Middle East Private Equity – Franchise Business Targets: Out With The New; In With The Old

May 31, 2016

As any investment professional located in the Middle East North Africa (MENA) region will tell you, franchise businesses have proved a very popular asset class for investors in the last few years. This article provides an overview of the key legal aspects to consider when buying/selling a franchise business and also focuses on practice points particular to the MENA market.

Background and Key Considerations

1.   What is a franchise business?

Franchising is the practice of a franchisor – the owner of a business – granting to a franchisee the right to use the franchisor firm’s business model and brand for a prescribed period of time in return for the franchisee paying (amongst other items) a franchise fee, and undertaking to comply with certain covenants in order to protect the franchised brand. In such a relationship, the franchisor’s success depends on the success of the franchisees.

Generally speaking, foreign entities are not able to undertake business activities in the MENA region without involving a local partner (i.e., as a result of foreign ownership requirements). As a consequence, franchise relationships are a very common method for recognised brands to operate in the MENA market. Franchise relationships are possible in almost every business sector but are most frequently found in the food and beverage (particularly fast food or ‘QSR’) and retail sectors.

Whereas in most other markets franchises are commonly granted on a ‘store by store’ basis (particularly for fast food outlets), for various reasons franchise arrangements in MENA have historically been conducted on a regional (or ‘country by country’) basis, leading to several ‘mega-franchises’, examples of which include:

• Azadea (a premier lifestyle retail company that owns and operates more than 50 leading international franchise concepts including Gap)
• Alshaya (a multinational retail franchise operator that operates more than 70 consumer retail brands including Starbucks)
• Majid Al Futtaim (a family-owned conglomerate with more than 135 fashion stores across the MENA region and more than 20 food and beverage (F&B) outlets in the Gulf Cooperation Council states and India)
• Olayan Group (a Saudi-based conglomerate that operates Burger King in the region together with various other F&B concepts)

2.   Why have franchise businesses become so popular recently?

Since Carlyle’s acquisition of Alamar (the franchisee of Domino’s Pizza and Dunkin’ Donuts) in 2011 and the acquisition of Shakespeare and Co by NBK Capital in 2013, franchise acquisitions, primarily in the F&B sector, have been particularly prevalent, with examples including:

• The investment in Kudu by Abraaj and TPG
• The acquisition of Reem Al Bawadi by Marka
• The acquisition of the Cravia Group (the franchisee of Five Guys in Saudi Arabia and Qatar and Cinnabon and Seattle’s Best in the wider region) by Fajr

There are additionally various other proposed ‘mega-deals’ that are reported to be in process (for example, the sales of Alamar, Americana (the franchisee of KFC and Pizza Hut) and Azadea).

While there are numerous reasons for the renewed focus on franchise businesses, from our experience, the most important of these include:

• Growth: Continued growth of the retail/F&B sectors in the MENA region
• Cash generation: The highly cash-generative nature of franchise businesses
• Presumed resilience: In a time when many business sectors are suffering (in particular the energy sector), many believe the consumer sector is less cyclical than others.
• Diversification: Regional investors are looking to diversify away from ‘traditional’ private equity investments (such as oil and gas service companies, heavy industry, etc.).
• Scalability: The franchise businesses that investors are targeting tend to be large enough to make the acquisition and possible exits viable.
• Value creation: Many of the franchises are operated in an old-fashioned/inefficient manner and many believe that relatively simple improvements will increase profits and achieve high returns on amounts invested.

3.   How do local laws impact franchise relationships?

In many MENA jurisdictions (as in others, such as the United States and Australia), laws have been put in place in order to protect the franchisee. However, such protection is usually only available to nationals of the country in question (or companies owned by those persons).

By way of example, in the UAE the relevant statute is the Commercial Agency Law No. 18 of 1981, as amended by Federal Law No. 14 of 1988, Federal Law No. 13 of 2006 and Federal Law No. 2 of 2010 (‘Agency Law’), which regulates the appointment of franchisees, commercial agents, sales representatives, and distributors in the UAE. The Agency Law will only apply to agreements that are registered with the UAE Federal Ministry of Economy and, as a result, franchisors generally consider it preferable not to have their agreements registered. 

Reviewing the Agency Law in detail is beyond the scope of this article, but for our purposes it is sufficient to note that:

• The registration of a franchise agreement will give the franchisee exclusivity in respect of the franchised products/services.
• A registered agreement cannot be terminated by the franchisor without the franchisor being able to show ‘justifiable cause’, even if the franchisor has a clear contractual right to terminate in the franchise agreement itself or if the term of the agreement has expired. In addition, even if a franchisor is able to establish ‘justifiable cause’ (which may be very difficult in a local court), it is likely that the franchisor will be ordered to pay an appropriate compensation payment to the franchisee for termination of the agreement. 
• The franchisee is able to instruct the UAE ports and customs authorities to prohibit the import of any products in respect of which it is the registered agent. This puts a registered franchisee in a strong negotiating position in the event that a franchisor wants to terminate an agreement and appoint a replacement franchisee. 

4.   What are the key legal aspects to consider when buying/selling a franchise business?

These will be dependent on the stage of the transaction.

