The SeniorCare Investor: Trying To Unwind Sunwest--
Making Difficult Assumptions In An Unstable Market
The clock is ticking for TIC investors, mortgage lenders, un-secured creditors and others, including management, as they all jockey for position to try to secure what funds and assets that they can as Sunwest Management and its affiliates unwind, restructure, dissolve or shrink—whichever way you want to describe it. What was a big mess at the end of last year has gotten even bigger with too many hands in the pot. With Alvarez & Marsal and Hamstreet & Associates, the chief restructuring officer (CRO), hired last year to consult and work on restructuring, that seemed one too many workout specialists.
Now that the SEC is involved with its securities fraud lawsuit, as well as the new receiver, Michael Grassmueck of Grassmueck Associates, who may be mucking things up a bit too much, the big mess has taken on serious proportions. We had never heard of them, and "them" may be him because the company’s web site does not list any other professionals. In fact, this may be the largest case he has ever worked on in terms of both assets and revenues, by a significant factor. Hmmm.
One of the reasons why we bring this up is that from April 2008 through March 2009, Sunwest paid more than $13.5 million in professional fees (according to the receiver), which includes legal counsel, restructuring consultants and other professionals. But Hamstreet indicates that Sunwest has paid $24.0 million in the same time period (so you think there is a problem with accounting records?). In the past four months, however, the company has averaged $1.8 million per month on professional fees, with a high of $2.1 million this past March. Hamstreet estimates that from March 2009 through March 2010 an additional $70.0 million can be expected to go out the door for these professional fees, and this for a company that is running a cash burn rate of $1.7 million per month at the facility level, which by no means includes all the mortgage payments. But we digress.
The new receiver, Michael Grassmueck, released his first interim report on April 23, and it includes some interesting, and somewhat amusing details. It is obvious, after reading through the report, that there is a certain degree of acrimony among the various parties trying to sort through the mess, and we are not talking about the creditors and TIC investors. It seems that Jon Harder, the co-founder and former CEO, is still butting heads with various parties, using two sets of attorneys to represent his interests, which the receiver claims are underwater from a financial perspective (and we have to agree). Furthermore, it appears that Sunwest is footing at least part of his legal bills, which makes little sense but if true, must be hard for the TIC investors—not to mention the creditors—to swallow. Mr. Harder had his chance to perhaps salvage a bad situation last year when Alvarez & Marsal came in and proposed to management early in the summer that they sell specific assets to raise some much-needed cash for operations and a possible restructuring. This was rejected by Mr. Harder, and while we don’t know if it would have saved the company, at least there would have been a better chance than waiting while the economy, the capital markets and Mr. Harder’s own financial situation all went down the toilet.
There is another group of interested parties who can’t be too happy with some of the correspondence emanating from Oregon either. On April 13, a letter went out to Sunwest "stakeholders," which included the TICs, from the chairman of the Sunwest management committee and the chief restructuring officer, Clyde Hamstreet. In the letter, they posed a few of the commonly asked questions. One was, "Does the fact that my property has been listed mean that it will be sold?" We all know that not every asset that gets listed is sold, but the answer must have raised the eyebrow, if not the ire, of quite a few parties from coast to coast. The answer started with this: "No. The marketing effort is a way to help us find out the fair market value of the listed properties." Really, and we were naïve enough to think that the marketing effort was designed to sell them to the highest bidder. We hear Sunwest has some vacancies in their dementia units for the not-the-brightest-bulb in the socket who crafted that answer and thought no one would take offense.
So a broker who listed a property might legitimately ask, "Am I being used?" A prospective buyer, who could have spent many hours and dollars on due diligence, might ask the same thing. The rational fallout is that brokers are not going to spend (or waste) a lot of time on these properties, especially if they bring buyers and are not protected when the April 30 deadline hits and the names are turned over to the creditor who may foreclose. This may "save" money in the short term, but it is no way to maximize a sales price. The fact that so many brokers who listed the properties with essentially 30-day bid deadlines did so says more about the hunger for inventory than anything else. One might even call the strategy absurd in this market. Financing commitments? Don’t worry about it. But we digress, again.
