Let’s start with an apology. My goal is to have Sunk Thoughts hit your spam folder every Friday. I missed that target, then missed it again due to an unusually busy travel schedule - including a trip to San Antonio that overlapped with the passing of the city’s most eminent businessman, the auto-dealer, radio entrepreneur, and professional sports team owner, Billy Joe “Red” McCombs.
Coming four years after the death of T. Boone Pickens, this marks another loss of a folksily-named Texas billionaire. In Red’s honor, today we’ll look at someone who made the reverse journey: from a career in sports to wealth-building through franchised businesses.
Each issue of Sunk Thoughts is hastily researched, written, and (when I have time) edited at the kitchen table of the metaphorical glass house I live in. So far be it from me to throw stones at another publication when it publishes an article that falls short of the highest standards of investigative rigor.
My reluctance to criticize is even greater when the subject of the article is a favorite athlete. That’s why that when it comes to this recent Financial Times piece on LeBron James’ off-court business ventures, I’ll only go as far as to say that I found it to be as interesting for what it didn’t include (e.g. quotes from anyone who wasn’t one of LeBron’s co-investors or paid advisors, mentions of that Crypto.com Super Bowl ad) as what it did.
I’ve spent hundreds of hours watching LeBron play basketball and am no closer to being able to dunk. A version of the same problem applies to studying LeBron’s investment record. You could read articles about his reported holdings and make out the familiar shape of some of the 2010s hottest themes: private markets, niche alternatives, media rights, health and wellness, fast casual dining.1 But you would also see a portfolio that can only be constructed in an investable universe very different from the one you and I exist in.
LeBron has the cachet to generate deal flow that a VCs and their Twitter ghost writers could only dream of. In addition to capital (or sometimes, in place of it), LeBron brings significant promotional value to the brands he invests in. To state the obvious, being one of the most famous and accomplished athletes in history will give you a unique combination of access to investment opportunities and ability to influence their outcomes.
What about being a slightly less famous and accomplished athlete though?
Say, a two time NBA All-Star who was a solid contributor on a championship team and earned more than $80 million over the course of a 14 year career? Caron “Tough Juice” Butler fits this bill, and thanks to a quirk of my brain chemistry whereby I routinely forget my closest friends’ birthdays but remember frivolous blog posts I read more than a decade ago, I happen to know something about his investments - specifically, that he was at one point a multi-unit Burger King franchisee.
The question posed in that blog post (by none other than Matt Yglesias) is why a person inclined to invest in Burger King but lacking obvious expertise as a fast food operator would choose to own individual franchise locations instead of buying shares of Burger King stock. Answering that question in the particular turns out to be quite tedious, but abstract away from the details of Burger King’s ever-shifting ownership structure and you get a larger framework for considering how value accrues in a franchise system.
Abstract away again and now you’re getting into some pretty crazy territory, where the 2002 Big East Conference Player of the Year starts to look like Eugene Fama with a better jump shot: someone who can help us demystify investment returns by breaking them down into underlying factors.
Theologians long ago abandoned the debate about how many angels can dance on the head of a pin and moved on to the question of how many explanatory variables should be included in asset pricing models.
No sooner has a statistical regression uncovered a predictive relationship between returns and some novel factor - market cap, for example - than people will question whether that relationship is not itself masking a deeper relationship. In the example above, there’s no reason why market cap should innately affect performance, but if shares of small cap stocks are on average more difficult to buy and sell, and/or if they tend to be issued by firms whose businesses are riskier, then this will show up as a correlation between small market caps and higher required rates of return.2
It’s turtles all the way down, and the turtles are named liquidity and risk.3 In the enlightened world I want my children to live in, where asset prices perfectly reflect all available information, every financial transaction would be understood as nothing more than a choice to accept more or less of these two qualities.
The real world is messier. Burger Kings especially. Still, I think we could construe Butler’s decision to become a franchisee rather than just a common stockholder as a reflection of the premium he implicitly places on risk and liquidity.
Franchise Players
First, risk. It seems obvious that free cash flow generated by his portfolio of six Burger Kings in Virginia and North Carolina would be riskier - that is, more volatile - than those earned by the larger franchisor.4
The Burger King franchisor is not only more geographically diversified (28,000 locations around the world as of 2022), it also has more diversified revenue sources, including royalty fees (4.5% of each store’s gross sales), franchise fees ($50,000 for the rights to a new location), and rent from leasing locations to some franchisees. Since royalty fees are set as a percentage of gross revenues, not store profit, the franchisor also has less exposure to volatility in expenses - primarily labor costs.
