With a string of restaurant bankruptcy filings within the last year, including Bertucci’s, Noon Mediterranean, Papa Gino’s and D’Angelo Grilled Sandwiches and most recently, Taco Bueno and the owner of Fatz Cafe, the restaurant industry is proving once again that it is not for the faint of heart. Ever-changing consumer tastes, rising labor costs, capital expenditure demands and unsustainable debt loads are just a few of the challenges faced by restaurant owners today. But for some, this market misfortune presents an opportunity to unlock value in distressed restaurant assets. When Taco Bueno filed for bankruptcy protection on November 6, it did so with a detailed plan in hand for quick emergence—convert existing secured debt (recently purchased by the anticipated new owner) to equity. This strategy, commonly referred to as “loan-to-own,” is an alternative to a direct equity or asset purchase of a target. Let’s look at the basics of the loan-to-own strategy and some potential pitfalls for the unseasoned.
Loan-to-own is a strategy that involves making a senior secured loan, or purchasing an existing senior secured loan, with the goal of converting that debt into controlling equity of the target borrower on a consensual or hostile basis. The strategy, which can be executed in or out of bankruptcy court and through different mechanisms, is founded on the fundamental bankruptcy principle that secured debt is repaid before unsecured debt, which is repaid before equity and, therefore, the secured debtholder is positioned to control or heavily influence the reorganization or sale process. In the case of Taco Bueno, the loan-to-own approach was the result of a collaborative process to divest the troubled restaurant. Taco Supremo, an affiliate of the restaurant franchisee giant Sun Holdings, acquired the secured debt of Taco Bueno at an auction and negotiated a restructuring support agreement with Taco Bueno that charts Taco Bueno’s course through the bankruptcy process and transitions ownership to Taco Supremo by equitizing its newly acquired secured debt. This loan-to-own plan required the cooperation of Taco Bueno, its initial lenders and Taco Supremo as the debt purchaser. While the bankruptcy case is still in its early stages, the goal is a January 2019 exit from bankruptcy under new ownership.
A loan-to-own strategy can be effectuated through a variety of means, but typically starts with an interested purchaser acquiring the existing debt of a distressed target company. An incumbent lender willing to engage in discussions with potential purchasers, and likely accept a steep discount on its anticipated loan repayment, is a prerequisite. But lenders, especially in the restaurant industry, are often more than willing to engage when battling the “deal fatigue” of a distressed credit that has diverted the lender’s time and resources. The lender in this scenario may also be weighing the potential of a protracted bankruptcy case (see RMH Franchise Holdings, Inc.) and a significantly reduced recovery given that restaurant loans are underwritten based on the “enterprise value” of the company—the inherent value of a company operating as a going concern—and not the value of the company’s assets, such as accounts receivable and inventory. While “asset-based” lenders in other industries are often willing to hold out knowing that the asset value of a company will support relatively high recoveries in either a liquidation or reorganization scenario, the limited liquid asset value of a restaurant in a tailspin is often cringeworthy in the eyes of a secured lender. Finally, most senior secured lenders have no interest in operating a restaurant and, therefore, ultimate ownership of the asset is undesirable.
Once the prospective purchaser has acquired the distressed target’s secured debt, it can proceed along a number of different avenues, including one, a consensual out-of-court restructuring that exchanges the existing secured debt for the equity of the company, two, an out-of-court foreclosure of the assets of the company led by the debtholder, three, a bankruptcy filing followed by a sale of the company to the debtholder, or four a bankruptcy filing followed by a plan of reorganization that converts the existing secured debt into equity of the company. In general, a distressed company and purchaser can benefit from an out-of-court process, which is typically quicker than a bankruptcy filing, results in less disruption (and less bankruptcy court and third-party scrutiny) to the operating business and is cheaper than a bankruptcy filing. However, an out-of-court process foregoes several Bankruptcy Code benefits, including a “breathing spell” from other creditor actions, the ability to force certain creditors to accept less than what they are owed, the ability to shed burdensome leases or other contracts, and the ability to sell assets free and clear of liens and claims or get a court’s blessing at confirmation.
In a bankruptcy scenario, the secured creditor holds substantial leverage. While a secured creditor already exerts considerable influence, if the creditor provides additional “debtor-in-possession” financing to the restaurant after filing the bankruptcy petition to fund the bankruptcy case, the debtholder can enhance its control position by conditioning its financing upon satisfaction of certain milestones in the case, including the filing of various sale and plan of reorganization filings, while also maintaining a veto right on unfavorable plans of reorganization. Regardless of the provision of debtor-in possession financing, if the restaurant assets are sold in bankruptcy, the debtholder can use its secured debt as a form of non-cash currency to purchase the assets. For example, if a restaurant’s outstanding $100 million secured loan is purchased for $25 million and the assets are subsequently sold in bankruptcy, the debtholder could “credit bid” up to $100 million in an auction without a cash outlay. Instead, the debt in the amount of the credit bid up to $100 million would simply be canceled. The debtholder is, of course, free to supplement its credit bid with a cash bid if a competitive auction sends the price over $100 million. The ability to credit bid puts the loan-to-own debtholder in a significantly better position than other interested buyers who must compete with all-cash bids and sets the stage for significant investment returns if the restaurant can succeed post-bankruptcy.
Alternatively, the debtholder could pursue ownership of the company in bankruptcy via negotiation of a plan of reorganization that converts its debt into equity. The debtholder can influence the plan through what is typically a blocking position on any competing plan of reorganization.
While the loan-to-own strategy provides the potential for a significant investment return upon a successful turnaround, it is not without risk. An asset purchase or equity purchase comes with assurance that, upon closing, the purchaser will own the company. However, a prospective purchaser in a loan-to-own scenario must make a potentially significant investment to acquire the secured debt of the restaurant without the certainty that it will be successful in exerting leverage to ultimately own the target. Even when the restaurant owner consents to the loan-to-own strategy, as is the case with Taco Bueno, hurdles can remain, including:
- Unsecured creditors or other interested parties can challenge various aspects of the underlying secured claim in an effort to derail the credit bid or minimize the influence of the secured claim in a plan of reorganization.
- Although a secured creditor typically holds a blocking position in any plan of reorganization, it is possible to overrule its objection through a “cram down” plan, which could force the loan-to-own investor to remain a lender on undesirable terms.
- Although typically reserved for egregious conduct, interested parties may seek to limit credit bidding “for cause,” which could cap any credit bid at the purchase price of the debt rather than the face amount of the debt (e.g., $25 million in the hypothetical above rather than $100 million).
- Also reserved for similar conduct, a secured claim can be “equitably subordinated” or recharacterized as equity, which has the effect of putting the secured claim behind unsecured creditors in the priority scheme and likely subject the claim to unfavorable treatment with minimal influence on the outcome of the case.
- If the target is a franchisee, franchisor consent must be obtained.
The loan-to-own strategy can unlock significant value in a distressed restaurant acquisition. However, the process is not without risks, and significant diligence should be conducted by any prospective debt purchaser to limit any potential vulnerabilities in effectuating the conversion from debt to equity. If the transaction is consummated through a bankruptcy filing, the purchaser should avoid imposing aggressive timelines that deprive third parties of an opportunity to participate in the case and should also be careful to avoid conduct perceived as inappropriate control of the company by a lender.