Avoiding Bankruptcy (and a couple of other tidbits)

In our continuing exploration and demystification of bankruptcy, I want to spend some time this week discussing some of the ways in which bankruptcy might be avoided. Separately, I also want to share a couple of other timely observations on things going on in the debt market, and in the press, which have some bearing on our industry and our near-term prospects. Finally, I want to invite you to stay tuned for the next episode in this series, which I expect will have some valuable information from one of the well-informed, professional guest writers I promised when we embarked on bankruptcy as a topic.

First -- avoiding bankruptcy:

You’ll recall that I’ve provided the following unofficial but practical working description of bankruptcy ... financial bankruptcy is essentially a recognition that a company, partnership, or other legal entity (the “Debtor”) cannot meet its financial obligations. So let’s dispense with the pat observation that the best way to avoid bankruptcy is to be more profitable, and focus on reality.

If we remake the working definition as a mathematical or logical statement, it looks something like this:
Bankruptcy: the condition whereby
(1) cash flow < debt service (over a protracted period of time) and
(2) immediate business value < total obligations

Thinking of it as these two tests, therefore, we can eliminate the condition by:
(a) boosting cash flow -- the simplistic observation noted above; or
(b) reducing debt service -- the amount which must be paid during a given period or series of periods; or
(c) increasing the value of the business; or
(d) decreasing the total amount of debt (the “obligations”)

OK. Take (a); if it were feasible in the short term, the rest wouldn’t matter. Let’s acknowledge that most companies nearing this situation have already done what they could to address (a) without taking draconian steps -- and I’ll return to some of those draconian steps later when we discuss what’s possible within a bankruptcy process.

Now take (b) and (d) together, for they’re truly related. If the operator, or “Debtor” in this circumstance, can make a clear and convincing case that the steps he or she has already taken to address profitability (a) will generate increasing returns in the future, it’s possible -- not easy, but possible -- to convince some Creditors that they should take one or both of the two steps which are within their power to address (b) and (d). Those two steps are:
reducing the current debt service burden on the company -- by reducing the rate of interest which is charged, reducing or delaying the required principal payments per any given period, or both; [This addresses (b)] and
reducing the total amount of debt on the company’s balance sheet. [This addresses (d)]
The Creditor doesn’t do this because he or she is feeling charitable, but because it offers an economic return -- usually in the form of a higher overall interest rate (with some portion deferred or non-cash) and/or a partial ownership in the company via outright shares, warrants, or so-called success compensation -- a large fee payable if and when the company achieves certain levels of performance.

Finally, take (c); the simplest way to do this is to bring in additional equity or investment capital. Generally, this capital will come in at the expense of the existing owners, meaning that their ownership position will be dramatically reduced, but it may still be a more economical solution than bearing the sizable costs and uncertainties of a bankruptcy. [For a recent example, please take a look at the public filings around the just-completed $25MM investment in Ruth’s Hospitality Group by Bruckmann, Rosser, Sherrill & Co.]

Obviously, each of these is worthy of much more time and discussion, but in this limited space we can at least set out the framework. We’ll refer back to the topic as we progress.

Now, two partially-related tidbits:

You’ve probably seen articles in the business and general press stating some variation of the message that “the credit markets have begun to open”. True, so far as it goes, but it’s not uniform: the bond markets, where large companies and institutions borrow from other large institutions, have certainly begun to loosen again, although they’re still -- and very properly -- much tighter than in 2005-2007. However, the middle market credit world of banks, commercial finance lenders, and the like, is still VERY tight; I’m working right now with a client which would have been besieged by offers for credit had it shown its current level of performance in 2005 or 2006, yet lender after lender tells me some variation of “We can’t really take on new customers like this yet,” either “because we still have some portfolio issues to solve”, or “because we’re really limiting our exposure to new names right now.” Until those two issues cease to exist, small business and midsize operators will not have the credit to (1) refinance existing, maturing debt from unsupportive lenders or (2) fund the new investments which will lead to growth. It’s still a very fragile economy, folks.

Finally, I couldn’t help but notice that one of the traditional industry publications predicted this week that there may be an increase in the number of bankruptcies and restructurings related to restaurants in the coming year. Gee -- perhaps if they’d read this and several other blog sources from people in the trenches (on FohBoh and elsewhere), they might have started that discussion a year ago. I was certainly not the first to talk about the issue -- some of you among my readers were on the cutting edge, both as operators and as advisors -- but we’ve clearly had a dialogue about the structural debt and finance issues in the industry for many months now. Nice to see the trade press catching up!

As I noted earlier -- stay tuned for some guest commentary on bankruptcy next time!