“Expecting a more hospitable lending environment? I believe it will be a while.” —Allan Hickok

Are these covenant problems an example of your maxim that when the going gets tough…

Yes, the weak get weaker. I doubt that any chain projected systemic erosion of restaurant-level profitability in their financial forecasts. The profit compression from weak traffic and hyper-inflated prime operating costs has squeezed the income statement and strained the balance sheet for many chains. Weak industry fundamentals will persist, and we are relearning that leverage cuts both ways.

You're not suggesting that leverage is a bad thing?

Leverage is a legitimate means of capitalizing a business and a tool used to increase shareholder returns. Several chains are or are about to encounter financial distress due to elevated debt levels and the liquidity constraints that can place upon the business. I am referring to debt as a multiple of EBITDA, and once that exceeds 5 times or 6 times, the company is considered highly levered.

And debt was attractive and widely available?

Yes, it was, before the credit crunch. Even if you weren't highly levered two years ago, you may be today due to a lower level of profitability. It doesn't really matter how strong your concept is, how smart or hard you're working, you're earning less money than before.

That's changing the way lenders view borrowers.

Lender risk profiles have changed significantly. It is hard to think about dependably obtaining debt financing with an all-in leverage ratio north of 3.5 times to 4.0 times today, compared to 5 times to 6 times a couple years ago.

Is that true across the board?

If there are more lenient lenders, please call me. Lenders have tightened lending standards because industry stress increases the number of troubled credits in their portfolio. The evidence is conclusive. Most chain concepts have flattish to negative year-over-year profit comparisons. This is created by the significant de-leveraging of the restaurant-level P&L. In other words, the efficiency with which you turn a dollar of sales into cash has been compromised in a pretty severe way.

Since traffic skids and costs rise...

Unfortunately. Operators do not have the pricing power to offset negative traffic with price increases, which is de-leveraging in its own right. Stir in the significant increase in prime costs, and profits can pull a disappearing act.

That's bad news for the debt burdened.

Well, yes, if you are in danger of violating your debt covenants, which are designed to protect lenders by maintaining establishedfixed-charge, profitability and leverage ratios. It gets complicated when companies supplement conventional bank financing with other debt instruments such as notes, bonds or subordinated debt.

What might happen in that case?

It is a more complicated capital structure that often will have cross-default provisions. So if you bust a covenant on one loan, you may trip covenants in others. You then have many constituencies to deal with if you seek an amendment. More importantly, you can't easily refinance your way out like you could a couple years ago.