M&A: Will 2023 prove to be a game of two halves?

The tumultuous trading conditions of the pandemic were usurped in 2022 by a wave of different and concurrent disruptive forces – the war in Ukraine, spiking energy prices, surging cost inflation, staff shortages and rising interest rates. These contributed to creating one of the most volatile operating environments in years, and 2023 looks set to be another year of great challenge in the hospitality sector, but operators and investors have little choice but to tackle such persistent issues head on.

However, there was still a steady flow of M&A activity during the year, from opportunistic brand acquisitions to strategic trade mergers, growth investment in scalable businesses and, towards the end of the year, an increasing number of restructuring-led deals. Some interesting deal themes emerged, which we expect to continue making a mark over the course of this year:

1. The return of the trade buyer

After a mostly inward-looking 2021, where the majority of operators were conserving cash or addressing their own balance sheets, 2022 saw the return of the strategic trade buyer, as they deployed acquisition strategies to maintain growth in a challenging economic environment.

Over the course of the year we saw TRG, Big Table, Tortilla and Revolution acquire Barburrito, Banana Tree, Chilango, and Peach, respectively. SSP also acquired 25 sites in the AMT coffee estate in October. These deals add additional brands to the buyers’ stable and provide further momentum for growth and conversion opportunities.

We also saw Greene King execute on the strategic acquisition of Hickory’s – a departure from its typical freehold remit. This deal made clear sense for both buyer and management, as Greene King plans to convert a number of its sites into the Hickory’s format, whilst the management team will benefit from Greene King’s central infrastructure, access to capital, and a sizeable potential pipeline to continue to grow the business.

Looking ahead, we expect to see strategic acquisitions by trade groups to be a continuing theme, as they provide entrepreneurs with the ability to de-risk their own position whilst benefitting from the greater resources of a bigger group and sharing the potential mutual upsides.

2. Competitive socialising a key theme

Competitive socialising (or leisure as it used to be known) was a key source of growth investment in 2022, as investors are attracted to additional high margin revenue streams, which translate to site operating metrics that are more resistant to inflationary pressures and less operationally geared.

International competitive socialising businesses secured substantial funding to accelerate US rollouts: Puttshack secured a $150m capital raise in October from BlackRock and Promethean, whilst State Of Play – the operator of Bounce, HiJingo, and Flight Club USA – raised $35m in March from Bregal, Acropolis, and Promethean plus a further £10m in July from its strategic partner, Red Engine.

On the domestic front, sector investor Imbiba were highly active in competitive socialising investments, completing deals for Formula One Arcade (February), Big Fang Collective (April) and Clays (December). While new adult-fairground concept Fairgame secured £5m investment (£2.5m from BGF) to launch its inaugural site in Canary Wharf.

Despite this flurry of activity last year, the segment is still relatively nascent, with strong opportunities for investors to claim the white space on offer, buoyed by the robust P&Ls that this kind of hospitality offering can deliver.

Two of the key questions for investors are: ‘who is the next buyer’? and ‘what does the exit look like’? Given the growth prospects for the industry, we believe that this will be a natural fit for further rounds of private equity funding or the public markets when they become more welcoming for consumer industries again. An interesting prospect, though, is the eventual creation of new trade buyers as these platforms aggregate multiple leisure concepts, or whether this space will attract broader entertainment groups who want to capture more of their customers’ leisure wallet.

3. QSR

QSR – or grab-and-go – businesses traded well during 2022, particularly those with drive-thrus as part of their estates, which have performed particularly strongly. Private equity firms are increasingly looking at franchise opportunities for businesses as an effective method of deploying capital, further illustrated recently by OpCapita’s investment in Soul Foods Group (a franchisee of KFC, Starbucks and Taco Bell) in September.

There has also been continued transactional activity from the burger chains, as Bridgepoint-backed Burger King UK continued its growth over the year through the acquisitions of Karali (45 franchised sites) and 12 units in January 2022 to continue their UK roll-up programme alongside developing new-build units. At the same time, McDonalds UK acquired one of its franchisees, Appt Group, in April to take 45 franchised sites in-house.

In addition, we are seeing substantial growth from North American-franchised operators into the UK, such as Popeyes, Wendy’s and Tim Hortons. It would be of little surprise to us if we saw more brands from across the pond land on UK shores, with US investors potentially even acquiring UK businesses to provide an initial foothold in the market.

