Is it time to recession-proof financing?
Rick Thompson, BMO Harris
Restaurant operators have been reveling in a strong economy and a climate where plenty of debt and equity is available to finance expansion. But those good times won’t last forever. In fact, some economists are predicting a recession may be lurking around the corner. So, now is the time to start thinking about recession-proofing financing and shoring up balance sheets to be better prepared for what lies ahead.
Despite rising interest rates, the restaurant sector remains flush with capital that is available from a variety of sources ranging from banks and SBA lenders to institutions, private equity and hedge funds, family offices, REITs and fintechs. “There has never been more liquidity that has been available to the restaurant space than there is now,” says Rick Thompson, managing director and group head of franchise finance at BMO Harris Bank in Irvine, California.
The number of restaurant lenders has “exploded” in the past few years, with more than 100 different capital providers providing junior and senior debt along with other types of equity capital. “There is just an unlimited number of options available to restaurant operators right now,” says Thompson.
Historically, banks, equipment financing companies and other specialty finance companies dominated restaurant financing. Over the years, more institutional capital has moved in to provide restaurant financing for chains, franchisors and franchisees. Part of that shift is largely because there is a lot of capital in the market looking for yield. “The restaurant space, if done properly, can be a relatively safe investment. So, I think it has attracted a lot of new investors,” says Thompson.
Investment capital hungry for yield has been attracted to the growth occurring within the restaurant industry with strong employment and consumer spending that is resulting in a bigger portion of food dollars going toward dining out. If anything, there is slightly less demand for commercial loans as restaurant companies are generating funds internally, agrees Karen Schonfeld, managing director and group head of franchise banking at M&T Bank.
Robert Daniel, Regions Restaurant Banking
What’s ahead for 2019?
Most lenders expect capital will continue to be accessible for franchisors and franchisee operators in 2019. “We have not seen at our bank, or among some of our peers, any tightening around credit structure or increases to rates. If anything, it is going a little bit in the other direction,” says Schonfeld. There is some caution in the casual dining space, but lenders are still being aggressive in the fast casual and QSR segments, she adds.
That being said, lenders remain disciplined in their underwriting and the ability for a franchisor or franchisee to access capital in the coming year will depend more on their performance and brand strength.
“It feels like there is still a lot of demand for institutional deals. On the large side, we may continue to see some brands that go private or trade to private equity, and I think the institutional capital market will still be aggressive for those types of deals,” says Robert Daniel, managing director and group head, Regions Restaurant Banking. “For some of the more middle market deals where brands have not been performing as well, I think you will see a retreat somewhat on leverage and to more conservative structures.”
Brands or franchisees that have been dealing with pressure on margins, same-store sales and traffic counts and eroding profitability will still find plenty of lenders to talk to about financing needs. However, it may be a little bit more challenging to get as much debt or the same terms that they were able to get in prior years, adds Daniel.
Advice for operators
The U.S. economy has been enjoying a prolonged growth cycle. If the country can maintain its positive momentum through June, it will set a record as the longest economic expansion in the post-WWII era. However, a recession at some point is inevitable, and some economists are predicting that a downturn—even a minor one—could emerge in late 2019 or early 2020. For restaurant operators, that means it’s time to think about recession-proofing financing.
“It’s not a good time to be thinking about how much cash you can take out of your business,” says Daniel. “It is a time to prepare for a downturn and shore up your balance sheet as much as you can.”
Karen Schonfeld, M&T Bank
Restaurants that have been in expansion mode are now seeing soaring construction and land costs, along with challenges of finding and paying for labor to staff those new units in a tight labor market. Given the rising costs and potential slowdown ahead, restaurants need to think hard about where they are investing their capital. “You really have to ask yourself, is this the best market to be building aggressively in, or would I be better off to make sure the existing base of stores are in the best possible shape and staffing is appropriate,” says Daniel.
Rather than pushing the envelope on leverage, operators should be gathering as much “dry powder” capacity as possible, adds Thompson. “Just because you can borrow a great deal of capital at very aggressive terms doesn’t mean that it is the right or prudent thing to do long-term for the company,” he says. Market corrections often produce buying and expansion opportunities, and operators that have good liquidity will be in a better position to take advantage of those opportunities, he says.
Franchise groups should consider taking defensive action to create better liquidity. There are a variety of ways to improve liquidity, including building cash reserves, freeing up or opening new lines of credit, and paying down debt today so that operators have a better financial profile should they need to borrower money in the future.
Another step that operators can take to avoid volatility is to fix interest rates. Currently, there is a very narrow spread between short-term and long-term borrowing rates, meaning there is very little additional cost associated with fixing a loan cost at three years versus seven years. The Fed has indicated it will continue to raise short-term borrowing rates over the next year, which could make it more expensive to borrow money. So, it could be advantageous for borrowers to lock in favorable rates now.
Borrowers looking to take on new debt in the near term can take advantage of competition to push for the most favorable terms they can get, such as longer amortizations and competitive rates. That being said, it is wise to also choose good financing partners.
“I think it is important to maintain strong relationships and have trust and openness, because at some point we will hit a recession and you want those partners that were there with you when times were good to also be there when business challenges arise,” says Schonfeld.