Initial stages. It goes without saying that carrying out due diligence on the franchise agreement(s) is of critical importance. Matters requiring particular attention include:

• Change of control (all modern, well-drafted franchise agreements will contain a provision entitling the franchisor to terminate the agreement upon a change of control of the franchisee)
• Franchise/marketing fee amounts
• Refurbishment/new store opening/other capex obligations
• Minimum purchase/business requirements
• Geographical coverage of the franchise relationship
• Assignability of rights (which may be even more relevant in the context of financing the acquisition)
• Term/renewal rights
• Termination rights
• Ongoing obligations as regards conduct of business/brand protection

However, in addition, and of equal (if not greater) importance, the relationship between the franchisor and the franchisee itself must be diligence/investigated. Relevant factors to take into consideration here include:

• Length of the franchise relationship
• Content and tone of correspondence between the franchise parties
• Historical breaches of the franchise agreement by the franchisee and how these were dealt with
• Future plans of the franchisor in the region

Most franchise agreements are (by the nature of their content) drafted in vague or subjective terms which, from a legal perspective, are likely to give the franchisor an arguable right of termination at many points in the relationship. Consequently, the strength of the franchisor/franchisee relationship is particularly important. The most obvious way to obtain such comfort is, of course, through a meeting or other direct correspondence with the franchisor. However, as a general rule sellers of franchise businesses are unwilling to allow access to franchisors until there is a sufficient level of deal certainty so as not to adversely affect the ongoing franchise relationship in case the transaction does not proceed.

It is also important for any buyer of a franchise business to understand the supply-chain arrangements of the franchise itself in order to ensure business continuity post-completion. In this way, the buyer can avoid being ‘held hostage’ to captive supplier arrangements where no substitute arrangements are available.

If the buyer wishes to finance the purchase price, it is important also to consider the terms on which the banks will be prepared to finance the acquisition when conducting diligence on the franchise agreements or discussing the terms with the franchisor. Because banks typically require an assignment of the franchise agreements as security for their loan, addressing upfront whether the franchise agreements are assignable, or procuring consent to assign them, can save a lot of time and effort later. Often the franchisor is not willing to allow assignment of the franchise agreement, so banks may require other forms of security.

There may also be issues arising in relation to leased premises for the stores/outlets operated by the franchisee (i.e., change of control provisions, landlords requiring increases in rent for granting consent, etc.). However, because such issues are not franchise business-specific, we do not discuss these further in this article.

Transaction documentation stage. In the vast majority of cases, a ‘clean’ consent from the franchisor to the implementation of the transaction will be the most important condition precedent to completion. This generally applies whether the underlying franchise agreement requires such consent to be obtained or not as, in almost all circumstances and independent of contractual terms, a buyer will require comfort on the continuing nature of the franchise relationship upon completing the acquisition.

In our experience, obtaining franchisor consent can be a relatively time-consuming process requiring input from, and the ongoing involvement of, all parties. In almost every situation, franchisors will require the buyer to provide detailed information both in order to fulfil ‘Know Your Customer’ requirements and to understand the buyer’s intention as regards future operations of the business. Because most franchisors are based outside of the region, misunderstandings in communications/differences in approach between franchisors and franchisees/buyers are common, and there is often a level of cultural education necessary in order to explain how business is undertaken in local markets. 

In some cases, changes to the underlying franchise agreement are required as a condition precedent to completion, although sellers will almost always strongly resist this approach (as will franchisors) unless there is a compelling argument otherwise (i.e., a very poorly drafted franchise agreement).

More commonly a franchisor may, in fact, require that certain ‘franchisor-friendly’ changes are made to the franchise arrangements as a pre-condition to granting its consent to the transaction. Whether or not a buyer is willing to accept such changes (or is contractually obliged to do so) will always depend on the context of the specific transaction and the changes being proposed.

Any well-advised buyer of a franchise business will also look for contractual protection to be given by the seller on the franchise relationship itself. Such coverage will usually take the form of specific warranties and (possibly) indemnities and will cover such matters as:

• Accuracy of disclosure regarding the franchise agreement(s) and relations with the franchisor
• Validity/enforceability of the underlying franchise agreement(s)
• Compliance with the terms of the franchise agreement(s) by the franchisee
• Information on historical breaches

In addition, the parties may agree upon price adjustment mechanisms whereby the purchase price will be reduced in the event that the franchise is terminated within a certain period of time following completion (although, again, this is something that is usually heavily resisted by sellers).

As noted above, if the acquisition is to be financed, it is key to ensure that the financing bank either is also comfortable with the assignability of the franchise agreements or, if they are unable to be assigned, that the bank understands this and is prepared to accept alternative security. Banks often expect to receive an assignment of the franchise agreement.  If this is not possible, it is important to ensurethat the bank understands this and factors this in as part of its credit approval process.

The buyer may also seek contractual protection on obtaining landlord consents to the transaction for leased stores/outlets. Sellers generally resist landlord consent as a condition precedent to the transaction and are more likely to accept protection granted through other means (such as a post-closing price adjustment where key leases are terminated). Again, as this is not something that is franchise business-specific, we will not discuss this further in this article.

Conclusion

Franchise businesses are becoming more and more important as an asset class in the MENA region. Given ongoing economic performance and developments in the wider global economy, this is a trend that is likely to continue in the short- to medium-term future.

While the acquisition or disposal of franchise businesses is, in many ways, similar to deals involving most other types of business, there are specific issues of which counterparties need to be aware. In order to ensure a smooth transaction, these need to be considered at an early stage in the process.