In An Attempt To Be Fair To All, Some Unexpected Results

Most reorganizations are complicated, but when you have hundreds of limited liability companies and partnerships (perhaps a few thousand), hundreds of tenant in common investors (TICs), dozens of secured lenders plus all the unsecured creditors, not to mention all of their lawyers, plus an SEC fraud lawsuit thrown into the mix against the founders of the firm, well, it can get difficult to sort out. The only certain thing is that not everyone with a stake in the Sunwest Management reorganization will be happy, but getting that result would be an impossible task for anyone.

The chief restructuring officer, or CRO (Clyde Hamstreet), and the receiver (Michael Grassmueck) have been pursuing a reorganization process with a goal of being “fair” to all parties involved, so that as many interested parties as possible get at least something when the process is completed. Obviously, those with the strongest positions may not agree with this process, and those with the weakest are thankful to get anything at all. And then there are those that probably shouldn’t get anything, but may end up with more than anyone would expect if the cards fall just right, but more on that later.

Late on August 26, a reorganization and distribution plan was filed with the U.S. District Court in Eugene, Oregon. There will be a several week “reply” period, with hearings that will be held in late September. The judge (Judge Hogan) may issue his ruling by October 1 if all goes as planned. The first step is the approval of the plan, the outline of which we will get to shortly. Following approval, the second step will involve a pre-packaged Chapter 11 bankruptcy filing by all the affiliated Sunwest entities, which will result in the creation of a new entity that will own the remaining properties. Finally, the new entity will hire a “new” management team to operate the properties owned by the new entity. If this sounds confusing, it really isn’t, but we won’t go into too much detail about the various options the TIC investors may have with regard to their future securities interests, which are largely driven by their particular tax situations. That can be confusing. This final process may go relatively smoothly, but there will be some obvious opposition.

So, what is the plan? As proposed, when the entity emerges from the pre-packaged bankruptcy, the properties not slated for sale will be placed into a newly formed REIT. This has been chosen as the best structure for a few reasons. First, the TIC investors relied on their monthly distributions (at least, until last year) as a source of income, and REITs are required to pay out 90% of their taxable income to their shareholders, so this structure will have similar characteristics to what they had been used to. Second, they are anticipating that the REIT will be a publicly “reporting” company, and as such it may be possible to better value the underlying shares as a REIT rather than as an operating company, especially with the expected transparency. In addition, the REIT entity may at some point file for an IPO or merge with another company, and they may believe that given its size this may be easier to accomplish than as an operating company. We’re not sure how potential underwriters will feel about taking it public, especially if any of the founders are still involved and whatever the outcome of the pending SEC lawsuit. It could be quite ugly from a legal point of view. Finally, the tax structure of a REIT was deemed to be beneficial to the investors as compared to a C-corporation.

The claimants in the Sunwest case will become shareholders of the new REIT, which will create a taxable REIT subsidiary (TRS), which will then enter into leases with the 150 or so properties being retained. All of the value (cash flow) of the properties will accrue to the REIT, whether lease payments or excess cash flow. Finally, an independent manager will be formed (mostly with existing Sunwest employees), which will be hired by the TRS to manage all the properties. A new CEO will be appointed as well. Ownership of this entity (call it ManCo) will be divided among employees (25%), senior management (40%) and the claimants/investors. The common ownership between the REIT and ManCo has to be less than 35% in this structure. It is unclear how much value there will be in ManCo, nor why employees and senior management will be “given” 65% ownership, other than the fact that many of these employees had invested in the Sunwest limited partnerships and lost something as well. Perhaps it is also meant as an incentive to stay on and help build stakeholder value. It is also unclear how these employees will monetize their 65% ownership stake in ManCo, or when they might be able to do so. As proposed, the REIT will have an independent board of directors that will initially include at least two transitional members who are familiar with Sunwest and its recent history. There will be a separate independent board for ManCo, but two directors from the REIT board will also sit on the ManCo board.

Because of certain tax implications for some TIC investors, the CRO and the receiver have recommended the possibility of wrapping a master limited partnership (MLP) structure around the REIT structure, with possible “UpReits” and “DownReits” involved, but that is getting a bit too technical for our purposes. In that event, stakeholders could get shares of the REIT or units in the MLP, both of which would be of equal value, according to the plan. The bottom line is that as proposed, the CRO and receiver hope to have an entity set up by the end of the year that is distributing excess cash flow to shareholders starting in 2010, with a potential sale of the REIT or a public offering sometime in the next several years. Shareholders of the REIT will be able to sell their shares before then if a reasonable private market develops for them. It is not inconceivable that some group of investors may try to gain control if they believe that the “market” value is too low, with serious upside potential as the financial performance of the 150 properties improves.

