Changing debt market puts deal-making power primarily in investors’ hands

Changing debt market puts deal-making power primarily in investors’ hands

Adepressed debt market has changed the borrowing landscape substantially, giving investors, rather than operators or bankers, bigger shares of lending clout.

At a time when lackluster sales and blockbuster costs are forcing many cash-strapped restaurant companies to restructure their corporate debt because of possible loan violations, the shift in power means less flexibility and more expensive capital.

(To view the charts featured in this week's print issue, click here) [3]

Experts estimate that companies looking to renegotiate loan terms ahead of or after covenant breaches are seeing rates rise between 2 percentage points and 4 percentage points.

Ruby Tuesday Inc. [4] and Krispy Kreme Doughnuts Inc. [5] both have said in recent weeks that negotiations with lenders were imperative to avoid a technical loan default or because a covenant had already been broken or was close to being broken. Sources also said privately held companies including Sagittarius Brands Inc., parent to the Del Taco [6] and Captain D’s [7] chains, and Perkins & Marie Callender’s [8] Inc. have been forced to reprice their corporate debt because of trouble meeting lending agreements. All restructured deals led to an increased cost of capital.

While many borrower-friendly banks emphasize client relationships, especially in the small restaurant finance space, certain investors in corporate debt are not as forgiving, sources said.

A debt investment analyst at a large hedge fund who requested anonymity because she actively trades in the restaurant sector said the balance of power between borrowers and lenders—and more importantly between lenders and the investors that trade in the debt markets—has shifted dramatically.

“Banks are just the middlemen,” she said. “Investors hold the cards.”

Because the debt markets have yet to recover from last summer’s subprime meltdown, most traders—whether active in bonds or other structured securities—are standing still. They are unable to sell positions that are now under-priced and unable to buy positions because of a lack of liquidity, the analyst said.

“Everyone is waiting it out,” she said, “because no one knows where the bottom is.”

A look at recent prices for certain corporate paper shows a drop to well below par, or the face value of a bond. Outback [9] Steakhouse parent OSI Restaurant Partners [10] LLC is trading in the mid-60 cents to the dollar. Prior to filing for bankruptcy protection, Vicorp’s corporate bonds were trading as low as the mid-20 cents to the dollar.

The market does take into account debt ratings and a company’s performance, however, and some bonds haven’t dipped to extremes. Darden [11] Restaurants, which is an investment-grade-rated company, shows pricing for its highest-return bond above par.

The depressed bond market creates a tough situation for any operator seeking any type of credit facility—or with the need to refinance a facility—because the funding of capital has risen so dramatically.

“Any deal priced between 2006 and through the early part of 2007 is likely to see between a 200 and 400 basis point repricing in borrowing cost,” said Nick Cole, managing director at Wells Fargo Commercial Capital.

The 200 to 400 basis point range is equivalent to an increase of between 2 percentage points and 4 percentage points.

“It is a very unpredictable situation for borrowers,” he continued. “Even if you feel pretty good about where you are, you’re more likely to be tucking away more cash than opening new restaurants because that rainy day could be coming.”

At Winston-Salem, N.C.-based Krispy Kreme, new arrangements led to an increase of 2 percentage points to its interest rates. Interest on the company’s term loan would move to LIBOR plus 5.5 percent from LIBOR plus 3.5 percent. LIBOR is the London interbank offer rate, or the rate at which banks borrow funds from each other. It is typically used as a benchmark for short-term lending rates. Fees on Krispy Kreme’s letters of credit also rose 2 percentage points to 5.75 percent, the company reported.

The changes came when Krispy Kreme, which was in compliance with all lending agreements, met with lenders in order to relax certain covenants that were expected to become “more stringent” this year. Krispy Kreme, which operates or franchises 449 namesake locations and has been challenged for more than three years with slowed sales and declining profit, holds a balance of $76.1 million on its term loan and $20.3 million in letters of credit.

At Perkins & Marie Callender’s, which operates or franchises 621 restaurants, rates rose about 2.5 percent on both its term loan, with a balance of about $21 million, as well as on its letters of credit, which stand at about $11 million, after the company broke its leverage ratio covenant at the end of last year. In a call this month with the company’s bondholders, Perkins & Marie Callender’s chief executive, Jay Trungale, said the Memphis, Tenn.-based company had worked out new, detailed arrangements to avoid future default and was comfortable with the current agreements.

When asked by an investor what the company could do to cushion its lending agreements, Trungale said “the flow through of sales to the bottom line” would determine its success.

“The key drivers are the key drivers that everyone else out there is looking for: sales and cost control,” he said. “At the end of the day, that’s what we’re all striving for.”

While many restaurant companies have been forced to pay higher costs for borrowing or fees for the waiver of covenant breaches, while some have been priced out of the market all together, there is at least one example given as a sign of positive traction in the lending market.

A franchisee that holds a $200 million credit facility and was facing a default was able to come to a beneficial arrangement with lenders, none of which were institutional holders, said a banker that requested he not be identified because he worked on the deal. The company, which he also did not identify, was able to negotiate with its investors an amendment to lending covenants that didn’t include a pricing increase, or a negotiation fee. The source said the history of the company’s performance and the strong relationships it holds with its investors were the drivers behind the positive outcome.