Bloomberg Law: NFS' Alan Gallup weighs in on post Covid Franchisee Challenges

Alex Wolf of Bloomberg Law recently interviewed NFS Asset Recovery specialist Alan Gallup for an article published in Bankruptcy Law. The article below, discusses some of the challenges facing franchise owners in this post Covid economy.

Fast Food Franchisee Bankruptcies Portend Industrywide Struggles

By Alex Wolf, Reporter | Bloomberg Law

• Brand franchisees strained by inflation, labor market, debt
• Bankruptcy used to facilitate restaurant sales, closures

Fast food franchisees are facing post-Covid headwinds that could spur more of them to file bankruptcy in the coming months.

Rising labor and food costs, ballooning interest rates, and corporate brand owners’ demands for upgrades and operational improvements have strained profitability for a number of fast-food chain operators. Many regional banks’ decision to tighten lending practices also have contributed to franchisees’ struggles.

A couple of sizable Burger King franchisees—Meridian Restaurants Unlimited LC and TOMS King Holdings LLC—recently filed for bankruptcy, citing steep business declines.

Premier Cajun Kings LLC, an Alabama-based operator of 19 Popeye’s restaurants, noted in its March bankruptcy court filings that “high inflation, increased borrowing rates, and an increasingly limited qualified labor force” have hurt its business.

Franchisors, whose revenues are largely based on store owners, are also sounding alarm on some of their franchisees’ outlook.

In a May 2 earnings call, Joshua Kobza, CEO of Restaurant Brands International, which owns Burger King and Popeye’s brands, acknowledged “a few recent insolvencies” among US Burger King franchisees. He also said he expects to see 300 to 400 franchised stores closing this year, noting “a fair degree of uncertainty regarding exact numbers.”

“It would be really surprising if there weren’t additional bankruptcies,” said restaurant finance and transaction consultant Carty Davis of C Squared Advisors LLC. The pressures of operating sometimes several dozen restaurant locations while keeping up with loan payments and dues to franchisors have created an “extremely difficult operating environment.”

Franchisors have largely been spared from the same financial woes of their franchisees. But the brand corporations are increasingly monitoring local markets and flexing their rights to vet third parties looking to take over struggling operators’ stores.

“One of the most important factors is the willingness of our franchisees who have troubled restaurants to work with us and commit to implementing the changes necessary,” Kobza told RBI investors this week. “If they can’t, we have operators ready to step in and do what’s required.”

While it’s unlikely that the number of quick service restaurants will shrink dramatically as a result of the recent distress, unprofitable locations will undoubtedly be closed, said Alan Gallup, a principal at business brokerage National Franchise Sales who specializes in asset recovery.

“It’s an unusual time in the industry,” said Gallup. “I think we’re only seeing the tip of the iceberg for the distressed assets.”

Margin Pressure

The Covid-19 pandemic left its mark on the quick service restaurant industry, providing a boon to food delivery or drive-thru options but dragging down indoor dining.

Meridian Restaurants, a Utah-based franchisee group that previously operated 116 Burger King locations across nine states, said in its March bankruptcy filing that it “suffered significantly from loss of foot traffic.”

Illinois-based TOMS King, which put subsidiaries operating 90 locations into bankruptcy in January, also noted a steep decline in revenue without proportionate decreases in rent and debt service.

Rising overhead costs and a lack of workers have exacerbated cash flow, Meridian and TOMS each said.

According to Gallup, many franchisees were able to get through the pandemic intact, but some operators received government aid and “kind of ate their seed corn.”

“They’re facing the fact now that the margins aren’t there, the profitability is not there,” he said.

The number of franchisees filing bankruptcy is still relatively low. But inflationary pressures and other macroeconomic factors make this a “uniquely distressed area” that isn’t confined to just one or two chains, said bankruptcy attorney Jonathan Shenson of Greenberg Glusker Fields Claman & Machtinger LLP.

“The takeaway is that food costs, labor costs really are impacting the bottom line,” he said.

Restructuring Options

Filing Chapter 11 gives struggling franchisees a pause on debt service and breathing room to reorganize or sell the business.

Meridian and TOMS King have already used bankruptcy to reject dozens of leases and shed unprofitable restaurant locations.

Bankruptcy has also provided a forum to sell parts of the business to third parties.

TOMS King last month received court approval to sell most of its bankrupt locations to bidders, including Burger King Company LLC. Premier Cajun Kings also won approval in late April to sell substantially all of its assets to Florida-based private equity firm AIM Associates Capital Group.

“There are buyers for almost every brand for stores that file,” said Davis of C Squared. These acquisitions will likely lead to “further consolidation with stronger operators.”

It’s likely that more regional operators will seek relief under Chapter 11 or a related bankruptcy subchapter—strictly for companies with less than $7.5 million of debt—to address underperforming stores, said Gallup.

As a cheaper alternative to bankruptcy, some struggling franchisees may negotiate with creditors to restructure out of court. They may also conduct a liquidation through an “assignment for the benefit of creditors,” commonly referred to as an “ABC,” which puts a trustee in charge of the wind-down process.

Franchisor Involvement

Franchisors are likely to retain outsized rights to control some parts of restructuring.

Brand owners can continue to require franchisees to follow corporate protocols. They also reserve the right to decide who can operate their branded locations. They also often have the ability to object if a franchisee who’s filed bankruptcy tries to sell restaurants to an unapproved or undesired third party.

“You can’t just have a franchisee in bankruptcy decide they’re going to sell their franchise because the franchisor has to have some sort of consent control over who is going to be their franchisee,” said bankruptcy attorney Kay Standridge Kress of Troutman Pepper Hamilton Sanders LLP. “You’re going to be in trouble if you can’t get your franchisor on board.”

Burger King challenged TOMS King’s proposed sale to 13th Floor Capital, citing doubts about 13th Floor’s ability to consummate the deal. The proposed buyer was later knocked out of the running at auction.

Popeye’s Louisiana Kitchen Inc. said it supported the bankruptcy sale executed by Premier Cajun Kings. But the franchisor also notified the court that it would object to any transfer of its franchise agreements until a winning bidder was selected and approved as a brand operator.

Attorney Benjamin Struby of Midwestern-based Lathrop GPM said he’s been increasingly telling franchisor clients to “keep a new eye on franchisees” for any signs of trouble that might require intervention, like delayed fee payments or failure to communicate.

A possible hike in franchisee bankruptcies is “something to be concerned about,” Struby said.

To contact the reporter on this story: Alex Wolf in New York at awolf@bloomberglaw.com