For more than a decade following the Global Financial Crisis, central banks around the world held interest rates down to essentially zero. The Bank of Canada (“BoC”) maintained its policy rate between 0.25% and 1.00% for almost a decade beginning in early-2009. This zero interest rate policy (“ZIRP”) made borrowing extremely cheap and contributed to a borrowing binge where companies aggressively invested, expanded and acquired. Hospitality is an example of an industry particularly hit hard by such an approach as they now jockey themselves to more stable pastures in a post-ZIRP world.
Murphy’s Law
The BoC began to noticeably lift its policy rate in mid-2017, and by early-2018, the policy rate exceeded more than 1.0%, the first time in nine years. It looked like the period of extremely low borrowing costs, driven by a financial crisis caused recession, was beginning to come to an end. Then the COVID-19 pandemic erupted. Around the world, lockdowns and social distancing rules limited economic activity, especially in hospitality. The pandemic-induced recession spurred central banks, including the BoC, to slash policy rates back down to essentially zero, making borrowing extremely cheap and accessible once again. Furthermore, Canadian governments, both federal and provincial, offered various forms of financial support, including wage (i.e., CEWS) and income subsidies (i.e., CERB”). This combination of ultra-low borrowing costs coupled with free money helped contribute to something Canadians haven’t seen in decades: inflation. Consumer prices noticeably rose at a rate that exceeded the upper end of the BoC’s target range of 3%, and by mid-2022, the headline consumer price index exceeded 8%. It was a classic case of too much money chasing too few goods. To slow inflation and borrowing, the BoC responded by raising its policy rate in early-2022. The tepid pace was evidently not enough, and as such, over the past 18 months, the BoC’s policy rate increased by almost 5 percentage points. The headlines around the financial strain faced by mortgage borrowers, especially variable rate borrowers, have been pronounced in recent months. Yet in the shadows of these glaring headlines lay a similar story for business owners.
The Hangover
To finance the many bars and restaurants built and/or acquired during the ZIRP era, hospitality groups took on debt. When used prudently, debt can be a cost-effective form of financing. The problem with debt is when there is too much of it, making the required payments very difficult to service. Since 2020, hospitality groups have faced a confluence of economic challenges that started with the pandemic. They first braved a recession, which was reflected in their shrinking revenues, before enduring a substantial increase in interest rates, which stressed their bloated balance sheets.
According to a study by Restaurants Canada, which represents over 30,000 businesses coast-to-coast, 51% of restaurants are losing money. The industry association said in May that the number of restaurants filing for bankruptcy has increased by 116% since 2022. A spokesperson indicated that 83% of Restaurant Canada’s members took out CEBA loans during the pandemic, and only 20% were able to repay them when the CEBA loans matured at the end of the year.
Some hospitality groups have sought creditor protection, which is intended to give them time to restructure their business operations, and/or how they are financed. This includes the likes of BC-based Joseph Richard Group, known for its chain of Townhall and S+L Kitchen & Bar restaurants located primarily in the Fraser Valley. If done right, restructuring could help them stave off bankruptcy.
Options
When dealing with too much debt, borrowers need to focus on the income statement or balance sheet, but preferably both. As summarized below, there are generally four options to consider:
- Debt restructuring could help fix a borrower’s balance sheet without making substantial changes to the business. The borrower could negotiate with creditors in coming up with an agreeable solution. The result could be an extended amortization period, a reduced interest rate, or a conversion of a loan into equity.
- Asset sales change the business and improve the balance sheet. This involves the borrower divesting select assets (e.g., redundant, periphery or underperforming business units) to generate cash for the purpose of repaying debt. Asset sales strengthen the borrower’s financial position and allow the borrower to focus and improve on its core business units. This is a process that Freehouse Collective began in August. Formerly known as Donnelly Group, the hospitality group operating out of B.C. and Ontario listed two of its Vancouver-based pubs for sale after receiving court approvals for creditor protection in May and debt restructuring in July.
- Capital injection would be appropriate when existing and/or new minority investors are bullish in the current business model and management team and find they (and the income statement) need more time to prove themselves out. This fresh capital effectively bolsters the balance sheet and usually doesn’t require a substantial change in the direction of the company.
- Distressed M&A occurs when an investor with deep pockets acquires a financially distressed company. The acquisition prevents the company from going into the hands of creditors, who could be more interested in an outright liquidation. The investor is often referred to as a “white knight” because it would usually allow the existing management team to continue running the company on terms (e.g., layoffs, asset sales, strategy) the existing board finds agreeable.
Next Steps
The world has changed a lot since the pandemic. So has the hospitality industry. Due to lockdowns and social distancing, food delivery had an enormous boost in the early days of the pandemic and proved to be a lifeline for restaurants. Food delivery looks to be a permanent fixture in the dining landscape. This would be consistent with the advent of virtual restaurants and ghost kitchens, which could make many restaurant dining rooms redundant. Costs associated with operating a traditional dine-in restaurant have risen tremendously due in part to the widely reported labour shortage nudging wages higher and higher. With the economics of the hospitality industry changing, strategies need to change as well.
The examples of Freehouse Collective, Joseph Richard Group and the hospitality industry simply highlight the challenges many businesses from various industries are facing in the current economic climate. If you find your company is in a similar situation trying to keep above water due in part to higher debt costs, the above strategies might be something to consider when trying to put your company in a much more stable financial position with creditors. Focusing on your core business and repositioning your resources is paramount so you, your board and management team can better adapt to the existing business climate.
About Baker Tilly Canada Capital Corporation
Baker Tilly Canada Capital Corporation is an independent advisory firm focused on serving small to mid-market entrepreneurial clients. Often these clients are not adequately served by business brokers or larger investment banking firms but still require – and deserve – sophisticated and experienced professionals to get the job done right. The Baker Tilly Canada Capital Corporation team has an impressive resume of credentials and decades of experience in M&A advisory, valuation, tax and corporate finance complemented by well-established networks of key contacts and partners.