Senior Living Business: Tough Economy Spurs Affiliation Discussions--
A Smart Idea For You? Experts Explore Benefits and Ramifications
February 1, 2009
In legal terms, an affiliation is simply a partnership of two or more parties. For senior living providers, an affiliation could involve a smaller, single-site organization partnering with a larger, multi-facility organization. Or it might involve two single-site organizations that create a third parent entity to govern both partners through a common board of directors. In either case, each affiliate remains intact.
Discussions about affiliations are ramping up in the current economic environment, according to Kathryn Brod, Senior Vice President and Director of Senior Living Research at Ziegler Capital Markets. Single-site organizations, in particular, are facing increasing market risk. Housing markets in some areas are challenged, maintaining occupancy is difficult, and plans to issue bonds to finance a repositioning are on hold due to the capital markets situation. “That becomes the final straw,” she observed. “Then, they start talking.” Multi-facility organizations generally have a more diversified market risk and more elasticity to deal with multiple issues, so more often it’s the single-site organization that starts the discussion.
“A small, single-site entity can hold on for a very long time,” added Jeff Petty, CEO at Wesley Enhanced Living, which was actually created years ago by affiliating a number of small not-for-profit organizations that “just agreed to come together and, in essence, turn over the keys,” according to Petty.
Speaking specifically about CCRCs, he added, “a small not-for-profit community can keep chugging along. We certainly see that around our region, where it seems there’s one on every street corner. But that may come to an end given the reality of this economy. Smaller facilities will have an increasingly hard time being good financial stewards, continuing their mission, providing services to their residents, and taking care of their employees. It will make sense for them to affiliate with a stronger, larger organization. And if the affiliation is done well, the smaller organization won’t lose its identity.”
According to Attorney Glenn Fox, partner at the Schnader Harrison Segal & Lewis law firm in Philadelphia, an affiliation offers advantages to each party in the areas of financing and taxes, licensure and permit transfers, and real estate and other asset transfers, to name a few. Fox, who has been involved in not-for-profit mergers and acquisitions for most of his 25-year legal career, cautioned that an affiliation (as opposed to an asset acquisition) might not be the best structure in every instance. “Each situation must be evaluated to see what may work best for the organization as a whole, including the residents, and with regard to the conditions under which the transaction is being proposed,” he said. “The organization looking to affiliate must take a hard look at itself to see where it is and where it wants to go.”
Finding a partner
Once an organization makes the decision to affiliate, where does it look for a partner? Many boards depend on their investment bankers, consultants, accountants, and lawyers—professionals in constant contact with the “players” in the industry—to help them find a potential partner or alert them when another organization is looking to affiliate. Those conversations might involve a client that doesn’t feel well positioned on its own and is looking at other organizations with which to affiliate; or it could involve a well-positioned client looking for new partners in order to grow.
“It’s really important to us that our clients ‘survive and thrive,’” said Brod, “and that gets us involved early on. We don’t want an organization’s situation to evolve into one where its back is against the wall. So we spend time educating people about early warning signs, helping them understand their options, and encouraging them to develop a set of trusted advisors. That doesn’t necessarily mean it will survive in its current form, but its residents will be cared for and its mission will be fulfilled—even if it means with a partner.”
Trying to match appropriate parties can be difficult, though, because the industry is so diverse. And unlike the for-profit world, where companies simply acquire a complementary business venture and build up, the not-for-profit side has many more issues that come into play—tax issues, health-care issues, state regulations, etc.
First and foremost, of course, the respective boards must determine whether the mission and goals of both partners are compatible. “That’s really part of their fiduciary duties to the organization,” said Fox. “An affiliation is a marriage, and that’s the dating phase. They get to know each other through meetings, visits, and so forth.”
A larger organization can provide financial stability to a smaller partner who is “holding on,” Petty pointed out; but if he were on the other side of the fence, he would shy away from affiliating with a very large organization for fear of being swallowed up and having to conform to everything he’s told. By joining a larger, but not huge, organization, the smaller entity could have an impact while keeping its own operation going. “Really large organizations certainly will have resources that even medium and large ones don’t have,” he said. “Resources are nice—and certainly having more room for error is better than less.”
As for two smaller organizations joining together and forming a third controlling entity, Petty believes that might be harder to accomplish. “If you get the right organizations, with just the right synergies, overlaps, and redundancies that can be eliminated, it could make sense,” he said. “I don’t know that it helps the partners retain their individual identities or that their individual missions could survive the merger, but it’s probably no better or worse than affiliating with a larger entity.”
Sometimes, organizations don’t have the luxury of selecting the “right” partner, given their particular circumstances. And individual difficulties are likely to be greater today due to the challenging economy.
Preparing for the process
Recognizing why you want to affiliate and what you want to accomplish is a crucial first step in the process. Fox calls it “game planning,” and it involves many internal discussions. “The board needs to know what they’re looking for in a partner and what they need brought to the table,” he explained. “They must be able to tell their story and must be honest about any issues they might have.”
