The financial crisis of the late 2000’s, the resulting recession and the tepid recovery have created a challenging environment for continuing care retirement communities (“CCRCs”). While a low interest rate environment during the past few years has made debt service easier, the primary factor in the recession—the decline in housing prices—has created a significant challenge for many CCRCs. Unable to meet occupancy targets and the related credit agreement covenants, many CCRCs are forced to restructure their balance sheets and operations, downsize, or both. A recent prepackaged bankruptcy by a CCRC illustrates one non-traditional, but highly effective, restructuring option.
CCRCs, by offering a range of living and service options, provide residents with an attractive long-term arrangement. Typically, new residents pay a one-time acquisition cost for a unit, with a guaranteed return of some or all of such amount upon departure. Monthly fees are usually very affordable, and offer residents a cafeteria-style set of options.
The CCRC model depends upon new residents having the financial wherewithal to pay the acquisition cost. For most prospective residents, the acquisition cost has historically come from the proceeds of the prospective new resident’s sale of his or her former residence. Until 2008, the model generally worked. Home prices typically appreciated, creating equity in the residence. Upon the sale, mortgage debt was paid down, and a prospective CCRC resident would have the funds to acquire the CCRC unit. Starting as early as 2005, and certainly by 2008, the model began to break down. The sub-prime mortgage crisis had the dual effect of causing a housing price crash and wiping out equity in many homes. Many prospective CCRC residents found they could not sell their homes and/or the sale would not generate sufficient proceeds to cover the CCRC unit cost. Suddenly, many CCRCs found their occupancy falling or at least not growing to projected (and necessary) levels.
CCRC Financial Model
The majority of CCRCs are financed through tax-exempt bond debt backed by irrevocable letters of credit. The bond trustee typically holds a lien over the CCRC’s assets, including the revenues and entrance fee deposits paid by residents. In addition, the bond documents generally require the indenture trustee to hold certain of the CCRC’s funds in a bond reserve account. In the event there are insufficient operating funds, the bond reserve account funds can be used only to pay the bondholders’ principal redemption payments, interest, costs, and fees. The bond documents usually restrict the indenture trustee’s use of reserved funds and do not permit the funds to be used to fund working capital needs of the CCRC. Furthermore, if the CCRC fails to make a required payment, the indenture trustee will make a draw under the letter of credit.
This type of financing may present financially distressed CCRCs with limited options in a workout or out-of-court restructuring. The bond documents usually contain consent requirements, pursuant to which all bondholders must consent to material modifications. Such a high threshold creates an almost insurmountable hurdle for an out-of-court workout. As a result, a number of CCRCs have decided, or been forced, to file a chapter 11 bankruptcy to continue operations and implement a restructuring or a sale.
Although most CCRCs that enter bankruptcy do so with the objective (or hope) of reorganizing, several impediments quickly arise. First, the uncertainty associated with a bankruptcy causes prospective residents to postpone decisions. Second, and perhaps more important, because many CCRCs are non-profits, they have no ability to raise new capital. Accordingly, their restructuring options are limited to debt reduction, often coupled with a refinancing. That refinancing, in turn, usually is insufficient to pay off the existing secured debt. The incumbent lenders are usually unwilling to accept less than full payment (a debt writedown) without a sale.
In light of the restructuring challenges CCRCs face, a CCRC that restructures successfully and remains independent is worth noting. Recently, South Franklin Circle, based in Bainbridge Township, Ohio, was able to do so. South Franklin’s financial distress resulted from the very typical scenario described above: too much debt coupled with a depressed surrounding real estate market crimping new purchases. Its out-of-court restructuring was stymied by one of its five lenders, which refused to consider any reduction in debt.
Rather than accept a restructuring dictated by the recalcitrant lender, and one that it felt was doomed to fail, South Franklin elected to pursue a prepackaged bankruptcy—meaning that prior to filing the bankruptcy petition, South Franklin Circle developed a plan of reorganization and negotiated and solicited votes from the necessary groups of creditors.
South Franklin’s decision to file bankruptcy was a difficult one. It was concerned about residents’ reactions as well as the impact on its marketing and sales efforts. South Franklin’s board concluded, however, that with careful planning and by using the prepackaged bankruptcy process, it could overcome the negative impact of a bankruptcy. Accordingly, it prepared a comprehensive media and communications program; it secured replacement financing; and it pushed its legal and advisory team to complete as much of the restructuring as possible prior to the bankruptcy filing, so as to minimize the amount of time South Franklin spent in bankruptcy.
The bankruptcy and restructuring were both resounding successes. South Franklin spent just 40 days in bankruptcy, almost the absolute minimum permitted under the law. It lost no residents and actually signed up several new residents. The membership agreements were reaffirmed, assuring existing (and new) residents that acquisition amounts would be repaid. And South Franklin reduced its senior secured debt by more than 50 percent—from $110 million to $50 million.
A prepackaged bankruptcy—or a bankruptcy generally—is not the answer for every CCRC restructuring. Its availability as an option turns on, among other things, the amount of debt and the number of holders of the debt, the viability of the underlying business and the prospects for maintenance of residency levels or increased levels, as the case may be. When a prepackaged bankruptcy is an option, it can shorten the process, reduce costs and reallocate the parties’ relative leverage. Even when it is not an option, consideration of a prepackaged bankruptcy and the threat of it may convince creditors to become more agreeable to the out-of-court restructuring.