Another source of embedded risk for most franchisees comes from leverage. Operating a restaurant is much more asset intensive than licensing a restaurant brand. Burger King franchise disclosure documents provide an estimated initial investment cost of ∼$1.9 - $3.4 million per location: without debt financing, franchisees face longer payback periods and equity returns severely constrained by the structurally thin margins of the restaurant industry. The largest Burger King franchisee (publicly traded Carrols Corporation) gives us an idea of the representative capital structure, reporting a long term debt to equity ratio of 220% in the latest fiscal year.
From the perspective of an owner-operator, it might seem counterintuitive to describe franchise investment as an expression of an appetite for higher risk. Oftentimes the primary motivation to become a franchisee rather than to start an independent business is to limit risk by tapping into an established product line and operating playbook.
It’s all relative. Everybody’s out here allocating along a spectrum of investable assets ranging from US treasury bills to near-expiration Dogecoin options, and a franchisee is no different. They accept the added uncertainty and effort inherent in running any business, as well as that of being the junior claimant to a lender and franchisor. In return, they expect to acquire a fairly predictable set of cash flows at a low enough price to produce a risk-adjusted return that’s at least as good as what they’d get from making an investment in the corporate franchisor. Or, for that matter, making any other investment.
Here it would be easy to build up and tear down a straw man argument that franchisees choose to invest on the unit rather than system level because they’re victims of the Lake Wobegon Effect, all assuming that they have what it takes to produce better than average returns as an operator. It’d be even easier when the franchisee in question is inexperienced or otherwise occupied, for instance, by a career as a professional athlete.
But I don’t think this would be a fair representation of how most franchisees see themselves. Earlier I characterized LeBron James’ investment history as being defined by a unique sort of access to opportunities and ability to influence their outcomes. If Caron Butler were to assess his franchising decision along those dimensions, he might very well conclude that his ability to influence a Burger King location’s performance is less important than his ability to win access to particularly attractive investment opportunities within the Burger King network. For those who are interested in reading more speculation about Caron Butler’s precise rationale, and how it might compare to those of Shaquille O’Neal, please reflect on your life priorities, and only then read this footnote.5
Access turns out to matter a lot in the franchise context. A good franchisor will grow its network aggressively enough to help build consumer brand awareness, but not so much to cannibalize existing franchisees’ sales, or undermine their ability to resell their locations when the time comes. Sustainable growth requires restricting the supply of franchisee licenses, allowing the franchisor significant discretion over who is allowed into the network and how large of territorial rights they are granted. In several excellent discussions on the Acquiring Minds and Fort podcasts, Twitter’s Wolf of Franchises cites Orangetheory Fitness as an example of an oversubscribed young franchise. For established brands, access is limited in a slightly different way: when locations/territories get sold, it tends to be to another franchisee.6
Size matters too. Multi-unit franchisees lower their average cost by spreading overhead across a larger sales volume, and the biggest franchisees can have considerable sway in the sometimes collaborative, sometimes adversarial interactions with the franchisor. (One way Ray Kroc altered the course of McDonald’s was by choosing to grow through single-location franchisees, who had less power to resist stringent quality standards.) This imperative for scale helps explain why the majority of franchise locations are owned by multi-unit operators.
So then, investment opportunities within the franchise network are both gated by the franchisor and concentrated among multi-unit franchisees. While these factors constrain the supply of a valuable asset (i.e. the right to operate within the network), their effect on that asset’s price can be surprisingly muted. As with the old two and twenty hedge fund fee structure, franchise fees tend to hew to familiar standards, and though the most attractive brands could probably capture greater surplus by auctioning off licenses to the highest bidder, in practice they don’t. Prices on the secondary market are likewise constrained: a franchisee looking to sell a half dozen Taco Bell locations in metro Milwaukee will find that the pool of potential buyers is not infinitely deep.
What I’ve just described is a market for an illiquid asset. In a market like this, we’d expect:
1) Less efficient price discovery, and the attendant possibility that a buyer might be able to acquire assets at less than their intrinsic values.
2) Investors who demand a greater return (i.e. lower price) to compensate for illiquidity.
How much the liquidity premium matters will depend on the person/institution. In recent years there’s been debate about investors’ apparent willingness to pay extra for illiquid assets (in the form of management fees and eye-watering private market valuations). Cliff Asness posited that:
“Multi-year illiquidity and its oft-accompanying pricing opacity may actually be a feature not a bug [because] liquid, accurately priced investments let you know precisely how volatile they are and they smack you in the face with it … Many investors actually realize that this accurate and timely information will make them worse investors as they’ll use that liquidity to panic and redeem at the worst times.
