Borrowers Must Manage Debt Proactively In This Difficult Economy
December 1, 2008
Many not-for-profit senior living organizations that are tax-exempt bond borrowers have little idea of their obligations to disclose changes in operations to bondholders and, as a result, may violate one or more of their bond covenants. Stress caused by the severe housing downturn and the more recent breakdown of the financial markets only exacerbates that likelihood.
“The current dismal financial environment will impact weak credits more than the strong credits,” according to Keith Bernard, Credit Analyst at Ziegler Research in New York, “but the effect will also vary depending on the type of facility and its location.”
When the severe housing downturn began, for example, CCRCs in Florida found it took a very long time, if ever, for people to sell their homes in order to come up with the entrance fee—while in Texas, homes continued to sell quickly and the impact on CCRCs was minimal. Some people in Florida kept their homes on the market and moved into a facility by using money from their portfolios for the entrance fee. Then the stock market deteriorated. Many people now aren’t even open to discussing a move.
Meanwhile, out West in Washington State and Oregon, people continue to be enthusiastic about the CCRC lifestyle and can’t move in fast enough.
As a result, many borrowers have come up with a list of marketing strategies—such as employing staging companies, getting banks to provide bridge loans, tweaking the entrance fee agreement (e.g., 30% up front, 30% six months later, etc.) to address the current market. “The marketing people have to work hard,” said Bernard. “The caveat is that you have to watch your expenses, because revenues are lower than expected.” In some cases, too, organizations have engaged consultants to find ways to squeeze revenues and reduce costs to avoid becoming out of balance with covenant requirements.
Commonly applied bond covenants
The operating ratio or occupancy covenant requires the borrower to achieve a certain percentage of occupancy within a given period of time and an ongoing occupancy rate going forward. The covenant might, for example, require 75% occupancy by the end of the second year, 85% occupancy by the end of the third year, and an ongoing 90% occupancy.
The debt-service coverage or rate covenant lays out the ratio required between operating cash flow and annual debt-service expense. If the debt service is $2 million at a ratio of 1.1x, for example, the borrower must generate $2.2 million of cash flow.
The days cash on hand or liquidity covenant addresses the number of days that the organization can continue to pay expenses from unrestricted cash without any revenue at all. The typical target for a CCRC is 200 days cash on hand. Some organizations with 100 or 200 days cash on hand have begun to chip away at that liquidity to cover shortfalls and debt service and weather the storm. But pulling from that source is a warning flag.
When bonds are written solely as variable-rate debt, the investment community has the security of the bank letter of credit (LOC) and, therefore, doesn’t pay much attention to the borrower’s credit. Instead, the investors look at the strength of the bank on which the LOC will be drawn. As we’ve learned over the last few months, banks can be shaky—and that has significantly compromised any sense of security that investors may have had.
Some borrowers have a combination of fixed-rate debt and variable-rate debt enhanced by a letter of credit. The LOC carries a bank reimbursement agreement that, in most cases, has stringent covenants that kick in first. Should the borrower become in violation of the bank reimbursement agreement, it is advisable to inform the fixed-rate debt investors, as well.
The importance of disclosure
Borrowers are required to disclose their financial circumstances through an annual audit but are smart to disclose information more frequently—particularly if they are getting into trouble. Many publish quarterly reports. In fact, the bond issue sometimes requires quarterly financial reports to the trustee. Occupancy calculations, for example, are usually done quarterly. “We advise our clients to be very proactive with disclosure,” Bernard said. “Providing quarterly statements enhances transparency. By being forthcoming, the borrower avoids issues going back to the market.”
With the greater sensitivity to the potential of defaults and bankruptcies in this current economic climate, the disclosure issue becomes even more important. Borrowers certainly don’t want to blindside investors with changes in management or in operations that may affect census, revenues, or debt attrition. Adequate and ongoing disclosure builds trust among investors and creates flexibility that is critical when trying to solve covenant problems. One of the basic principles of disclosure, however, is to tell all investors at the same time. Selective disclosure violates SEC regulations, because investors who receive the information first could speculate as to whether to buy or sell bonds based on that information.
