It appears the restaurant industry is growing again. Over the last two years, the domestic landscape expanded by 18,000 locations, according to recent data from The NPD Group. While still under pre-pandemic counts, the upward mobility could signal a shift on multiple fronts. Given profitability challenges, construction and permitting delays, and the continued grapple with surging costs, it’s unlikely 2023 turns out to be a robust development year. But some pundits expect that to flip as soon as 2024. So this coming year might, in some respect, turn out to be a positioning year for those brands ready to capitalize.

Nick Cole, head of restaurant and hospitality finance at Mitsubishi UFJ Financial Group, noted, even with recent growth, the number of restaurants per capita is at its lowest point in 25 years. Cole said it’s proving difficult to get return on capital for new unit development in the current macroeconomic backdrop. 

Yet restaurants, innovating with smaller footprints and second-generation spaces, are using alternatives to build more because they see what’s ahead. 

The National Restaurant Association’s State of the Industry Report, released Tuesday, forecasted the sector to reach $997 billion in sales in 2023, driven in part by higher menu prices. Also, 47 percent of operators expected competition to be more intense than last year. At least four in 10 operators in each of the three limited-service segments—quick service, fast casual, and coffee and snack—felt the addition of drive-thru lanes would become more common. 

Per NPD, total foodservice traffic, restaurants and retail foodservice combined, rose 2 percent in January, and restaurant visits climbed 3 percent over visit losses due to the Omicron variant last year. Foodservice consumer spending hiked 7 percent in the month compared to a year ago.  

In January, dine-in visits upped 24 percent over a gain of 41 percent in January 2022. Even with the increases, dine-in or on-premises traffic is still recovering from the steep pandemic-related declines of 2020. Off-premises, primarily drive-thru and delivery, remain higher than pre-virus days (one reason operators expect growth in these arenas) 9 and 88 percent, respectively, versus three years ago.

And what about M&A? It’s been a slower market of late thanks to these same profitability and macro challenges. Erik Herrmann, partner and head of the Investment Group at CapitalSpring, chatted with QSR to discuss how restaurant concepts can secure financing in 2023’s economic climate, and what could be to come.

Let’s start with some 2023 headwinds. What factors in the marketplace today do you think could challenge operators?

There are a few key marketplace factors that could challenge operators today, including: higher commodities costs, elevated interest rates, and a potential downward shift in consumer spending.

Specifically, how are some of these external forces affecting a restaurant’s ability to secure financing?

We have seen performance headwinds on the cost side throughout 2022, which has led to margin erosion and a reduction in EBITDA. The primary operating headwind has been on the commodities side, and in some cases the cost increase has been extreme. This dynamic both limits the financing capacity of businesses as well as reduces the number of lenders or investors who might invest. In addition, the cost of financing has increased significantly as a result of the Fed raising rates, which pressures typical lending ratios. 

What impact is the fact the cost of loans has gone up so much having on restaurant deals?

There’s a Domino effect at play right now, with many in the restaurant industry unwilling to bet on what are perceived as riskier deals. As a result, growth plans are impacted, and lenders are being more reserved with what they are willing to underwrite to.

Do you think this could lead to more M&A activity, less, or something else?

We have seen M&A activity dramatically slow over the last few quarters. That said, we are starting to see a slight uptick in opportunities coming to market in 2023. A primary driver of M&A activity is business health and positive momentum, which was definitely not the case in 2022. As earnings hopefully stabilize in 2023 due to normalization of the cost environment, we are expecting to see more M&A activity. Investors really need to see a business moving in the right direction in order to have conviction in investing. On the rate side, obviously higher rates will impact debt capacity and perhaps valuation. I think it is likely that higher rates are around for a period of years, so the market will just need to adjust to that new reality. For sellers that are hoping to return to 2021 performance and valuations before selling, it might be a while.

What are lenders looking for in restaurant concepts amid this climate? Likewise, what are investors looking for in brands?

As always, I think investors and lenders are looking for strong businesses operated by experienced management teams. Stability and growth in earnings is key. For some, brand or segment are also key criteria. I don’t think the criteria have moved as much as the fact that fewer businesses meet the criteria at the moment.

How can restaurant operators proceed if they want to get deals done? How has the approach changed from recent years?

Since there are more limited investment and lending options available to companies at the moment, the key is to broadly canvas the market. Using conventional bank financing works well in conventional times, but there are many other options for operators who are willing to explore. In this environment, it’s also about having a flexible capital structure that is resilient to whatever the next challenge might be. If the post-COVID period has taught us anything, it’s that the “new normal” has significant volatility. Working with investors or lenders that can provide flexibility and also ones that understand the ups and downs is more critical today than ever. 

What are some options for restaurants to secure capital beyond the typical focuses?

Interest-only debt, fixed-rate debt, Pik toggle loans, debt with warrants structures, debt+minority equity and more, offering various trade-offs for different situations. 

Speaking broadly, what’s a topic that’s going to define the industry in 2023 people might not necessarily be talking about today?

I think people are talking about the right factors. Commodities relief, risk in consumer spending, and longer term, leveraging technology to drive greater efficiency in the operating model.