…
I mean, let’s get real, does anyone seriously doubt that at least part of the attraction of PE, and its wildly growing popularity, is an increasing acceptance among investors that they will have to get very aggressive to reach their goals (e.g., underfunded pension plans and the like), but still possess an absolute aversion to living under the true reported volatility this aggression entails?”
In his post on Caron Butler, Matt Yglesias suggests a related reason why an NBA player might seek out illiquidity:
“He needs to sock lots of money away for a time when his earning power will rapidly diminish. This requires a lot of self-discipline. Not only the discipline to resist spending lots of money on yourself, but the discipline to avoid the social pressure to spend lots of money on others—on family and friends and friends’ family members in need. Under the circumstances, socking as much of the money away as possible in illiquid investments can be a very smart form of pre-commitment device.”
In this context, illiquidity represents a voluntary relinquishing of control by an investor who is imperfectly rational but decently self-aware, willing to take risks but skeptical of their ability to manage them optimally. Franchisees relinquish control in other ways as well - of product line, marketing strategy, even which suppliers they use. Humility is in baked into the model.
Someone once said that “80% of success in life is just showing up.”7 Modern financial theory has since taught us that the other 20% mostly comes down to index investing and dollar cost averaging. Still, it's always worthwhile to think about the reasons why someone might opt for an active strategy when more passive alternatives are available.8
Operating as a Burger King franchisee is one of the sweatiest, most active investing types imaginable: deep fryers break, cooks quit, children get lost in ball pits. It might seem crazy that anyone would choose to put their capital at risk in this endeavor, but then again, any decision to buy or sell is a form of insanity akin to believing that you know better than the sum of human knowledge reflected in a market price. So let’s be grateful for all the crazies out there.
Guys like me like Iraq.
“Nothing has changed in the oil business in the last one hundred years … It’s still the big guy versus the little guy, the Seven Sisters versus the independent oil company. The Seven Sisters like the Saudis. Guys like me like Iraq.”
-Oscar Wyatt, founder of Coastal Corporation and part-time hostage negotiator, quoted in a 1991 Texas Monthly profile.
Those holdings have included small stakes in Beats by Dre, Blaze Pizza, and Fenway Sports Group, as well as more significant ones in businesses co-founded by LeBron: Ladder (sports nutrition) and Spring Hill Company (media). The terms of other partnerships are more vague. I know I can do a Lebron-led meditation in the Calm app; I don’t know whether he’s being compensated with equity. LeBron also owns a Major League Pickleball team, but this would seem to be something that all celebrities are required to do in the year 2023.
Higher required rates of return meaning a lower valuation for a given set of expected cash flows.
I’d be remiss not to use this as an opportunity to mention that my college roommate kept two pet turtles, named Billy and Joel. Sometime spring semester of junior year, Joel died. Unless it was Billy. I forget.
I warned that it would be tedious to track the details of Burger King’s ever-shifting ownership, but for what it’s worth, Caron Butler seems to have become a franchisee in the period when BK (the franchisor) had been spun off from Diageo and acquired by a private equity consortium led by TPG and Bain Capital. It later relisted as a standalone public company, was acquired by the Brazilian investment firm 3G Capital, and merged with the Canadian chain Tim Horton’s under the name Restaurant Brands International.
Caron Butler actually did have some fast food operational experience before becoming a franchisee: he’s talked about having worked at a Burger King while in high school. More pertinent for his investment decision might have been the circumstances behind the sale. One of the largest Burger King franchisees filed for Chapter 11, and the parent franchisor helped arrange a fire sale of locations, including to a group of prominent Black athletes and businessmen. Knowing literally nothing more about this topic, I’m optimistic that Butler acquired his franchise locations at a discount and has enjoyed a solid return.
Shaquille O’Neal has an extensive enough record of franchise investments to warrant articles cataloging all of them. Though he’s owned dozens of Five Guys and Auntie Anne’s, the Big Aristotle has evolved into a franchisor himself with his Big Chicken concept. Even when Shaq remains a franchisee, he seeks tighter alignment with the franchisor’s economics: at Papa John’s, where he’s a board member and paid spokesman, he collects a royalty of 20 cents for every Shaqaroni pizzas sold.
Another podcast recommendation: this interview with Brian Beers, an entrepreneur who has acquired 30 locations within the Midas auto care network.
Okay, fine, that someone was Woody Allen but I’m not trying to get into all that.
Two final possibilities, both much more believable than any of the theoretical mumbo jumbo about risk tolerance and liquidity preferences I described above. Owning a business gives people 1) purpose, and 2) tax write-offs in ways that owning shares of stock do not.