You'd never know there was a recession if you talked to Eric Casaburi. The founder of Retrofitness, Colts Neck, NJ, speaks animatedly about how he plans to expand his 40 corporate and franchised clubs by 350 in the next three years. And he says he has the money to do it.

Casaburi's private equity partner, Lake Capital, Chicago, was one of several companies that wooed Casaburi, finally winning him over and infusing an undisclosed amount of capital into his company last fall (although Lake Capital's Web site says it typically commits $50 million to $75 million of equity into companies). The private equity firm just infused another $5 million into Retrofitness this spring.

“We joke around in the office that we are in the ‘Retro’ bubble,” Casaburi says. “Not that we don't feel bad that there's a recession, but actually, it's fueled my company's growth.”

With $1.2 billion under asset management, Lake Capital wants to spread its money around but can't seem to find the right fit, Casaburi says. One of the private equity firm's principals told Casaburi recently that he typically looks at 2,000 businesses a year and buys about four, but this year he may have to look at 4,000 businesses and buy just two.

Lake Capital isn't the only investor itching to get a piece of the health club industry. More than a dozen private equity-funded deals occurred in the industry in the past three to four years, according to Peter Moore, principal, head of the Active Lifestyle & Wellness Group at Sagent Advisors, an investment banking firm based in New York. However, the tighter credit market and almost nonexistent debt market has slowed investment in the fitness industry as much as in most other industries, many people familiar with the situation say. They also agree that capital is still available for proven business models and club operators who know where to look.

“When the dust settles, there will be continued interest in the space because I think the health club industry groups that provide a high level of service at a reasonable price and have recurring revenue streams are inherently good business models,” Moore says.

Brian Smith, principal at San Francisco-based Partnership Capital Growth, a broker dealer that provides merger and acquisition, financing and capital structure advisory services to middle market companies, agrees that the growth potential and cash flow dynamics of the club industry are appealing to investors. Although clubs require continual reinvestment, the return on that is often in excess of 20 percent, which is a great option for investors, Smith says.

In Their Words

Last year, Summit Partners, a global growth equity investor with offices in Boston, Palo Alto, CA, and London, invested in Snap Fitness, Chanhassen, MN.

Summit Partners has raised more than $11 billion in capital in its 25 years and has made more than 300 investments, yet Snap Fitness is Summit Partners' first foray into the fitness business. Summit Partners had been looking to get into the fitness and health and wellness sector for more than 20 years, says Peter Rottier, a Summit Partners vice president.

“The challenges we've always had is that the traditional club market was very capital intensive from a growth perspective,” says Rottier, who would not disclose the amount of the investment into Snap Fitness. “If you have a store, in order to open your next store, it takes a lot of money. We always kind of wrestled with that.”

Rottier, who joined the Snap Fitness board of directors upon completion of the investment, says Summit Partners contacted Snap Fitness CEO and founder Peter Taunton about 2 ½ years ago. When Summit Partners examined the 24-hour key-card club model, the company saw not only growth potential but also capital efficiency with Snap Fitness' low overhead and little or no staff on hand at the clubs, Rottier says.

Despite the looming recession, Summit Partners made the investment in Snap Fitness in May 2008 with the belief that the fitness club industry has held up during past economic downturns.

“We spent time thinking about it, and we thought that Snap would be at least better positioned than most to weather the storm here,” Rottier says. “I like our positioning in a challenging market, being a value-priced concept that also offers a lot of convenience to our customers.”

WestView Capital Partners, Boston, liked what it saw in Titan Fitness Holdings, McLean, VA, one of the largest Gold's Gym franchisees in the United States. Titan Fitness plans to grow from 16 clubs in North Carolina, Minnesota and Nevada to 60 over the next five years. WestView has invested about $2 million into the clubs so far, says Matt Carroll, a general partner with WestView. That money went into acquiring clubs and for capital expenditures, such as cosmetic improvements, facility upgrades and equipment upgrades.

“We've got a significant amount of equity behind the business that hasn't been invested yet,” Carroll says. “We have a bank line with a couple of different banks that we took on where we can tap those lenders as we grow. What we've been most cautious about is we want to make sure that we're buying good assets that are going to perform for us. We're very sensitive to make sure that we don't leverage the business. The idea is to use bank financing down the road to help us do more acquisitions and to build new clubs.”

