As a concept, the "new normal" has been referenced many times over the past three years but has proven elusive to pin down. The economy and the hospitality sector have been impacted by many different and significant factors over this period, whether that be the disruption from rapid inflation or the longer-than-anticipated recovery period from the pandemic.
However, we believe that if we peer through the lens of investment in the sector, the signs are clear: we have now entered the "new normal". Operating conditions are not easy, but the volatility of recent years has calmed. M&A activity is increasing, interest rates have stabilised and financing markets are functioning. Debt is available – it's more expensive than it used to be, but it is available. We expect these more stable conditions to translate into more deal activity.
On the back of this stabilisation, we're thankfully returning to a world where business value is driven by operational performance and growth prospects. Good businesses with demonstrable growth opportunities are attracting the kind of healthy valuation metrics that could have only been anticipated in "normal" times.
This contrasts with the recent past, which for some was a period to sit tight and wait for external pressures to ease. We believe we're now in the space – save for any more macroeconomic shocks – that represents a more stable situation. There does not appear to be any remaining external factors that can be reasonably expected to materially improve valuations simply by waiting (unlike, for example, sitting out the inflation spike). Investors can be comfortable now in assessing investment opportunities based on future business plans (backed up with solid historical performance), weighing up the risk of delivering these and then attributing corresponding competitive valuations for growing, high-quality businesses.
Investors are focused again on fundamentals: the top-line growth that businesses can drive from current channels; the scope for expansion and rollout; what extent the operational team has an ability to grow margins; the strength of a brand in the minds of consumers and, of course, the strength of a management team to go out and deliver the business plan.
Amid this, we expect to continue to see a focus on deals as a mechanism for delivering synergies, such as when trade buyers have an opportunity to combine or bolt-on businesses to their existing operational platform. There remains a significant opportunity via the benefits of scale, not just from a people perspective, but also in terms of supply chain and procurement. In terms of securing operational synergies, the Big Table Group's deal for The Restaurant Group's leisure division is an interesting example. Management teams will be looking at similar opportunities and asking themselves how they can bring in additional brands and assets to their existing portfolio, secure synergies with their existing operations, and invest to improve customer propositions.
Notwithstanding the peril of sweeping generalisations, we sense a new awareness of the extent to which a single brand can be expanded in a single market. It feels like there is widespread recognition in the UK that the maximum number of sites for most single formats is lower now than it perhaps was eight-to-ten years ago. This means operators are thinking about new formats and new channels much earlier in the expansionary cycle of a brand.
They are looking more at possible international plays and, accordingly, we're starting to see more successes where companies are expanding beyond their home market. Franchising is also increasingly on the agenda, as a low cost-of-capital route to brand scale. When franchise income becomes a material income stream in a business, it has the ability to drive strong valuations as it tends to attract higher valuation multiples. It also enables businesses to enter new territories at a lower risk versus equity-owned models.
In terms of what will drive deal activity through the remainder of this year and in 2025, factors include: the more stable macroeconomic picture, potential reductions in interest rates, a return to margin expansion and also a realisation that time will not necessarily improve the value picture. Valuation improvement will now be driven by business performance, not a current shock subsiding. The ability to forecast more accurately is also critical, as this helps build confidence in the financial thesis and business plan.
Against this backdrop, we expect to see private equity seeking exits on long-held assets. We will continue to see strategic consolidation plays, not just because of the benefits of synergies and the cost savings, but also as a viable route for bigger businesses to find different ways to grow. For larger businesses buying smaller platforms, an additional brand can provide more white space expansion opportunities, driving all-important growth.
It will be interesting to see which new investors enter the sector and to what degree these new buyers see an opportunity to innovate to develop businesses differently, to justify their investments and transform returns.
A subplot is the impending debt maturities some businesses are facing, with associated refinancing needs on the horizon. We are seeing some current examples hitting the headlines. For those businesses that perhaps haven't performed quite as strongly as they would have hoped, combined with the relatively higher cost of debt, some of these refinancings may prove challenging. Some are likely to require new money from shareholders to enable the refinancing to take place. If shareholders don't have access to that money, we can expect them to have to go out to the market, find a new funding partner, or potentially sell the business (or parts of it).
In conclusion, and returning to our main theme, it is clear that there is a positive backdrop for sector M&A; there is demand and appetite, and we are seeing deals getting done in both growth scenarios and more challenged situations. It certainly seems the case that we are now in the new normal, where investment opportunities are evaluated on the business fundamentals – namely strength of operation, profit growth, and expansion potential, and that is what is driving valuations.
This article first appeared in Propel.
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