In his preliminary report, the receiver indicated that contrary to popular opinion, Sunwest’s management (Mr. Harder) wasn’t just taking funds from cash flowing properties and funding unprofitable ones. They were taking cash from distressed properties and sending it to non-distressed ones as well. Apparently, it all had to do with which facility had the cash and which one needed it on any particular day. There is a new take on the phrase "if you build it, they will come." It is now, "if it’s there, they will take it." As we all know, this is not the way to run a business, at least not successfully, especially when you are using other people’s money and you want to avoid charges of securities fraud by the SEC.
Sooner or later, Mr. Harder has to come to terms with the fact that Sunwest is no longer his baby. According to the receiver, "Mr. Harder appears to have an agenda which is at odds with the others in the case; one which involves retaining a seemingly unrealistic number of overencumbered facilities in light of present cash flow and limited refinancing opportunities. Moreover, he appears to be vying to propose a plan in his bankruptcy case or otherwise which is competing and interfering with the work of the CRO." The receiver continues, saying that Mr. Harder’s efforts "put at risk the distribution to others, a gamble he may be willing to take to try to get back in the money. But, this outcome is at direct odds with all senior claimants and unfairly reduces the prospects for their distribution." If TIC investors were upset six months ago, they will be going postal when they start reading things like this. After all, it was their money that Harder & Co. has risked, and lost, and they deserve what they can get before he receives a penny (and after lenders get paid).
This brings us to another sore topic, which involves the prospects for the secured creditors. The receiver would like to avoid foreclosure by secured creditors on the assets which are believed to be "of value" to the receivership estate (Sunwest), but would allow assets lacking value to be taken back by the secured creditors. This seems to be a little like having your cake and eating it too, which is made more complicated by the fact that TIC investors could have an adverse tax consequence in the event that some assets are foreclosed. The receiver goes on to say that the Court "and others" recognize that "a reasonable balance must be reached between the economic interests of the secured creditors (who took the risk of bankruptcy and other such occurrences in exchange for lucrative loan terms with payment of fees and interest), and the interests of the equity holders." Come again? Lucrative loan terms? Does this guy even understand what the lending environment was like when Sunwest went on its buying binge? Lenders were tripping over themselves to put out money during the bull market at loan terms that became more and more aggressive. And, as we have stated many times, lenders usually get the lowest returns because they have the lowest level of risk with their "secured" interest. We suppose the value of having a lien on a property is declining in this new political atmosphere, but at least the Senate prevented the mortgage industry from being Obamatized when it voted down a bill on April 30 that would have let bankruptcy judges reduce the value of some mortgages. So much for security and a legally binding document. Even though most lenders demanded personal guarantees from Mr. Harder, after a billion dollars or so of such guarantees, many of them finally realized the meaninglessness of that signature.
Now that we have had the opportunity to rant and rave about the receiver, it’s time to move on to the restructuring consultant, Hamstreet & Associates, and their PowerPoint presentation to Sunwest investors and other stakeholders (revised April 2). In the presentation, we learned that revenues and net operating income at the senior living properties have been growing from September through November of last year (adjusted for recent sales). In November, revenues and NOI were about $38.5 million and $9.5 million, respectively, which is a somewhat respectable 25% operating margin and on an annualized basis results in revenues and NOI of about $462 million and $114 million, respectively. Capping that in-place NOI at 9% yields a value of $1.27 billion, which is not even close to the debt outstanding. In a statistic that will surely surprise the other providers, Hamstreet claims that Sunwest has a higher monthly revenue per unit ($2,671) than both Sunrise Senior Living (NYSE: SRZ), which they put at $2,549, and Emeritus Corporation (NYSE: ESC) at $1,777. The highest of the group was Assisted Living Concepts (NYSE: ALC), which is counterintuitive since they are sort of known to be the low-cost producer of the group. None of these figures seem to be accurate.
The next step was to try to determine a "restructuring" value and present various possibilities as to how to go about restructuring the components of Sunwest. Although Hamstreet stated that their numbers were preliminary and subject to change, they presented, rather simplistically, that they believe the value of the senior living assets could be increased by a total of $560 million to $580 million over the next few years. Of that amount, $350 million was attributed to holding the properties for three years until "normal" markets return, which would result in a 25% to 30% increase in value from recent Sunwest sales prices, or about $25,000 per unit for the 14,000 units remaining. We’re not sure what they mean by "normal" markets, but we have yet to talk with anyone with half a brain who thinks that we will be returning to the market of 2007 and its associated cap rates anytime in the next few years, if ever. Also, the 25% to 30% increase in value seems very arbitrary and not where the real potential value could be for these assets.