4. Operational real estate remains strong

A key trend that we also tipped last year was the emergence of operational real estate as an attractive asset class, and a continuation of pub transactions.

We have seen a flurry of activity from investors into the pub sector, particularly in relation to securing an operating platform that provides the ability to deploy capital on further site acquisitions.

Alchemy’s acquisition of Brasserie Bar Co. – the operator of Brasserie Blanc and premium White Brasserie Pubs – was swiftly followed by the purchase of further freeholds, which we expect to continue given the business’ track record in site conversions. In a similar vein, the Inn Collection was acquired by the Harris Family in a deal reported to be as high as £300m, illustrating the value of high-quality real estate.

Given the number of investment fund-backed pub groups including more recently backed platforms such as Punch (Fortress), Brasserie Bar Co. (Alchemy), Urban Pubs & Bars (Davidson Kempner), Redcat (Oaktree), Valiant Pub Company (Njord Partners), and Portobello Brewery (Zetland), and recently rumoured disposal programmes such as the 1,000 units from Stonegate, we expect competition for pub assets to be fierce in 2023. However, we note that the recent softening of debt markets may put capital at a premium and mean that these buyers are more selective in their targeting.

5. Better, together

Continuing the theme of pubs, a highly notable deal in December was the merger between Liberation Group and Cirrus Inns. This deal, which we were very pleased to have advised on, drew on significant strategic, cultural, and commercial similarities between the two freehold, premium food-led groups with significant levels of accommodation and has facilitated the creation of one of the largest privately owned premium pub businesses in the UK.

As operators navigate the headwinds of 2023 and begin looking towards 2024, we would expect operators to consider whether value can be created for shareholders by combining/merging with a business with similar strategic objectives to create a more powerful and resilient market standing. We expect this to be an option that more groups will consider through 2023.

Overall outlook for 2023

Private equity and debt-backed leveraged buyout deals have historically been a staple of the sector and a critical source of M&A activity – one of the most high-profile private equity-backed deals during the year was Arc Inspirations’ £19m backing from BGF in April.

However, for this type of transaction to work from a financial perspective, investors and, crucially, lenders need to be comfortable with the financial projections of the business and the broader macroeconomic environment.

Clearly, the volatility of the past 12 months has led to a substantial tightening of the availability of debt finance. Accordingly, private equity was generally not in a position to enter the market at traditional pricing levels and many planned M&A sale processes were put on hold.

For mid-market deal activity to fully recover, we need private equity to bounce back to a position where they can transact at scale. The key drivers for this to materialise will be:

• The stabilisation of inflation (thus removing volatility and making forecasting more reliable).
• Additional data on consumer spending (to demonstrate that consumer demand is resilient in the face of a reduction of disposable income).
• ’Lapping’ the impact of Ukraine inflation and VAT change (to remove the impact of any ‘noise’ in the numbers and minimise adjustments).
• Stabilisation of interest rates.

We expect all of these factors to come into play heading into the second half of 2023, which should in turn open up the debt markets and bring private equity back to the market. We are already seeing signs of this return with the investment by TriSpan in Mowgli.

In addition to private equity deals, we believe 2023 has the potential to present an inflection point for a number of businesses.

First, we expect to see some fundamental restructurings of businesses where they are simply unable to continue trading due to cash constraints and/or unviable sites. In recent weeks, this was the case for Byron and Crussh, as well as Ping Pong and AMT previously. Unfortunately, we expect to see more businesses succumb to this fate during a potentially challenging first half of the year.

In addition, we expect there to be a number of businesses facing an impending debt maturity where, because of reduced profit margins and increased interest rates, these businesses are not able to support as much debt as they have currently, creating a funding gap. These businesses will need new money from their existing owners (or raised from asset sales) or from new funding partners, as without this they will face the need to restructure their balance sheet or even be put up for sale.

As operators release their Christmas trading figures, a picture is building of relatively robust trading over the festive period, which should provide some cash for businesses to hunker down through a potentially challenging first quarter. For businesses that have sufficiently robust trading or access to capital, we believe that there should be optimism looking ahead to 2023 and that there should be a recovery in M&A activity heading into the second half of the year.

Graeme Smith is managing director and Craig Rachel is a director at AlixPartners