several different clients, the perceived risk would be lower, and the cash flow value would be higher. Thus, creating value.
During the initial company assessment, the private equity firm will separate the company into different baskets: one for each operational value generator like in the case of McDonald’s the restaurant business and the franchise business and one for each asset class like real estate. This separation is important for two reasons: to minimize discount dragging where the risk of one value generator affects the value of another one and to identify capital creation opportunities. Like in the McDonald’s example, the real estate business has a lower risk profile than the operational businesses and separating them creates value by allowing the company to discount the cash flow generated by the assets using a lower discount rate. The second reason is to analyze the real need of each asset and its potential leverage potential. Every asset that can be sold, leaseback or re-financed is an opportunity to create capital to be allocated. This capital creation strategy is so important that most of the big private equity firms have their own real estate and private debt funds.
Like Mcdonald’s, most companies are a combination of several different value generators and understanding it is crucial to maximizing company value. Different value generators have a different return on investment and risk profiles. And depending on how the company combines them can create or destroy company value.
Recently, we advised a company on how to create value and one of the main takeaways was “split your company into a consulting company and a software company”. The company had created two software and had a consulting team to implement them. The risk profile of a consulting company was dragging the company value down and holding the potential growth of the software company. As two separate businesses under different brands, the company would have a much better cash flow forecast and better combined company value.
Takeaway
Every company is a combination of value generators and how you structure it will influence your company value and its value creation plan.
Peloton Value Creation Advisory
Led by a former Private Equity Chief Value Officer, Luis Senra, Peloton’s Private Equity Paradigm enables clients to deploy the same strategies for value creation as those employed by major private equity firms.
Creating value is what all owners and managers aim to do. Sometimes it takes a step away from conventional shareholder value analytics to achieve a major breakthrough and get the results you deserve. Peloton’s Private Equity Paradigm enables that step-change to occur.