Will the New Year signal an inflection point for Hospitality operators?

While the men’s football World Cup and the festive season may have provided welcome boosts for the UK’s hospitality sector, the need to cut costs from across the profits and losses and to preserve cash (whether through rescheduling investment activities such as opening new sites or regularly assessing pricing levels to reflect inflation and customer demand) remains a constant.

That need is set to intensify as we enter this first quarter of 2023. It is a moment we believe could – with the continued macroeconomic challenges in play – herald an inflection point for many businesses, and one that could kick-start M&A activity when we move into the second half of the year.

In recent weeks, the most regular issue expressed to us from operators – aside from the impact of train strikes and the knock-on effect on Christmas bookings – is the challenge of the cost base, the uncertainty of where costs will go, and when some of the massive inflationary strain will eventually relent. Clearly, the upcoming near-10% rise in the national minimum wage in April 2023 further increases the pressure and will force many operators to focus on what efficiencies might be available in staffing costs next year.

While operators themselves may be hedged on costs such as energy and debt interest, their suppliers may not be, meaning that even with forward planning it is hard to avoid the impact of inflation in the cost base. Added to that, the consumer response to falling disposable income is yet to be fully understood. Government intervention on energy has provided some relief but it is yet to be seen how much consumers will cut back now that the heating is on, or on the back of anxiety that their mortgage rates will rise in line with interest rate increases. Thankfully, employment levels are still high, which provides some solace.

Refinancing challenges

Many operators are still evaluating the position at which they have entered the new year. The prevailing macroeconomic conditions may again require businesses to address parts of their portfolio that have slid underwater. At the same time, some financing agreements that were amended and extended during the pandemic – buying vital time for operational recovery – are due to roll off in 2023. Facilities that mature in 2023 may trigger a need to refinance, and it could well be the case that debt capacity is lower when that time arrives. Interest rates are higher, profit margins have probably been compressed, and there may not be as much appetite in the market for debt finance.

If that is the case, it could result in a funding gap that needs to be bridged either by equity, or possibly by other sources of finance. We think these maturing facilities could well drive transaction activity next year, which may mean refinancing, fundraising, or even disposing of part or all of the business. Completing M&As or fundraisings against an uncertain economic backdrop will demand a very different skillset to realise value, generate appropriate levels of liquidity, and satisfy shareholders with reasonable returns.

It will be critical for sellers to initiate longer lead times to prepare businesses for the market. A clear plan on how the business will look and operate after a transaction is a must and could place some companies ahead of others when it comes to funding support – and, crucially, the scale of that funding support. Talking to clients, it’s about being able to navigate this acute short-term disruption, but to do so in a way that leaves the business as well positioned as possible to take advantage of growth when it clears.

Cost control and communication are critical

The areas that come up time and time again in discussion include a laser focus on costs and energy-efficiency measures. There’s also the ability to raise prices to respond to inflation but the need to balance that against the customer’s willingness and ability to pay. Staff will continue to be the linchpin asset for businesses, and as we work through disruptions – or the ‘perma-crisis’ as UKHospitality chief executive Kate Nicholls dubbed it recently – the need to invest and keep that team together grows ever more important.

Operators also need to communicate with funders – whether it’s concerning equity or debt – and if there is a need to refinance, then starting those discussions early is vital. Finance providers will need longer to get comfortable with financial forecasts and businesses may need to speak to a broader range of funding providers. For example, when it comes to debt, it is important to speak not only to banks, but also to specialist lending funds that may offer larger debt amounts with more flexibility, but typically at a higher cost.

Of course, once we navigate the short-term seismic challenges in early 2023, thoughts will inevitably turn back to that medium-term focus, and that’s all around the strategic plan to grow. As we emerge from the (short-term) disruption, we should have greater visibility on what a ‘normalised’ cost base means, and more clarity on what this all means for reforecasts, numbers, and key performance indicators. Channel strategies (dine-in, delivery, or retail) or digital strategies will need to be refreshed, whether it’s front of house or back of house. Tying those things together will still need continued investment and finding a way of not only engaging with the customer but also driving efficiency in operations.

We still see a number of groups with white space to expand into, looking at new sites and also talking to investors to push on with roll-out programmes, taking advantage of other groups stepping back from expansion. We also believe there will be a rise in structured deals, where perhaps there’s still that ambition to grow, but maybe the equity structure doesn’t quite stack up to facilitate or support expansion. This can mean raising preferred equity or mezzanine debt, where the funding can come in to fuel growth without diluting equity positions if the business plan is met.

Operational real estate, such as pubs and accommodation, will likely remain popular, in terms of backing new platforms and also investing in those platforms that already exist. Of course, there is the current disruption in the market to overcome first, but perhaps once that happens we will see a return to more fertile M&A conditions as we contemplate the second half of 2023.

An earlier version of this article was previously published in Propel