The SeniorCare Investor: Making Progress At Sunwest
An Update On Divestitures And The Reorganization Plan
Although there is still a lot of work that needs to get done,and decisions that need to be made, it is quite possible that by the end of the summer lenders, investors, buyers and brokers, and let’s not forget the residents, will all have a better idea of the future of what may be the former Sunwest Management. We say "former" because we assume any future as an operating company will most likely come with a different name because, unfortunately, the taint of the past would be difficult to overcome. We can only imagine a member of a credit committee at a bank two years from now about to provide financing and googling the Sunwest name. Loan Denied.
There have been a few developments since our last story two months ago, so it may be best to break down what is happening with updates on the divestiture program, the reorganization plan(s), operations and the rumor mill. As we mentioned two months ago, there has been a lot of frustration among the buyers of the Sunwest properties because they have gone through three different bid processes since late last year—one process while Jon Harder was still in charge, another after he left the company and a third when the SEC got involved. Many buyers have thought their bids were falling on deaf ears. As it turns out, that was not really the case; it was just that as the people involved in the process changed, the decisions on how to sell the properties, who would decide on the offers and what role the TICs and creditors would have just evolved over time, and that didn’t make many people happy. Since the large portfolio sale to Lone Star early in the year, we believe there have not been any additional property sales, although there are several that are under contract for sale. According to Alvarez & Marsal, which is the restructuring company with the primary responsibility for following through with the divestiture program, the process has not changed in the past 60 days or more and they are working through the bids that were received on both the April 30 and June 25 deadlines.
The four firms that we know have been working on a variety of number of Sunwest properties have been Marcus & Millichap, CB Richard Ellis, JCH Consulting and Senior Living Investment Brokerage. There may be other firms, but these are the ones we know of. Combined, they have probably received well over 100 offers for the various properties they have listed. Jake Gehl of Marcus & Millichap indicated that he had received nearly 50 offers on his first batch of 12 to 13 properties, and most were at or above the debt amounts. The other brokerage firms seem to be getting similar responses in the market, which means that demand has remained strong despite the credit markets. It also must mean that these buyers believe they can obtain the financing for their acquisitions, which is good news. Otherwise, why waste their time?
In the cases where the offers are coming in less than the debt, we have heard that some lenders would rather foreclose, hold the property and wait until the value gets close to the appraised value three years ago and then sell. All we can say to them is, good luck. The properties that are currently in the process of being sold are what are referred to as Tier 3 and 4 assets, with Tier 3 covering operating costs but not debt service, and Tier 4 not even covering operating costs. That’s a tough group of assets, but surprisingly, the demand has been relatively strong. We have been told that "they" expect most, if not all, of these assets to be sold, under contract for sale or handed back to the lender by September. That is actually great news for the buyers, the brokers and the market in general as well as for Sunwest.
There is a pending lawsuit by a creditor group that is appealing the restraining order preventing them from exercising their rights of foreclosure, and if they win that appeal, things could change drastically and negotiations could get nasty. And Judge Hogan, the lead judge in the reorganization, would most likely blow a gasket. Some of the people involved do not want to re-write real estate and mortgage finance law as part of the reorganization of Sunwest; others, we are not so sure. So, after months of confusion and mixed signals, if we can believe what we are hearing, the divestiture process will be coming to a conclusion by the end of the summer, and then on to the next step, the reorganization of the remaining assets and business.
Although there were several potential reorganization plans three months ago, the one that appears to be gaining traction is what we refer to as the "roll-up" plan. This involves taking the remaining properties and rolling up the various equity interests in the real estate, both the TICs and, we assume, the former Sunwest management team and most particularly Jon Harder (more on that later), and give them pro rata ownership interests in the new Sunwest, which we’ll call NewCo. How they determine that pro rata share will be a work in progress, and this is all predicated upon getting the secured creditors on board to restructure their debt for NewCo. We have heard that several are in preliminary agreement to do so at reasonable fixed rates for a three- to five-year term, and others are still talking.
The reason for choosing this option is that the receiver has determined that the flow of funds between the properties was so voluminous and the commingling so widespread, that it is impossible to say that a Tier 1 property with great current cash flow, and thus a high value, didn’t get that way without cash from any number of other properties. The Tier 1 asset equity investor will be the loser in this situation, but for months "they" have been saying they want to be fair to everyone. From what we hear, Judge Hogan seems to like this track and is not too concerned about the Tier 1 investors. What the receiver seems to be saying is that with the cash moving around so much, this really is a securities transaction and not a real estate transaction, so all investors should be thrown in together and not have claims to their individual assets. We still disagree with that conclusion (perhaps that first step toward rewriting real estate law?), but we are just an observer.
The theory is that if the TIC investors remove from Sunwest the best 30 properties, what remains will be so low in value that all other parties will get very little. That is why the chairman of the Management & TIC Committee is pushing what he calls the "Unitary Enterprise" concept. With its large size and management, in three years time Newco could go public or be sold to another company, and investors would then reap their reward, according to this concept. He believes that there is greater value in a larger size, but fails to understand that in this business, big is often not good, and often it can lead to big problems. In most cases, the well-run regional company with 15 to 30 properties (or fewer) has higher operating margins and occupancy levels than those with more than 100 properties. They are closer to the operations, to the "boots on the ground" so to speak, and can adapt to changes in the market faster than a company with 400 properties (just look at Sunrise). As they say, health care is local. Obviously, keeping the 30 best properties in Newco will result in a stronger company, but in many cases three or four smaller Newcos would be run more efficiently and would thus yield higher values down the road, assuming you could assemble three or four solid management teams. We know that this is too much work and that it would not be easy, but it would have better potential and, actually, be less risky, because one group of properties wouldn’t be able to pull the whole ship down.