“At Ziegler, we try to facilitate continuing disclosure calls for credits that we’ve underwritten,” Bernard said. “These are calls where public information is presented and all the stakeholders are able to ask questions at once. Everyone can listen in, which avoids the risk of selectively disclosing information to a particular bondholder.”
Alternatively, some borrowers post information on their website, making it accessible to all stakeholders whenever they wish to view it.
When a covenant is violated…
Borrowers are required to perform an annual audit and are obligated to disclose the results to the bond trustee, which sends them to every investor. The auditors perform covenant calculations and declare whether the covenant is met or not. When a covenant is missed, the bondholders must be notified within 90 days of the completion of the annual audit. The organization then has 30 days to hire a management consultant to perform an operational review and present a report on the covenant violation and how to fix it.
Management consultant Dan Gray, President of Continuum Development Services, is experiencing an increase in bond covenant violation work, which usually amounts to about 25% of the operations reviews conducted by his firm. He expects the number of covenant violation-related reviews to continue to increase over the next year. Gray’s reviews concentrate on three main areas:
1. Revenue enhancement. Does it make competitive sense, for example, to change from all-inclusive pricing to level-of-care pricing?
2. Governance and management structure. Is the board effective? Does the management team have the right skills?
3. Productivity. How do labor productivity metrics compare to benchmark figures?
“We have 15-20 items that we review,” said Gray, “such as how to schedule housekeeping or nursing staff, how to price meals, lost revenue reporting, maximizing fund development, and so forth. I run across a lot of covenant violation clients who really just need to get their prices up or cut expenses. They may be overstaffed in nursing. Or they may be discounting below their true variable cost to try to get people in the door.”
The consultant’s report must be completed within 90 days of the declaration of a bond covenant violation.
The organization must then implement a plan based on the recommendations. If the borrower doesn’t make a genuine effort to implement those recommendations
and justify any non-achievement, the facility goes into default.
A particularly proactive underwriter that knows in October if a borrower is going to miss a January covenant will set the wheels in motion immediately so the consultant’s report coincides as closely as possible with the completion of the annual audit and the notification to bondholders. “Bondholders appreciate borrowers who act ahead of the required timeline with a plan in place and evidence of the fix happening,” said Gray.
Avoiding bond covenant violations
According to Gray, some of the mistakes that led his clients down the covenant violation path include:
• Bad plan due to the wrong product, a weak market, or unrealistic revenue/cost projections.
• Poor implementation due to management incompetence, weak governance, insufficient focus.
• Lack of flexibility, making it difficult to deal with rising construction costs, opening delays, housing market changes, labor shortages, or unplanned taxes.
• Straying from their knitting, or getting into the project without the necessary structure or expertise.
• Delaying repositioning, resulting in a decline in occupancy, a weakened balance sheet, and a declining quality of service.
• Neglect—even the best-intentioned organizations face cost creep, downward rate pressure, and the need for service enhancement.
• Unwillingness to walk away from ventures that aren’t working.
• Ignoring operations while focusing attention on the new project.
• Not understanding board member and management roles (gear governance towards strategy and keep management’s focus on operations).
• Poor information and financial reporting systems — one of the biggest problems that Gray continues to come across.
When undergoing a review, Gray looks for revenue/ expense improvements that will strengthen the organization’s financial performance, improve debt-service capacity, increase days cash on hand, and create additional opportunities for communities to act strategically in order to achieve their mission. He examines major areas of operations (e.g., health center, dining services, environmental services, plant operations, marketing), as well as indirect service staff, resident care, staff interaction, and physical appearance.
Gray cautions his clients not to focus on the past or to try to place blame and not to place too much emphasis on the numbers. It is the initiatives that are important. Also, they must allow adequate time for implementation of the findings included in his reports.
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