The second component of increased value, representing about $90 million, came from increasing occupancy for the portfolio from 74% to 85%. Imagine that, an 11 percentage point increase in occupancy when everyone involved in Sunwest is still fighting, not to mention they would have to have a new management team to come in to accomplish this, assuming it is possible (which, by the way, we believe it is over a several-year period with the right people running things). According to our calculations, however, that increase in occupancy would result in an increase in annual revenues of about $50 million which, at a conservative 40% incremental profit margin, would result in an increase in value of between $200 million and $220 million assuming a cap rate between 9% and 10%. The incremental margin on going from 74% to 85% occupancy should actually be much higher, which would just take the increase in value even higher, perhaps to $300 million.
Next, Hamstreet assumes that a 5% increase in the current operating margin, or $150 per month for 12,000 residents at 85% occupancy, would increase value by $80 million. But doing that math results in an increase in NOI of $21.6 million, yielding an increase in value of more than $200 million, using our cap rate assumptions (we just don’t get their math). Finally, they assume that with better management of Sunwest they could increase NOI by $10 million, with an increase in value of $40 million to $60 million. We aren’t sure what that really means, because wouldn’t an 11 percentage point increase in occupancy plus a 5 percentage point increase in margins already imply better management? Anyway, using their assumptions, but our math, we get close to their increase in value range without relying on "normal" markets for the majority of it (as they did).
The problem, however, is in the simplicity of their analysis, and we are not sure whether this is just part of an attempt to persuade the TIC investors, and the courts, to keep Sunwest intact and prevent the creditors from foreclosing, because an increase in value of that magnitude is a win-win for all parties, unless you are a lender with a currently performing mortgage who wants out. The other problem is that it is very easy to simply "assume" occupancy goes up 1,100 basis points, or that margins increase on top of that. Someone has to do the hard work, and we just aren’t sure whether that "someone" (obviously, many people) is in residence at the company. In addition, these assumptions are basically across the board for the communities, and there are some properties that are just plain dogs whose bark will only grow louder as time goes on and will never see anything close to 85% occupancy.
Furthermore, Hamstreet has broken down the Sunwest senior living properties into four tiers. There are approximately 120 to 150 Tier 1 & 2 properties (with about $126 million of TIC investments), with Tier 1 being defined as currently being able to cover operating costs, debt service and TIC payments, and Tier 2 covering just operating costs and debt service. The remaining 65 to 95 properties ($119 million of TIC investments) are either Tier 3 (covers just operating costs) or Tier 4 (covers nothing). Obviously, the investors and lenders in Tier 1 properties have a much different agenda as to how to proceed than those with Tier 4 properties, even though the financial condition of any property can change rapidly to move up and down the tiers. Hamstreet has estimated that if the properties were liquidated under current market conditions, 63% of the TIC investors would be unlikely to recover any of their investment, and only 15% would recover 100%. Hamstreet’s agenda, it would appear, is to level the playing field and throw everything into one bucket so that there is something for everyone. And we were under the impression that socialism was passé.
Hamstreet has proposed four possible workout "concepts." These include leaving everything as is with no effort to help investors in the Tier 3 and 4 properties; rolling the investors in the Tier 3 and 4 properties into Mr. Harder’s and other former senior management’s equity interests in the Tier 1 and 2 properties; treating all dollars invested as equal (the one pot theory), with all investors thrown in with each investor receiving a pro rata investment in a new entity based on original dollars invested; or the hybrid plan (two pots), with investors in the Tier 1 and 2 properties getting a larger share of the "good" pot than the other investors, and Tier 3 and 4 investors getting a larger share of the "bad" pot than the other investors. It is hard to see how the TICs would let either of these last two "concepts" come to pass. And, it should be mentioned, they don’t deal with the secured lenders’ position in the totem pole.
Now it is easy to understand why we started this story by calling it a big mess. We believe, however, that it would be easier to accomplish some goals if the original management team is removed from the situation completely and cut off from any financial support whatsoever. Seldom do you see this level of involvement from people who 1) caused the financial mess because they took irresponsible risks and started to believe they were invincible, and 2) were accused by the SEC of a massive securities fraud. Soon we will start to hear about the results of the bids that were due by the end of April on a dozen or two properties, and that may provide an indication of what may happen in the coming months. Rest assured, we will have more to write on, but hopefully not this much.