Acquisition Is Still Subject To Court Approval And Auction
Depending on whom you were talking with in early January, the deal between Blackstone Real Estate Advisors and Sunwest Management was going to be signed “any day now.”  Or, it was a dead deal and Judge Hogan was pushing, along with the Management Committee, for an alternative structure from an alternative buyer.  Although we were never too sure who to believe, as far as we were concerned there was still just one deal on the table, and that was the Blackstone offer.  There is another one circling, which we will get to in a moment, but during the first two weeks of January, only Blackstone, with its partners Emeritus Corporation (NYSE: ESC) and Columbia Pacific Advisors (Dan Baty), had pretty much everything in place to finally move forward.
 The definitive sales agreement with Blackstone was finally announced on January 19 for 134 properties with 11,096 units for a total purchase price of $1.153 billion.  There are 6,175 assisted living units, 2,944 independent living units, 1,782 memory care units and 195 skilled nursing beds.  The price is comprised of $235 million of cash and the assumption of $918 million of debt, of which Mr. Baty and his various partners control 30%, or $275.5 million.  This new price comes to about $103,900 per unit and represents a drop of 14 properties and about $100 million in price from their earlier offer.  That is what due diligence is all about, but we hear that The Judge was none too happy about it.  If the offer is “approved” by the court, the Blackstone deal will become the stalking horse bid in a bankruptcy auction “to be held later this year,” which we hope means by March or April at the latest.  Not to lay blame, but the Erickson Retirement Communities bankruptcy filing, stalking horse bid approval and final auction took place faster than The Judge and his lawyer friends can play a round of golf in the Oregon rain.  But we digress.
 As part of the new offer, the Blackstone joint venture offered a potential equity rollover of up to $25 million for the existing Sunwest TIC investors, which we assume would reduce the cash portion of the offer dollar for dollar.  Obviously, this is meant to be something of a peace offering to those TIC investors who believe there is significant upside in the Sunwest operations and, perhaps more importantly, don’t need any cash at this point in time.  We assume these are the larger TIC investors and not the “mom and pop” investors who have a few hundred thousand dollars invested rather than the several million invested by what we call the “controlling TICs.”  This was a smart move on the part of Blackstone, and our guess is that this will be where there is the most wiggle room as the negotiations or competing offers come into play. 
 Other details of the transaction, other than being subject to bankruptcy court approval and a six-week bidding period, are the requirement that any competing bid be at least $26 million higher than the Blackstone bid (more on this later), and that a competing bidder have a net worth greater than $500 million and assets of at least $2.5 billion.  It looks like that takes Jon Harder out of the running.  In addition, there is a break-up fee equal to the greater of $9.0 million, or 10% of the amount that the successful bidder’s cash/equity price exceeds $235 million.  For its part, Emeritus will be investing up to $26 million, and will receive a management fee equal to 5% of revenues plus incentive fees.  The management contract alone will be accretive to Emeritus, with Morgan Keegan’s estimates of $0.12 to $0.15 of cash flow from operations per share, and that’s before any growth potential. 
 So what’s keeping the deal from getting done, which, by the way, would be the largest transaction in our industry since the fourth quarter of 2007?  First of all, there are the large TIC investors who believe they are leaving too much money on the table with the Blackstone offer, especially with a sale at a market bottom.  They believe that as occupancy improves at the Sunwest facilities, and as the capital markets stabilize, the cash flow-generating potential will increase, and the value will ultimately rise.  And they are right, and that is pretty much what Blackstone is counting on, or any other bidder, otherwise they wouldn’t be wasting their time. 
 The difference is, and it is not an insignificant one, that Blackstone will be counting on Emeritus to improve the census, operations and cash flow, and we are not too sure who the TIC investors think will do the job for them.  Some say the existing Sunwest management team, and while we are not sure exactly who is there today, after what they have been through who knows who will be there tomorrow?  In addition, if the TICs think that they are leaving money on the table, how and when do they plan on taking it off the table in the future, and who will decide the best way to do that?  Disagreement among the investors could lead to delays and missed market opportunities.  Yes, we know that the REIT structure and a public offering down the road has been discussed, but REIT IPO windows are not always open, especially for an IPO with just one tenant, and one tenant with a troubled past.  Think about that discount in pricing.
 Here’s where the story begins to get complicated.  The reason why Blackstone slipped its “up to $25 million equity rollover” into its offer is because the only known potential competing bid is one that will involve an approximately $100 million “preferred” investment (for now), with perhaps half going to cash out some of the TIC investors (who want out now) and half going toward working capital and needed capital improvements.  The remaining TIC investors would ride with the new investor to take advantage of any appreciation in value in the properties, which everyone is assuming will happen. 
 As a preferred investment, the investor usually has a return preference before others get any return, and the others we assume would be the TICs and any other stakeholders and unsecured creditors that The Judge deems worthy of having a future claim.  So, standing in line ahead of the TIC investors would be the creditors with $918 million of debt, followed by the new preferred investor with a $100 million commitment (for now).  The only name mentioned to date as the potential investor, and it is mentioned a lot, is Boston-based AEW Capital Management, but others may see the merits of this structure and join the bidding fray when it is opened up, but we doubt it given the due diligence requirement.  For now, we will assume it is a duel between Blackstone and AEW, and we understand that AEW may have caught up to Blackstone on the due diligence front.
 A second problem is that we don’t see how the court (and from what we hear, The Judge did not exactly major in economics) or the investment bank hired by the Chief Restructuring Officer to handle the auction, Moelis & Company, will be able to compare the two offers as we understand them to be (when the second offer is formally made).  How does one decide whether a competing offer, for argument’s sake from AEW, is $26 million higher than the Blackstone offer when it is a preferred investment that is less than 50% of the cash offer from Blackstone and less than 10% of the total offer when the assumed debt is included?  And how do you decide which one is better for the stakeholders, which is what we understand to be The Judge’s main concern?  Cash today, or less cash today with the hopes of even more cash at some later, unspecified date?  And better for which stakeholders?  This is obviously complicated with many competing interests, but we think that if there is going to be an auction, it should be on the same playing field, with the same rules (meaning terms).
 Now that you’ve asked, here’s how we see it playing out.  If AEW (or someone else) does make a competing bid with a preferred investment, say the $100 million that has been bandied about to start with, and The Judge seems to think this is the way to go, Blackstone will do one of two things.  It will increase the amount of the equity rollover in its current bid to satisfy a larger contingent of the TICs, and it probably has some room to increase the total cash/equity rollover portion of its bid, with that increase depending on how much it wants to do the deal and what other returns are available to Blackstone in the market right now.  Or, it will play the “preferred investment” game, topping an AEW bid and getting its 30% annual return with a smaller investment, and not worrying about what to do down the road with the $918 million of debt. 
 How high AEW would go is anyone’s guess, and we will be the first to admit that we do not have a clue, but if they do make a formal offer and take part in an auction, we suspect that the total cash portion of the offer will go up by $25 to $50 million, if not more, whether in Blackstone’s current structure or in the preferred investment structure.  If AEW or another bidder offered $200 million in a preferred investment structure, then more TICs would get on board, but that may be a stretch because there is the issue of real control compared with theoretical control of the assets, and the higher the investment the more real control the investor will demand.  And if the cash increases, especially with a higher rollover amount, the receiver and the CRO would probably recommend an enhanced Blackstone offer to The Judge, who could then feel inclined to take it.  And who said Judge Hogan didn’t understand economics 101?