Moving Slowly

Getting bank financing is proving more difficult for many in the industry because of the lack of a debt market, according to Sharon Zackfia, analyst with William Blair & Co., an investment firm in Chicago.

Rottier says funds are available for club operators in the private equity and venture capital world, although the process of getting to those funds has become more challenging. Some private equity firms are unable to raise funds and some may close, he says.

“The availability of financing today in the private equity world is less than what it was two years ago, and the hurdle for those investment dollars is much higher,” Rottier says.

Although interest is still there, many investors are on hold for now until the tides turn. That pause means a slowdown in new club openings for many operators. Publicly traded companies Life Time Fitness, Chanhassen, MN, and Town Sports International (TSI), both of which Zackfia follows, are opening fewer new clubs in 2009 than 2008. TSI, New York, opened nine clubs in 2008 but will open just four clubs this year. Life Time is scheduled to open seven or eight clubs this year after opening 11 clubs last year.

“What we're seeing in the health club industry is pretty similar to what we're seeing in other publicly traded retailers or restaurants,” Zackfia says. “Obviously, profits are under some pressure, but also there's the consideration that real estate costs may come down further, whether you are talking about buying the real estate or whether you're talking about leasing the real estate. To the extent that there's pressure on real estate pricing, there's a real fundamental question about the urgency of opening a location.”

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The slowdown in the health club business due to the lack of capital and investment is actually the least pronounced of the three subsectors Zackfia covers (restaurants, retail and leisure).

“That said, there is clearly pricing pressure in the health club space not unlike what you're seeing in other areas of leisure,” Zackfia says. “To date, there's been fairly good success at getting new members in the door at discounted initiation and/or discounted dues prices, but clearly those members are less profitable than members a couple of years ago.”

Buyers' Market

That could mean that health clubs will be less profitable this year. Lower revenues, combined with uncertainty in the market, and uncertainty about how long the health club market can remain resilient, lead to lower valuations of health clubs, which leads to a large “bid-ask spread” when it comes to private equity transactions. A buyer might want to pay five times EBITDA (earnings before interest, taxes, depreciation and amortization), when a seller believes his or her club company is worth seven or eight times EBITDA, for example. Buyers also can gauge public companies like Life Time Fitness and TSI to get a better idea of what club companies are worth today, says David King, senior managing director of private equity firm Irving Place Capital, New York. King sits on the boards of several companies, including 24 Hour Fitness, San Ramon, CA, and the Canadian club company Extreme Fitness.

How much lower are certain companies valued? Zackfia says that Life Time's price to equity ratio (P/E) is in the high single digits at this point on 2009 earnings.

“Historically, it had averaged a forward annual P/E in the high 20s, so that's a big collapse — maybe even a little bit greater than what you've seen in broader retail,” Zackfia says. “There has been incrementally more concern for companies that have a higher degree of leverage than for those that don't have any leverage. So in the fitness club space, whether it's actual debt or capitalized leases, they tend to be fairly leveraged.”

Because of the gap between the bid and ask, some sellers are using seller notes to finance a portion of the buyouts, says Smith, who adds that this type of arrangement has become unusual during the last 10 years because it's been a robust period in which people had been willing to pay premium prices for assets. Now, however, those looking for liquidity often can only find a price that works for the seller by bringing in some additional debt to fill the gap.

“The real reason why people are bringing in investors and are willing to take the short-term dilution is because they are focused on total value,” Smith says. “If I take an investor, especially in uncertain times, I have the capital I need. If there is a hiccup along the way or a bump in the road, I have a well-capitalized company with access to cash to help get me through that, with the ultimate hope that my total return three to five years from now outweighs the fact that I sold a portion of my company today at what could be a below market multiple.”

King says that until the bid-ask spread is covered, not much buying and selling will occur in the industry.

“Seller expectations and buyer expectations have to be radically reset before you get a return to a healthy M&A market for clubs,” King says. “It's the reality of the new world.”

Even though Carroll from WestView Capital Partners agrees that few private equity firms will make investments in the fitness industry right now, he says that the firms that are already in the industry will be active because they can grab a few assets at reasonable valuations.

Smith says some regional players are becoming more aggressive about entering new markets and using this time to grab up other regional players or mom-and-pops that fit into their longer-term plan, but national players might also start selling assets to fund debt repayment or selling property no longer core to their longer term plans.

