News Flash For Lenders And Investors (again)

I spend much of my life with the investors, lenders, builders, and leasing companies who provide capital to this industry.  Let’s just acknowledge at the outset that, without them, the restaurant industry would not exist -- at least not in the grand scale, and immense variety, that we see it today.  Many thanks to them for making it all possible; after all (just to cite a few statistics which bear repeating) ... this industry is probably the second-largest non-government employer in the US economy, directly responsible for almost 13 million jobs (and indirectly, many hundreds of thousands more), and its annual sales of over $600 Billion are responsible for a total annual economic impact of well over $1.5 Trillion!


Had the industry grown as it started, by bootstrapping, we would never have reached this level.  Many farsighted lenders and investors, beginning in the post-World War II era and expanding rapidly in the 1970s and 1980s, were needed to fund the tremendous growth of the past thirty-some years.  Not to make a bad pun, but the industry owes these investors and lenders a tremendous debt.


Unfortunately, the industry DOES owe some of these lenders a tremendous debt, and some of the investors (through such structures as preferred stock and convertible notes)  have also become de facto debtholders.


There’s a sustainable level of debt for most companies, in this or any other industry.  That debt (whether in the form of loans, leases, sale/lease capital, or subordinated capital) permits expansion at a faster pace than corporate earnings alone could fund, and can be retired within a reasonable period either through the earnings of the growing company or through the standalone cash flows if no growth investment takes place.


There’s also a level beyond which the debt leverage runs the risk of being unsupportable.  Financial analysts and students in business schools constantly test operating assumptions and actual performance to determine whether the companies they invest in, or monitor, are likely to cross the line.  One of the measures analysts often refer to is the “Z score”; without going into too much detail, it’s been shown to be a fairly good predictor of future distress.


Here’s the catch: most analyses, whether by lenders, analysts or investors, base much of their judgement on past results, and extend them into the near future.  As we saw in 2007-8-9, that wasn’t a very good way to test a concept’s likelihood of distress, and thus we ended up with bankruptcy sales of brands such as Max & Erma’s, Village Inn, Charlie Brown’s, Oceanaire, Buca, Fuddruckers, Daphne’s, and Claim Jumper, and more recently Perkins and Marie Callender’s, as well as a good many franchisees of various systems.  Each of these was capitalized (or levered) in such an aggressive way that it was expected (required?) to grow, yet meet its debt service and generate a solid return for investors, so long as the world went on relatively smoothly; because the world had a few issues, the lenders lost some or all their investment, and in many cases the lenders also lost a portion of their stake.


It perhaps less widely discussed that there’s a follow-on crop of brands and franchisees, perhaps not quite so aggressively capitalized, which continue to exist only because their lenders have deferred debt payments or restructured obligations.  That’s not necessarily a bad thing; the lenders will still likely get their capital (perhaps over eight-ten years instead of the five in their models), because the companies’ growth plans have been curtailed, and perhaps some weak units have been shed.  The investors are unlikely to get a return ON their capital, although they may yet at least see a return OF that capital when the brand or franchisee cluster is eventually sold.  I’ve referred to some of these in the past as zombie companies; others will likely eventually return to profitability, although they face a tough few years first.


The important detail, which at least a few lenders and investors need to remember during this extended repayment period, is that they’re NOT the company.  They may OWN the company, and -- as directors -- dictate its strategy, but they rely on those nearly 13 million restaurant operators to keep the lights on in the stores, and the smiles on the faces of the servers.


I don’t wish to put all lenders, landlords, and investors in a bad light.  Over the past four years, I’ve seen some remarkably enlightened treatment of the operating team by investors, who have persuaded or fought the lenders to be sure the operators were well cared for.  I’ve also seen lenders pushing investors to provide the operators with more support when resources were scarce.  But, more often than I’d have hoped, I’ve seen the reverse: investors and/or lenders so focused on squeezing an extra point of margin that they’ve removed any incentive for management, staff, servers and chefs to take care of the guests.  I leave it to your imagination to think what comes next ...

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Tags: capital, distress, finance, investment


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