COVID-19, Private Equity and Restaurants

At a glance, private equity (PE) and restaurants make for strange bedfellows. PE firms (and their investors) prioritize stable businesses that predictably generate considerable cash flow, preferably without too much seasonality. This is not the way that most investors and industry observers would describe the majority of restaurants. Over the past dozen years, in particular, rising labor, food, and real estate costs have created even greater barriers to success in an industry already known for an alarmingly high failure rate.

However, as consumer behavior and demographics evolved in the early part of the century, financial sponsors (mainly PE firms) came to see the restaurant business not only as a growth driver but one with untapped avenues for increased efficiency. For starters, a strong restaurant brand provides opportunities for licensing and marketing agreements with other portfolio companies in related and complementary industries, such as entertainment venues, retail and mixed-use real estate, and supermarkets. Secondly, technological advances (digital ordering and loyalty programs, mobile payments, and “smarter” budgeting and supply chain management) present chances to further automate a traditionally human-intensive business. Additionally, though the cost of real estate had risen, in many cases restaurants provide exposure to properties in well-established or potentially attractive areas. Finally, restaurants had historically carried little debt, resulting in an attractive combination of a) minimal preexisting debt service cost and b) the capacity for leverage.

In good (at the very least, “normal”) times, private equity provides resources to help restaurant operators build and expand their businesses. Beyond simple seed, bridge, or growth capital, PE firms provide restaurant operators with strategic guidance and access to expertise in not only business operations, but in the navigation of the financial markets. Against the backdrop of a healthy economy, the benefits of partnering with a financial sponsor can be significant.

It’s vital, however, that operators are aware that these partnerships carry considerable risk – namely that the objectives and priorities of a long-term business owner and a financial sponsor align only for a finite period of time. Obvious though it sounds, it’s vital that a restaurant operator remain cognizant of the fact that, while a PE firm may well be a strategic partner, it is, first and foremost, responsible to its own investors. The objective, always, is profitability, typically within three to five years, whether via a sale to another company in the industry, an IPO, or a “secondary transaction” (sale to another financial buyer). Though some firms do take a longer view – Atlanta-based Roark Capital being one of them, whose portfolio features the likes of Auntie Anne’s Cinnabon, Jamba Juice, Arby’s, Buffalo Wild Wings, Sonic Drive-In and Jimmy John’s, is one such example – the overwhelming majority of PE investors simply will not share the long-term perspective of a founder or an operator.

Given this, it’s not uncommon for an investor – who, post-investment, is now included in the decision-making process – to favor strategies aimed at maximizing revenue, cash flow, and profitability in the shorter term. Appeals from an operator for a more patient and measured build are seldom the preferred route, resulting in shorter-sighted initiatives, aggressive cost-cutting, often in the form of automation and reduced staff, and, in the case of significant disagreement, management shakeups or reduced financial support. And leverage. There is always leverage.

Over the past decade, private equity accelerated the industry’s growth, its own acquisition spree resulting (as of March 2020, according to Restaurant Business) in PE firms holding stakes (minority and controlling) in at least 40% of the largest restaurant franchisees in the U.S. Along the way, however, their pursuit of growth and increased margins (operating margins of 4%-5% are typical) saw the industry take on debt at a historically high clip. Exacerbating the issue is that an already crowded and competitive market became saturated, with growth suffering, while leverage rose and bank debt became pricier and harder to secure.

These are far leaner times. The COVID-19 pandemic that has claimed millions of U.S. jobs (including roughly five million in food and beverage services), impacted every sector of the economy, forced a multi-month closure of all bars and dining venues, has hindered subsequent attempts to re-open, may cost the industry as much as $240 billion by year-end and has cast a shadow over the very nature of entertainment and socializing going forward. The market’s current quagmire threatens the existence of just about every independent eatery, 75% of whom (as of May) reported taking on new debt of over $50,000 – and over 12% taking on more than $500,000 – with just 66% confident they’ll survive through October without the benefit of direct aid.

Though the crisis poses the greatest threat to indie names, the pain is hardly limited to the mom-and-pop shops. The early months of 2020 wreaked havoc across the restaurant industry, devastating the values of restaurants unable to pivot to a delivery- or takeaway-centric model, and drove a number of publicly-traded names – including Darden, Bloomin’ Brands, Cheesecake Factory, Ruth’s Restaurant Group, BJ’s Restaurants, Brinker International and Dave & Buster’s – to issue equity or debt at below-market prices. Additionally, the fallout from the crisis has thus far claimed a number of household names – Pizza Hut/Wendy’s franchisee NPC International, Chuck E. Cheese, FoodFirst Global Restaurants, Garden Fresh Restaurants, Le Pain Quotidien (US), Cosí, CraftWorks Holdings, Sonic franchisee SD Holdings, Houlihan’s, Bar Louie and, most recently, California Pizza Kitchen and Matchbox Food Group have all sought bankruptcy protection, with Red Lobster reportedly “exploring strategic alternatives”.

Not coincidentally, many of these high-profile casualties had received financial sponsorship from PE firms. They enjoyed the profitability that accompanies increased leverage in good times but are now left to sort through the pain wrought by excess leverage in the face of a sum-of-all-fears cataclysm.

