The SeniorCare Investor: Erickson Troubles Not Over--

Two Illinois CCRCs File For Bankruptcy Protection

 In April of this year, the bankruptcy court entered an order confirming the plan of reorganization of Erickson Retirement Communities and the sale of certain assets to Redwood Capital Investment.  Many people thought that would be the end of it; others thought it was only the beginning.  We’re not sure when the saga will end, but with some recent events, it won’t be anytime soon.

 On June 15, two CCRCs that are still managed by Erickson but that were not part of the corporate bankruptcy filing last November and were also not part of the sale to Redwood, filed for Chapter 11 bankruptcy protection.  Located in Illinois, both are partially completed CCRCs that are owned by separate not-for-profit entities.  Monarch Landing, located on 76 acres in Naperville, Illinois, had issued $178.7 in tax-exempt bonds in 2007 on top of a $15 million “special tax district” bond in 2006.  Of the 1,498 independent living units, 84 assisted living units and 132 skilled nursing beds that were anticipated to be developed, only 360 of the IL units have been completed and available for rent, and occupancy on June 15 was 71.4%, down one resident from April.  For the four months ended April 30, 2010, revenues were $2.5 million and operating expenses were just under $3.2 million before interest expense and amortized entrance-fee income.

 The second community, called Sedgebrook, is located on 92 acres in Lincolnshire, Illinois, and is also owned by a not-for-profit that issued $137.1 million in tax exempt bonds in 2007 on top of $15 million in special tax district bonds in 2004.  This community was planned to have 1,380 IL units, 96 AL units and 132 skilled nursing beds when completed.  As of June 15, 469 IL units had been completed with an occupancy of 87.2%, 44 AL units were available with 22.7% occupancy and 44 skilled beds were available with 50.0% occupancy for an overall occupancy rate of 79%, which is up from 77% in April.  For the four months ended April 30, 2010, revenues were $5.0 million and operating expenses were $6.2 million, so there is a larger deficit before interest expense and entrance-fee amortization.
 
 After the plan of reorganization was approved and Redwood took over the management of Erickson, there was supposed to be a 90-day marketing period when an outside representative (CLW Realty Group) would market both the Sedgebrook and Monarch Landing properties, and Redwood would have a non-exclusive right to negotiate a purchase as well.  Well, a funny thing happened on the way to more stable times.  Apparently, the bond trustee for the fixed rate bondholders “swept” the excess funds from the Monarch Landing account, prompting a bit of an allergic reaction called a bankruptcy protection filing.  Fearing it was going to happen to Sedgebrook as well, both not-for-profits decided to file, and the ubiquitous Alvarez & Marsal (Paul Rundell) became the chief restructuring officer for both entities. 

 There will be a July 16 hearing to go over the bidding procedure, with bids due by the end of the day on September 8 and an auction to be held on September 14 if there is more than one qualified bid.  The stalking horse bidder is David Reis and his Senior Care Development, with a $43.27 million bid for both CCRCs combined, comprised of $14 million of cash and $29 million of assumed debt, which we assume is the remaining balance of the special tax district bonds.  This comes to just $47,000 per unit/bed plus all the extra land for any future development.  Obviously, that doesn’t leave much for the other bondholders, who are being represented by the law firm Mintz Levin.  But what is the alternative?  Both of these properties are a long way from being cash flow positive before debt service, and one of them doesn’t even have the assisted living and skilled nursing component that residents of CCRCs expect.  And there is that liability of entrance-fee refunds.  Consequently, the true cost will include the working capital necessary to keep the communities going until they are cash flow positive, plus, at least in the case of Monarch Landing, the eventual development of the assisted living and skilled nursing component. 

 The process will take place with the purpose of generating the maximum value for the creditors.  But that will not be the entire story, and the highest price may not result in the winning bid.  Of relative importance will be how the bidders treat the current residency agreements.  It is highly unlikely that any bidder will include the cancellation of the agreements as part of a bid, such as what happened last year in Pennsylvania.  But some bidders, such as the stalking horse, may include some improvements to the residency agreements as part of a bid, which may be looked upon quite favorably by the bankruptcy judge.  And, if improvements to the agreements are for future as well as existing residents, that could go a long way in the negotiations. 

 We assume that Redwood will join the bidding process, and that KKR, which lost in the final bidding for Erickson, may join in, but these two properties may be too small of a platform for the private equity firm to jump into the seniors housing arena.  Mr. Reis was a good choice to get things rolling.  He has bought, sold and developed CCRCs, and has very strong opinions on the right way to do things and how to treat the residents.  And he has always used Life Care Services as his management company, and would presumably do so with these two CCRCs if he is the winning bidder, and there aren’t many companies that have Life Care’s experience.  Having recently had lunch with some residents at his Meadow Ridge CCRC in Connecticut (unbeknownst to Mr. Reis until after the fact), we expected to be impressed with the physical attributes of the community, but what really impressed us was how complimentary the residents were of the management of the community and their ability to control costs without compromising service, which they like because that helps to keep rate increases down.  This community, however, is at a much higher price point than the Erickson CCRCs.  Mr. Reis believes that Life Care Services can operate the Erickson CCRCs at a lower breakeven point than Erickson (or Redwood) can, and perhaps that will allow him to make a higher bid.  On the other hand, Redwood would be losing the management fee income from these two properties if it loses the bidding, plus the future development potential, so it has an incentive to bid up the price as well.

 It is very difficult to even make a guess as to how high the bidding will go because of the current lack of positive cash flow, the uncertainty of when the two communities will become profitable and the cost and timing of any future development at the sites.  Partly because the two CCRCs are practically in the backyard of Brookdale Senior Living (NYSE: BKD), one could think it would be a likely bidder, but it is doubtful the company would want to take on a negative cash flow acquisition at this time or the development risk.  Plus, the CCRC industry is coming under attack from some areas of the government.

 The U.S. Special Committee on Aging has set a hearing date of July 21 to discuss the findings of the General Accountability Office (GAO) study on CCRCs, which includes the financial solvency of CCRCs, the debt financing structures (hello, Erickson), entrance fee refund policies, state regulatory policies and financial disclosure practices at CCRCs.  On top of this, the Internal Revenue Service has gone after Classic Residence by Hyatt for more than $107 million of “underpaid” taxes relating to the tax treatment of entrance fees paid by residents.  We don’t understand why the IRS has suddenly decided to reverse course on this tax treatment, and we believe they will lose in court, but it is odd that they would go after the company controlled by President Obama’s 2008 National Finance Chairwoman, Penny Pritzker.  The refundable portion (usually 90%) of the entrance fee has been treated by the IRS as an interest-free loan to the provider in the past, and we don’t know why that should change now, other than the Treasury looking for money anywhere it can.  One of the things the GAO report will be taking a hard look at is the timing and conditions governing the refund of the entrance fees.  In one case with Hyatt, the provider apparently has up to 25 years to fill a vacant unit and refund the entrance fee.  We don’t think it has ever come to that, but it is those types of practices that Mr. Reis and Senior Care Development have avoided and will continue to do so as they pursue the two Erickson CCRCs in Illinois.