Turnaround Time

Recently, President Barack Obama proposed a plan to buy bad assets to free up more credit. This plan could help on the back end, Smith says, by allowing operators access to capital to make club improvements, to buy or build new units or to allow liquidity for the operator and allow investors to come in at prices that will work for a seller.

Smith speculated that the market might turn around in early 2010. Zackfia says some signs of life had already occurred in the debt market this year, with some increased capacity from lenders making the market seem more viable than in the fourth quarter of last year. However, she says that the market is still challenging.

“There's definitely potential in the health club space because I don't think health clubs have stratified different demographics as well as perhaps, say, the restaurant industry has,” Zackfia says. “So I think there are opportunities there, but the reality is that probably 90 percent of health clubs serve the same member, and as with restaurants and retail, there is going to be a very Darwinian evolution over the next few years, where the strong will end up getting stronger and there will be a fallout amongst the weaker.”

Historically, investors have short-term memories, so from a standpoint of when the investment starts coming back into the overall financial markets, things will move quickly, Moore says. However, he doesn't see them returning to the valuation levels of the last few years because he says he believes that the debt financing should never return to the level that it was.

“Companies were overleveraged to the point that there was no viable way that they were going to be able to repay their debt,” Moore says. “Hopefully, what is learned from this is, build a good business and you'll get good value for it.”

Moore adds that the health club industry is recession resilient and, therefore, it is less sensitive to economic swings compared to the restaurant, hotel or luxury markets.

“But when there is a lack of confidence, everyone takes a hit,” Moore says.

For more on this story, including how the franchised markets are being affected, see the online version of this article at www.fitnessbusinesspro.com.

This Is Your Wake-up Call

Eric Casaburi would like to give the health club industry a wake-up call.

“You have to stop thinking like a gym owner and start thinking like a bank,” the owner of Retrofitness, a 40-club franchisor, says. “That's how you are going to get your money. The answer is not in the member. It's in the cash flow to maintain working capital and open more stores.”

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Many health club operators just don't know how to find the capital that's out there, Casaburi says, because they don't get the big picture and they don't understand growth and financing.

“They are looking at how to get their next dollar, and I'm looking at how to spend my next dollar,” he says. Casaburi considers himself in the franchising business rather than the health club business. He works with attorneys, accountants and public relations firms that have business and franchising experience rather than health club experience.

Brian Smith, principal at Partnership Capital Growth, San Francisco, says that well-operated and profitable club owners don't need to look for investors because investors will find them.

“The fitness club space has grown up enough over the last 15 years that the groups we've talked to are looking,” Smith says. “If you are in the No. 1, 2 or 3 spots in the market, I'm sure you've talked to someone.”

However, for club owners who don't have investors beating down their doors, Peter Moore, Sagent Advisors, New York, suggests they put together a detailed growth plan with specific and attractive locations. The operators then must continue to prove out that they are able to manage through a difficult period of time and maintain their core membership base. They must show that the unit economics of their business model work and can be replicated.

Health club owners who follow these steps should be better able to attract a bank or private equity firm, Moore says.

“A health club chain needs to have a pretty detailed path of what they are trying to accomplish, why it's differentiated and how they are going to make money,” Moore says.

The Money Behind Some Growing Players

Club operators who over expanded or who don't offer a differentiated product are going to be in trouble during this recession, many investment experts agree.

“Companies who really have looked at bringing in an equity partner are the ones we see as having the most flexibility in these times and are the best capitalized,” says Brian Smith, principal at Partnership Capital Growth, San Francisco.

So as real estate prices drop and other club companies find it difficult to get capital for growth, keep your eyes on these club companies, who are just some of the companies poised to grow because of the deep pockets behind them.

  • LA Fitness, Irvine, CA (Madison Dearborn Partners, Chicago)
  • Retrofitness, Colts Neck, NJ (Lake Capital, Chicago)
  • Rush Fitness, Knoxville, TN (Orchard Holdings Group, Cincinnati, OH)
  • Snap Fitness, Chanhassen, MN (Summit Partners, Boston)
  • Titan Fitness Holdings, McLean, VA (WestView Capital, Boston)
  • Urban Active, Lexington, KY (Laurel Crown Partners, Los Angeles)
  • Western Athletic Clubs, San Francisco (KSL Capital Partners, Denver, CO)