Five of the names above – Krystal, CraftWorks Holdings Inc., Bar Louie, Le Pain Quotidien U.S., and FoodFirst – have since found suitors to acquire them out of bankruptcy. In many cases, a lifeline has arrived via “credit bid”, an increasingly common transaction in which lenders acquire a company in exchange for the cancellation (or assumption) of debt and a capital injection. This is how investment manager Fortress Investment Group – a senior lender to both Krystal and CraftWorks – acquired approximately 300 company-owned and franchise Krystal restaurants for under $50 million, as well as Logan’s Roadhouse, Old Chicago, Gordon Biersch and six other chains owned by CraftWorks Holdings (about 190 total locations), for $93 million. Meanwhile, lenders to gastropub operator Bar Louie, led by Antares Capital LP, acquired more than 50 locations with a credit bid of $82.5 million in May, while the U.S. division of Le Pain Quotidien was acquired in late June by Aurify Brands LLC in exchange for just $3 million in bankruptcy financing. Meanwhile, about half of FoodFirst’s nearly 100 Brio and Bravo locations were sold to Earl Enterprises Inc., the parent of Planet Hollywood, for around $30 million – investment firm GP Investments paid $100 million for FoodFirst in 2018.

Compounding matters is the fact that many investment firms and strategic buyers are preoccupied with recapitalization and rehabilitation of existing assets to contemplate adding new brands to their portfolios. This has eliminated much of the competition to acquire what would otherwise have been attractive assets at depressed valuations, creating a golden opportunity for well-capitalized financial and strategic buyers.

One such buyer is PE giant Apollo Global Management, which, in a recent call with investors revealed it has poured over $1 billion into 10 distressed assets and is tracking hundreds of others. In addition to providing bridge financing in sectors where banks are reluctant to lend (leisure and travel among them), the firm also plans to use its funds to acquire the discounted debt of its own portfolio companies.

Some would argue – as Apollo has – that, “financing is temporary but valuation is permanent”, and shocks to the market caused by COVID-19 have presented a “time to shine”. Perhaps. This is an opportune moment to recall that Apollo is an investor, ultimately accountable to its own investors. Professionals doing a job – and doing it quite well, one might add.  Of course, Apollo is hardly the only firm with a mandate to seek out returns in the fallout of COVID. Nor is the phenomenon limited to financial firms, as industry giants with minimal debt and access to cheap capital – the likes of McDonald’s, Domino’s, and Chipotle – view the current market as an opportunity for acquisition, expansion or upgrades.

And, yes, in unimaginably turbulent times, sacrifice is demanded in the name of survival. It’s a buyer’s market. However, the most extreme of these sacrifices – acceptance of a minimal amount of capital, at terms disadvantageous even in a depressed market, while still shouldering the risks of forced bankruptcy or significant loss of equity and assets and even more disadvantageous terms – would reshape restaurant ownership for years to come. “Ownership” would receive far greater emphasis than “restaurant”. There is a compelling case to make that this should not be the only way forward.

A short-term silver lining has been proposed in Washington, as the federal government strives (admittedly with differing results) toward a second round of stimulus. In addition to extending the added weekly unemployment benefits that provided vital liquidity to consumers, the discussion has focused on the allocation of remaining funds (unspecified but in the “hundreds of billions”) from the Paycheck Protection Program (PPP), which officially ended August 8. Treasury Secretary Mnuchin has suggested the money go to the hardest-hit industries, including restaurants.

Additionally, in mid-June, Senator Roger Wicker (R-MS) and Rep. Earl Blumenauer (D-OR) introduced the RESTAURANTS Act, legislation with bipartisan support in both chambers of Congress, as well as high-profile corporate endorsement, from the likes of American Express, Coca-Cola, Delta Air Lines, Hyatt Hotels, Resy, Sysco and U.S. Foods. If passed, the bill would establish a $120 billion fund to provide short-term capital to small restaurant companies (defined as “neither publicly-traded nor part of a chain of 20+ locations”).

While certainly a step in the right direction, the RESTAURANTS Act, like Federal PPP loans (for those business owners who received funds) would be little more than a temporary respite, providing small companies with operating capital, along with time to explore longer-term financing and strategic options. This luxury, to be able to truly reimagine a business rather than simply having to choose between survival and extinction, would allow small restaurants a lifeline while de-levering, allowing them to negotiate from a position of relative strength.

It’s a brutal environment in which to operate any business, let alone one that’s historically challenging noted for its thin margins and predicated largely on public gathering. As they navigate closures, capacity limitations, rising food costs, potential supply chain disruptions, and customers who are both wary of public dining (which may continue for some time) and facing their own financial and emotional pandemic fallouts, most restaurants are fighting for their lives. Much of what they’re seeking – capital and strategic expertise – remains unchanged. These days, concerns also loom about simply making rent and payroll payments, as well as servicing considerable (and mounting) debt, in the face of dwindling liquidity and uncertainty as to when they’ll once again be able to operate their businesses as intended. This is not the moment to wager control of a company, on less-than-favorable terms, in exchange for a short-term infusion of cash. More than ever, restaurant owners must find partners whose interests are aligned with their own and are committed to implementing solutions with the long-term health of a business in mind.

Constructed more than three years ago on a foundation of top-tier accounting, financial advisory, strategic consulting and executive management experience, Chicago-based Virtas Partners (and partner of EMERGING) is the ideal ally for any restaurant owner seeking long-term solutions to those most pressing of concerns. Decades of experience gained at some of the world’s top consultancies, financial institutions and corporations – with particular insight into the food and beverage industry – have prepared them for this scenario. Whether assessing capital structure, restructuring debt, renegotiating leases, strategic cost-cutting, optimizing operations, or adapting a business model to the “new normal”, the Virtas team is uniquely suited to help a restaurant not only survive the madness of the short term but to build a sustainable foundation for that magical day, at some uncertain point in the future, when the “old normal” returns.

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