Anyone who has worked the back of the house at a popular restaurant knows how chaotic the kitchen can feel during a restaurant “rush” hour—knives, spoons, and spatulas being swung around, glassware flying, line cooks and sous chefs furiously plating food and sending it out. The same intensity will also mark what the restaurant bankruptcy “industry” as a whole will experience in the second half of 2020, through at least, the middle of 2021. But, out of the haze of bankruptcy filings, there will be some golden opportunities for a savvy PE firm or other restaurant chains with an appetite for a good deal.
A Little History
It should be noted that pre-COVID, restaurant chain Chapter 11 or 7 bankruptcy filings were on the rise despite a strong economy. In 2019 alone, companies seeking bankruptcy protection included Perkins, Houlihan’s, Restaurants Unlimited (multiple locations including Kincaid’s and Palomino), Kona Grill, Granite City, and The Palm. There were multiple reasons for these and other pre-COVID filings including: over-competition caused in part by cheap money and relatively low barriers to entry; excessive bank debt to fund expansion; poor real estate locations or lease terms; a marked increase in delivery/e-commerce eating away (pun intended) at restaurant margins; minimum wage increases in several cities; and changing consumer tastes (often attributed to millennials preferring the margin-killing delivery services). Additionally, many shopping centers and malls added more restaurants, in part to replace lost retail tenants. This has changed the ratio of restaurant to retail at these centers and, in many instances, resulted in less overall potential customers for the restaurants, while increasing the supply of available restaurant choices.
Even in pre-COVID 2020, at least five restaurant chains filed for bankruptcy protection. Articles written in early March, just a week before most restaurant COVID-19 closures suggested that restaurant bankruptcies were increasing with more on the way. Interestingly enough, these articles didn’t even reference the unfathomable closures that would soon follow caused by COVID-19. The fact that COVID-19 wasn’t even on the radar two weeks prior to the wave of COVID-19 related closures combined with an already weak industry that was seeing, generally speaking, anemic growth of low margin business, should be predictive of the additionally massive impact of these temporary closures.
The PPP helped slow the tide of smaller chains (noting that some of the larger ones such as Shake Shack had to disavow their borrowed funds), but for some, PPP was really just prolonging the inevitable. No doubt, while several restaurant chains in the quick service space (QSRs) have seen double-digit, same-store sales growth, COVID-19 has provided an additional untimely blow to the casual dining space that cannot transition as nimbly to a takeout-only model. Furthermore, as restaurants start to re-open—potentially more than once as several states have recoiled some of their earlier opening plans—casual dining restaurants have to deal with reduced seating capacity to accommodate social distancing in addition to a litany of other unfamiliar COVID-related requirements (e.g. providing and requiring PPE; taking reservations only for seating).
In the interim, several restaurant companies are trying to do what they can proactively, from renegotiating (or trying to renegotiate) lease terms—most after missing April’s rent payment at a minimum—to renegotiating their loan operating covenants. In my experience, banks are more sympathetic than landlords in terms of making COVID-related concessions, perhaps because landlords have banks to deal with as well. Historically, landlords have generally been unflinching to threats of bankruptcy when dealing with delinquent tenants. Perhaps that will change with the realization that there may not be a lot of new tenants available to backfill for a tardy, but operating restaurant tenant. Candidly, financing new restaurant growth won’t be very easy from either an equity or debt perspective.
So where does that leave us today? Some restaurant chains, such as QSRs, will continue to fare better, even though they face many of the same issues that were prevalent pre-COVID such as increasing minimum wages and competition. Other restaurant chains, such as those in the casual dining space, are going to have to try new measures to adapt to the new landscape. For others, bankruptcy may be the only option.
Other than a fortunate buyer, there are few winners in a Chapter 7 bankruptcy filing. Equity owners and landlords are on the losing end of this. Even the secured creditors usually receive a pittance of their original investment; sales of used restaurant capital equipment were poor prior to COVID-19, so one can only imagine how abysmal they will be post-COVID. Perhaps the used restaurant equipment market will mirror the oil futures markets a few months ago when the price of crude went negative, reflecting the cost of storage.
For those restaurants with creditors willing to finance a bankruptcy in the hopes of recouping something…anything, a Chapter 11 bankruptcy filing may be the only option. To be clear, a Chapter 11 bankruptcy filing is expensive—requiring teams of bankruptcy lawyers, “turnaround” management firms, and other professionals whose livelihood is based solely upon bankruptcy filings and who all require secured and expensive payments upfront.
However, whatever the faults of the process, it is inevitable that there will be an onslaught of Chapter 11 filings for chain restaurant companies seeking bankruptcy protection in the balance of 2020, and likely through 2021. Many restaurant CFOs and their lawyers will become quite familiar with 363 asset purchase agreements and the various provisions that make them unique to the standard purchase agreements, with stalking-horse bidders and the inherent strategies involved in the stalking-horse process.
On the positive side, for some prospective buyers, be they other restaurant companies or private equity firms, there could be substantial opportunities for the taking with the ability to reject those costly pre-COVID leases for something more fitting for the new restaurant model regime. Restaurants, unlike brick-and-mortar retail, are not going away; people are social. We have to eat, after all.
Going forward, prospective buyers of distressed restaurant assets should start their legwork soon. There are a myriad of talented investment banking firms available to help ferret out potential transactions, regardless of whether the prospective buyer is in or out of the restaurant space. Line up your lawyers with 363 buy-side experience and start strategizing. In my experience as counsel on such matters, these proceedings require a bit of work and a good measure of strategy, just as every chef will tell you that a good menu requires careful planning.