Our understanding is that the secured lenders will basically end up keeping their loans in place, but the terms will be changed with at least a three- to five-year maturity and below-market interest rates to give the company more financial breathing room to get back on its feet and improve occupancy, operations and cash flow. It is our understanding that these lenders will keep their security interest in their respective assets, but that the REIT will be able to use company-wide cash flow for mortgage payments, something that while not new for the entity, will be above board this time around. As we mentioned, the lenders are by no means all in agreement with this reorganization plan, but our assumption is that they will end up on board, because the alternative could be worse. We still believe that if anyone’s rights have been trampled on in this reorganization, it has been the lenders. Other real estate lenders will be watching this very closely, and the fear is that the end result will be tighter conditions on borrowers in the future to avoid being “Hoganized.”

Cash distributions will be made from any proceeds from the sale of assets currently in process, excess cash from operations and, most importantly, from any third party claims, such as the lawsuits that have already been filed against the former accountants and law firm of Sunwest, since it is alleged that they either knowingly participated in misleading the TIC investors, or should have known. We don’t know about that, but the larger the settlement, the larger the pie grows, and that is what Jon Harder, Darryl Fisher and Wally Gutzler (known as HFG) are hoping for. These three top executives from Sunwest, as part of the reorganization plan, will be dumping all of their partnership interests into the pot, so to speak, and the way these hundreds of partnerships and LLCs were originally set up, these three essentially control virtually every asset. Because of the Unitary Enterprise concept that is being used, HFG were stakeholders as much as anyone else, and were entitled to the same economic benefits of the newly created entity as the other “investors,” or so we assume the theory goes, as hard as that may be to swallow. And, although they are not guaranteed any executive position with any of the new entities, they are not prohibited from having any position either. We know this will boil the blood of most of the TIC investors and secured lenders.

For those of you who thought that Mr. Harder would never be in a position to control the former Sunwest again, you may want to take a deep breath. As proposed, on the effective date of the reorganization plan, HFG will receive initial securities entitling them to up to 25% (over time, keep reading) of the MLP which, as we stated above, will have the same value characteristics as the REIT (meaning, one MLP unit will be worth the same as one REIT share). These securities will give HFG a “membership interest” in the MLP, with a book value of $100,000, and they will have no voting rights and initially no rights to cash distributions. On the third anniversary of the effective date, HFG can convert these membership interests into MLP units or REIT shares. Once the total value of the REIT/MLP securities held by the other investors, combined with the value of cash distributions (such as proceeds from third party lawsuits, etc.), reaches $500 million (the initial “trigger point”), HFG’s ownership interest in the REIT/MLP will begin to rise. In effect, HFG will receive an increasing ownership share as the total value (market value plus distributions) increases. At $600 million, they would control 5.13%, at $750 million, 10.0% and at $1.0 billion, 25%. Remember, the trade-off was that they put all of their property partnership interests into the pot, essentially “giving up their rights” to what could have been an initial ownership interest in excess of 25%; otherwise, we assume, they could have made the argument that they really controlled the assets and there would be little left for anyone else and could have tied up the reorganization process for a long time, not to mention the lawsuits. As we said a few months ago, their lawyers were worth every penny that was paid to them.
In the event that the independent board of directors of the REIT decides to enter into a sale or merger of the REIT during the first three years, HFG will also have a right of first refusal. This is for the entire enterprise and not for any individual assets. However, no sale or merger of the company can occur in the first four years without court approval. In addition, after HFG send in their financial disclosure forms to be reviewed by the receiver, if acceptable to the receiver, the receiver waives any claims that may be made against HFG and their families arising out of or related to their activities at Sunwest, including any claims for “disgorgement,” other than possibly material omissions or misrepresentations. All we can say is, Wow. Finally, the receivership entities will pay Harder up to $200,000 for legal and professional fees between August 7 and December 1, 2009, and up to $100,000 each to Fisher and Gutzler, and Harder will receive $20,000 for the filing of his required bankruptcy schedules. All three will also receive an annual $75,000 payment each for three years, but it is unclear what this is for. The only thing that is clear is that this will certainly rankle the investors and creditors as there seems to be no rational explanation for this.

