Hospitality finance in troubled times06 May 2020
In our continuing series of articles on topical issues confronting lenders, we will now turn our attention to the hospitality sector.
When referring to ‘hospitality’, our focus is on pubs, clubs and licensed premises (such as restaurants). This market sector has been particularly hard hit by COVID-19, in that:
- most clubs have shut down completely
- many pubs are limited to providing take-away meals in an effort to try and keep their kitchens open and some staff working, and
- many restaurants are in a similar position to pubs, offering take-away meals from basic menus.
As a consequence of the social distancing rules that have been put in place, it is highly likely that a number of these venues will have to continue to operate at less than full capacity even once they re-open.
More to the point: Will club and pub patrons be in a position, or be inclined, to spend their highly limited discretionary income on hospitality and gaming?
Most lenders have now invoked provisions that are specifically aimed at the hospitality sector and which are intended to provide certain concessions for a sector especially hard hit by COVID-19 and may include:
- waiver of covenant breaches (for a specific period)—mainly financial covenants but also continuing business style covenants, and
- deferral of principal and/or interest payments.
Where applicable, we have generally seen lenders apply a suspension period of 3 or 6 months (Suspension Period). Note the reference to ‘suspension’. Care must be exercised to ensure that any such concessions have a sunset date after which any waivers no longer operate.
Notwithstanding the Prime Minister’s recent comments, given that social distancing rules will remain in place for some time to come, it is almost certain that businesses in the hospitality sector more broadly will be among the last to fully re-commence ‘normal’ trading. This raises the question of how to approach a return to loan financing obligation compliance and the restoration of regular payment obligations.
Standard financial covenants that are likely to apply to a business operating in the hospitality sector include:
- Interest Cover Ratio (ICR), and
- Debt Service Cover Ratio (DSCR).
Given that there is likely to be little or no cash-flow in current circumstances, it is highly likely that these obligations are not being complied with and it is probable that any trading-up period following relaxation of any social distancing requirements is unlikely to see an immediate reversion to pre COVID-19 levels of business.
So what steps can lenders take with a view to the lifting of restrictions?
Post Suspension Period review
One approach is to conduct a facility review for the period following the end of any Suspension Period. The purpose of this review is to try and identify what the borrower’s cash-flow might look like in the coming months ahead.
Concessions by State and Commonwealth authorities
Any such review will need to take into account the many and varied concessions granted by State and Commonwealth authorities. In NSW, as at the time of this article, there are a number of concessions in place, including:
- Deferral of gaming machine tax payments for a period of 6 months from March 2020 until September 2020. Note the reference to ‘deferral’.
- Deferral of lotteries and Keno payments for 6 months from April 2020 to 30 September 2020.
- Payroll tax deferrals:
- For businesses with total grouped wages more than $10 million, the ability to defer payment of payroll tax for up to 6 months from April 2020 to October 2020, and
- For businesses with total grouped wages less than $10 million, a reduction of 25% of the liability when lodging the annual reconciliation, or, for those taxpayers who lodge and pay monthly, no payment for the months of March, April or May 2020.
- Liquor Licence fees—most licensees will have their annual liquor licence base fee and trading hours risk loading waived for 12 months. This applies to the period 15 March 2020 to 14 March 2021.
All of these concessions will need to be taken into account when considering any potential for an on-going waiver. Care will need to be taken to determine:
- If the tax and other concessions from authorities will continue to apply. If not, what will be the impact on cash-flow?
- Are the concessions truly waivers or are they deferrals—for example, will pubs that have continued with reduced trading (such as take-away food) and, in some cases, liquor shop sales, have some liability, given their continued trading, for any of the concessions?
Other considerations for a review
In addition to considering the impact of these regulatory/tax issues, thought should also be given to the following:
- Changed consumer habits—will customers be more cautious with what is, after all, discretionary spending. In particular, will in-house gaming revenues return to pre COVID-19 levels?
- Capex—what will be the capital expenditure requirements of borrowers and will operators need to re-stock beyond pre COVID-19 levels?
- Staffing—many workers in this sector are casuals. Having regard to the likely level of unemployment, it would reasonable to assume this will not be an issue but will potential new workers have the necessary RSA credentials?
- Premises valuations—are freehold premises valuations relevant and, if so, has there been a decline in valuations?
- Premises leases—are premises leases relevant and, if so, have there been any lease concessions provided to borrowers?
- Additional operating costs—are authorities likely to require elevated requirements of cleaning, provision of sanitizer and additional laundry needs, on operators for the foreseeable future even after re-opening? If so, then this represents a significant increase in operating costs with no corresponding increase in revenue.
As we identified above, it is important that any waivers or concessions granted to borrowers are sufficiently specific and are for a fixed period and not indefinite. A formal or informal mechanism may need to be established for a review process to occur at the end of any Suspension Period. Borrowers will no doubt push for generic waivers of any breaches linked to COVID-19 issues or for waivers/deferrals that do not have sunset dates. Such arrangements carry risks for lenders. The options for lenders are:
- embed a formal review process to take place at the end of the Suspension Period. Care must be taken to ensure that, from the lender’s perspective, the review must be to its satisfaction and will not automatically result in any extension of the waiver regime, and
- simply have a Suspension Period with a clear statement that the borrower must re-commence full compliance at the end of the Suspension Period.
We have focussed on the issues of financial covenant breach and deferral of payment obligations. In any facility agreement there will also be the customary raft of representations, warranties and undertakings—such as corporate authority and solvency.
There is no reason that compliance with such obligations should be suspended. Of particular relevance is the representation that the borrower is solvent. In theory if a borrower is not trading and has the benefit of the tax relief referred to above, then they should be solvent. We are aware of some borrowers asking their lenders to waive compliance with this basic obligation. This should be treated with the utmost caution. Any such waiver, at the very least, could imply that the borrower is not solvent.
There should also be no reason why borrowers are unable to comply with orthodox obligations that are not related to their cash-flow position.
NSW lock out law changes
Also of note for lenders are the imminent relaxation of some of the NSW lock out laws and the introduction of a de-merit points system. In brief, what is proposed is:
- replacement of the 3 strikes system with a system of escalating sanctions for multiple breaches of liquor laws, which will lead to a suspension of trading for periods of 7 to 14 days
- abolition of certain restrictions around live entertainment, and
- discounts of 5% of licensing fees for venues that accrue no demerit points over a 3 to 5 year period and a 10% discount for venues that maintain a clean record for 5 years or more.
What this means for the hospitality industry?
The hospitality sector has been particularly hard hit by COVID-19. Anecdotally, there were some businesses that were not trading so well before the onset of COVID-19. It may be that those businesses will be unable to recover from the ‘COVID-19 shock’. Care should therefore be taken when assessing such credits to identify whether they will remain viable in the aftermath.
As will be the case with other industry sectors, such as retail, it is likely that there will be a period of consolidation and that smaller traders may struggle to confront the challenges and long trade up period when life returns to something approaching normality—and who can say what the new normal look like?
One probable outcome is that there will be further consolidation in the sector. The big are likely, with better balance sheets and financial means, to get bigger while some independent operators may well find life in a post COVID-19 environment more challenging.