For example, a smaller organization may want to partner with a larger organization to benefit from economies of scale and a common fundraising base. Or it may not have the resources to maintain operations and compete effectively nor the financial strength to access the capital it needs. Affiliating with a larger, stronger organization may provide instant access to expertise and a capital infusion to bring the campus up to speed. For its part, the larger partner gains access to a new or expanded market without enduring the five- to seven-year timeline and costs to develop a new property.
In many cases, the motivation to combine organizations, creating a separate controlling entity, is to become stronger through efficiencies in purchasing and in the labor force, including management staff. Or an organization may simply be having difficulty finding new people to serve on its board and welcomes the infusion of new blood.
Nevertheless, it always comes back to mission. “That’s really what drives the whole process. And it can derail a transaction faster than anything else,” said Fox.
Negotiating the transaction
“These types of transactions should be negotiated by experienced professionals who have handled this type of not-for-profit transaction,” Fox stressed. “In the end, the transaction will be completed faster, cheaper, and more efficiently.”
A general counsel’s knowledge will be invaluable to the negotiating process. But if the general counsel has no experience negotiating this type of deal, it makes sense to look for someone with experience to work on the negotiations alongside the general counsel.
Financial and legal due diligence must take place on both fronts, with all records and governance information in good order for the other party’s review. Having one individual or a small team control the business side of the process on behalf of each organization helps keep everything straight and make the transaction better, faster, and more economical for everyone involved.
Dealing with debt
When an existing not-for-profit community with debt outstanding is looking to affiliate with a partner, that prospective partner needs to assess the debt structure of the existing community, take into account its own debt structure, the corporate structure of each, and determine the optimal alternative, according to Dan Hermann, Managing Director and Group Head, Senior Living Finance, at Ziegler Capital Markets. “The prospective partner must also examine the expected governance structure, the operating side, and how linked the two partners will be,” he added.
If the existing community has tax-exempt debt outstanding, the question is whether it’s favorable debt or unfavorable debt and whether it should be preserved. “If it’s low-cost, fixed-rate debt with a reasonable amortization and reasonable covenants—and given the recent markets, it could well be—it should be preserved,” said Hermann. “If it’s variable-rate debt with a letter of credit, the relationship with the letter-of-credit bank may be meaningful and also should be preserved.”
The optimum solution for a not-for-profit affiliation is for the larger organization or the newly formed combined entity to step in as the controlling or sole corporate member of the existing corporation’s favorable tax-exempt debt outstanding. “That will avoid an asset acquisition,” said Hermann, “which would trigger a tax rule that requires independent living units, defined as ‘residential rental’ by the IRS (and which often picks up assisted living units, as well), to be financed on a first-time basis in order to qualify for tax-exempt financing.”
A not-for-profit would only want to do an asset acquisition when the acquiring partner doesn’t want to take on the liabilities of the smaller entity. That happens most often in the case of distressed campuses that end up in bankruptcy or foreclosure, which often leads to a restructuring process, and they end up as asset acquisitions.
If the outstanding debt is unfavorable — if it carries a high fixed-rate of interest or is a problematic bank loan or is variable-rate debt with a problematic bank — then the controlling entity will want to consider refinancing. That requires a six-month waiting period before closing the new financing.
Other issues and impacts
“Each deal is unique, with it’s own set of complications and ramifications and issues that need to be worked out,” said Fox. “Timing is always a big factor. Once people decide to commit to a transaction, they want it done immediately. But some things — getting to know the partner, understanding its mission and what drives its organization, and learning how it focuses on various issues that may be important to each organization — take time and must be resolved before the professionals step in. And the timing of other things, such as government approvals, are simply not under the organization’s control.”
Pre-2007, it was not unusual for transactions to take a year or 18 months to complete. “Today, that timeframe is likely to be compressed,” Fox suggested, “because people will not be able to wait that long to close the transaction.”
One significant issue that always must be resolved (and is sometimes very sticky) is the merging of the boards of directors. The new or combined board usually mimics the structure of one of the organizations, but “it’s all negotiable,” said Fox. “An affiliation allows the ability for some carryover. It’s always helpful to have some members of the new board with first-hand knowledge of the existing organization’s history and why things were set up in a certain way.”
The not-for-profit sector still has a lot of what Petty calls “operational boards.” And when you’re combining boards, whether it’s a couple of members from the target joining the board of the larger organization or two boards merging together, the operational types — “people who want to make decisions about mashed potatoes” — don’t easily mix with a strategic-level board. “You’ll simply end up with a lot of really unhappy people,” he said. And an unworkable board. “You must try to mesh so many things when you bring organizations together that you just can’t afford to make it any harder on the board,” he continued. “But if you can put likeminded people together, who are willing to let go of their own parochial interests and look at the larger whole and who recognize that they’re now serving the combined entity, then I believe you’ll do fine either way.”