Everything seems to be based on the fair market value of the properties as of March 2, 2009, which may have been close to the low point operationally because the CRO had spent the prior four months trying to stabilize a rapidly deteriorating situation. It appears that he and his team succeeded, and since March the internal focus has moved to operations (as well as the reorganization plan), and the results appear to confirm this. In the second quarter, revenues were up 4.4% from the year-ago quarter, net operating income increased by 10.1% and the operating margin jumped by 550 basis points (we believe this is same-community results, otherwise the changes would be meaningless). This obviously compares favorably with the publicly traded companies, with the difference being that Sunwest is coming off a much worse base. In addition, through July the company has had three straight months of occupancy increases. In other words, things are starting to click there, and our guess is that they will continue to click, especially as the company emerges from receivership and employees become true stakeholders.

As all of this happens, the enterprise value will obviously rise (and it most probably already has increased since March), which means that the $500 million “trigger point” will be reached sooner than some people may have expected. It is quite possible that this is what Mr. Harder has believed all along, as he always maintained that given time, he could have worked everything out. The problem with his theory is that time would never have healed the bad assets that he paid too much for and purchased with too much debt. Without the restructuring process, it is doubtful that he could have divested that many assets without the secured lenders collapsing the entire enterprise. The freezing of the capital markets and the decline in the real estate market in general merely accelerated the demise of Sunwest, and there were loud whispers in the market that started before August 2007 that the Sunwest house of cards was on dangerous footing and that it was going to collapse at any time; it just needed a trigger, and that was obviously pulled. Time was not on Mr. Harder’s side last year, but it may be on his side going forward, because his economic interest will only grow as time moves on. Who would have thought?

Based on numbers that may be a little dated now, it appears that the “equity” of the remaining assets that will go into the new REIT is worth about $1.0 billion (using a 9.5% cap rate, which may be low). This is counteracted by about $1.0 billion of mortgage debt. Based on our calculations, we will assume that each 100 basis-point increase in occupancy will yield about $4.0 million in incremental annual cash flow, which would be worth an additional $42 million in equity (again using the 9.5% cap rate). Recent occupancy figures have not been released, but we assume that for the 150 properties going into the new REIT it is still less than 80%, since early reorganization scenarios had the portfolio going from 74% to 85% occupancy, which represented one way the new entity would increase value for stakeholders. Consequently, it is not unreasonable to see occupancy approaching 85% to 90%, which could provide up to $500 million of additional value (at least in theory). When added to any proceeds from third party lawsuits, sales of other assets net of the debt and other items, one can see how HFG’s share will start moving toward that 25% figure.

We don’t know anyone who is going to like this, but from an objective point of view, what was the choice? HFG did have majority control of the partnerships and LLCs that owned the Sunwest properties, and without these equity interests participating in the reorganization, it is questionable how the reorganization would be accomplished. The point of the CRO and the receiver, we assume, is that if the stakeholders are paid back their investment, and the secured creditors that are still in the mix with the remaining 150 properties are getting paid their interest at par (albeit at below market rates), who, exactly, should share in the upside if not the founders, who are still last in line with their hands out, even though they are the ones who created the mess in the first pace? We may not agree with that in principal, but the CRO is trying to get the reorganization completed by year-end 2009, not 2010, 2011 or beyond, which could have been the case without this structure. What is still not clear is what happens to the foregone interest and partner payments that lenders and TIC investors haven’t received for a year.

This is certainly not an optimal outcome for many of the investors and lenders, and we still don’t know what impact the SEC charges of fraud will have on this reorganization. In a local newspaper, an attorney for the SEC was recently quoted as saying, “It’s unprecedented that somebody gets to commit fraud to the tune of $400 million and then could emerge with a 25 percent equity interest in the emerged company. That’s relatively novel.” And that’s also an understatement, and perhaps the “rumor” that the SEC has settled with Mr. Harder is just that. We have also heard that the Oregon Attorney General is now fired up. No one envies the position of the CRO, but he has moved the process along, there is light at the end of the tunnel, operations are on the upswing and in four months we may not have any long stories to write about the Sunwest saga. The only thing that seems to have stalled a bit is the contract negotiations for the property sales, as we were hoping that more of them would have reached the closing table by now. There’s always next month. Still, we have an uneasy feeling about this reorganization plan and whether Judge Hogan has an agenda of his own. There appears to be a distinct bias against the out-of-state lenders that dominate the secured creditors group. Let’s hope that the end result of this reorganization is not the re-writing of real estate finance law.