According to recent reports from the chief restructuring officer (CRO), Clyde Hamstreet (Hamstreet & Co.), operationally the remaining Sunwest assets appear to be gaining some traction. When we spoke to Hamstreet & Co. several months ago, they said their first priority was stabilizing a rather desperate situation and then they would focus on operations. They have since hired a former executive from Senior Lifestyle Corporation as the new chief operating officer at Sunwest (hopefully he will be well compensated), and Hamstreet has reported that revenues and net operating income in April 2009 were both up by 5.75% and 16.06%, respectively, compared with the year-ago April. Also in the same time frame, the operating margin has increased by 239 basis points to 26.86%.
These results are for communities currently managed by Sunwest and we assume are same-facility results. Annualizing that cash flow figure would give an equity value (before any debt) of nearly $1.0 billion, but the total debt outstanding is much higher than that. The CRO has started to put some money into the properties for physical plant upgrades and maintenance, and while it is still a relatively small number for the number of properties involved, at least it is a start. It is looking like the Newco, if the reorganization plan (still a work in process) goes through, will include approximately 130 properties with about 10,500 units. This assumes that the divestiture program, which is approaching third base, is successfully completed.
A progress report must be filed with Judge Hogan by July 13 with the final, and detailed, reorganization plan by August 1, and we are going to assume he will act very quickly assuming he likes what he sees on July 13. And then there are the rumors. The biggest one, and the one we give the most credence to because it is so widespread that we probably shouldn’t even call it a rumor, is that the SEC has agreed to a settlement with Jon Harder. Apparently, that settlement includes no jail time for Mr. Harder, the removal of the word "fraud" from the settlement and any agreed upon infractions he has admitted to be guilty of and only a large fine to be paid by Mr. Harder, which we assume is several million dollars. When he filed for personal bankruptcy protection on December 31, 2008, we assume he still had millions of dollars that he had distributed to himself in the last several years, so coming up with the funds will not be an issue. When we first heard about the settlement we were incredulous because it made no sense that after the SEC’s scathing charges of securities fraud, including Sunwest being operated as "a virtual Ponzi scheme," it would be looking to settle in this environment of no mercy for those who violated the trust of investors, if not the law. We may never find out why the SEC became so generous, but the second part of the rumor is that they are now in settlement discussions with Darryl Fisher (the former COO). All we can say is that Mr. Harder’s lawyers have been worth every penny (or should we say millions) that he is paying them, and he has quite a few of them on retainer. Another rumor was that just before he relinquished his title at Sunwest and filed for personal bankruptcy protection, Mr. Harder prepaid much of his legal expenses, but that could just be sour grapes. If it is true, it was very smart.
Now, what many people are talking about is Mr. Harder’s supposed desire to take back the helm of Sunwest (Newco) after it emerges from receivership. If there is one thing we are pretty sure of, it would be his desire to do this because Sunwest was his "baby" and all along he has argued that if given time, he could work things out operationally and build up cash flow so that it would be a very valuable enterprise above and beyond the existing debt. His argument was that the lenders forced the company into its current state of affairs, and while that may be partially true, they only did that because the company couldn’t pay them what it promised and they had to protect their interests, not to mention that the "promised" 10% to 12% payments to the TIC investors began to disappear as well.
In looking at the possible roll-up plan of reorganization, we thought that Mr. Harder’s equity interests in all the properties (which are considerable) could result in a situation whereby he would receive a pro rata share of Newco which could equal 20% to 30% of the new entity, which could be considered effective control. Apparently, that is not the case, as his interests have been assigned to the receiver, and we have been told that he will only receive some compensation for those interests once all creditors and other investors have been paid in full. Since we haven’t talked with anyone who thinks that will actually happen, he may be left out in the cold.
The one caveat is that there are a few third party lawsuits going on that could generate significant funds for the receiver, the biggest one being the $400 million lawsuit against Sunwest’s former law firm for allegedly writing misleading offering memoranda, and a $20 million lawsuit against the accountants for aiding and abetting breaches of duty. We don’t know the merit of these lawsuits, and they are usually settled by the defendant’s insurance companies, but they could help spread the wealth, so to speak. It is also possible that Mr. Harder has something up his sleeve that no one knows about, and if his lawyers are getting him out of his troubles with the SEC with a simple fine, we assume they have been working on protecting his financial interests in Sunwest, as inconceivable as that may be to creditors and TIC investors.
There is no doubt that this is a very complicated reorganization case with an unusual number of competing interests and legal entities (perhaps up to six for each property). When it is over, and Newco emerges from the mess, it will take at least a few years for the new management to increase occupancy levels to more normal levels, and if the secured creditors line up with three- to five-year fixed rate debt, there will be some breathing room without having to worry about the direction of interest rates or the need to refinance in the short term. While no one is predicting that cap rates and valuations will ever get back to 2007 levels, there is some expectation that they will go sideways for the next several years, unless high interest rates and inflation rear their ugly heads. If that happens, the secured creditors may be in the game for longer than they thought.