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The ongoing impact of the decline in real estate values is resulting in the need for expert testimony to establish reasonable lending structures, reorganization plans, market oriented reconciliation of valuations, and highest and best use review. Focus professionals regularly supply this expert testimony and litigation support on behalf of debtor and creditor counsel. Our expert testimony and litigation support assists counsel in achieving the best outcomes for their clients.

The work out process related to real estate loans has been evolving over the past few years. The first stages involved amending existing loans and establishing new repayment plans. When those repayment plans were not successful, the second stage required additional amendments, or bankruptcy protection. In many cases the borrower/lender relationship is in a new stage — one which involves litigation related to reasonable lending structures, achievable reorganization plans, values, and lender liability.

Case Example 1: Reasonable Lending Structures

In a recent case, a Focus professional, with several decades of real estate lending experience, was able to quickly survey the current market for loan structures and provide Expert Testimony regarding the reasonableness of a lending structure proposed by the borrower. In this example, the Focus professional supported lender’s counsel in establishing reasonable current advance rates, interest rates, and repayment strategies. When dealing with a troubled lending situation, Focus professionals are uniquely qualified to understand and opine regarding the reasonableness of a proposed lending structure.

Case Example 2: Achievable Reorganization Plans

In another case, a Focus professional reviewed the borrower’s reorganization plan to establish achievability. During the review of the real estate property entitlements, the Focus professional discovered the borrower had failed to meet certain requirements related to property tax abatement. The financial impact of this issue was significant to this case and resulted in the need to develop an alternative reorganization plan. Without the review of the Focus professional, this problem would not have been discovered until well into the reorganization time period and would have caused the plan to fail.

Case Example 3: Valuation

In another case, our Professionals provided fairness opinions and related expert witness support in confirmation of the prices paid and recovery generated by the sale of projects and divisions of real estate entities. The opinions prepared by Focus professionals assisted the client company in finalizing the sale closings at market prices. By contrast, without those opinions, the purchasers would have required reduced prices and the lenders would have been unwilling to release assets. The timely preparation of the opinions, and the expert testimony support, allowed the divisions of the company to be sold quickly and at market prices.

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In order to incentivize the development and renovation of affordable housing properties, the government has provided tax benefits to developers and their investors. Tax credit property owner/operators have unique rules governing their actions, and are subject to unique requirements from the various regulatory authorities involved with their respective properties. These rules and regulations must be dealt with adeptly in a workout scenario.

The federal government and housing constituencies discovered decades ago that the private sector was much more adept than the public sector at providing affordable housing to individuals, families and seniors. In order to incentivize the development and renovation of affordable housing properties, over the years, the government has provided tax benefits to developers and their investors.

Since 1986, these tax benefits have come principally from federal tax credits provided pursuant to Section 42 of the tax code. These tax credits provide developers with an economic benefit that has been successfully utilized to attract equity capital to these affordable properties. This equity provides the funds needed to supplement loans and grants, such that debt service can be maintained at a level that allows for affordable rents, as well as provides for a profit component to the developer.

In addition, subsidies are often made available to developers through a variety of sources and in a variety of forms. Taken together, the tax credits and various subsidies have provided the means for the private sector to be successful in fulfilling a necessary public purpose in the provision of affordable housing properties. Nonetheless, it is not uncommon to see that a combination of an overly aggressive financing strategy coupled with an unrealistically low expectation of operating expenses can cause affordable housing properties and their owner/operators to struggle, just as with market-rate properties.

When this occurs, the problems facing the owner/operator can quickly become compounded and impair its ability to see its way through to a successful resolution of its financial issues due to the restrictions and penalties that come with affordable housing tax credits.

The Fundamentals of Tax Credit Properties

Tax credit properties operate pursuant to Section 42 of the Internal Revenue Service Code. In order to operate as a tax credit property, a developer needs to apply for and receive an allocation of tax credits from the agency within its state responsible for such allocations. Once received, these allocations provide tax credits over a ten-year period in a set amount to the developer, so long as the property is operated in compliance with the provisions of the tax credit program.

These provisions require, in part, that the properties rent their units to qualifying tenants at qualifying rental rates throughout a 15 year period. If units are not appropriately rented, then the developer stands to not receive the tax credits attributable to such units during that year. Additionally, and critically, such failure to qualify units or to have the property fall out of compliance with the provisions of the tax credit program can cause the developer to have to recapture a portion of tax credit already received, along with an interest penalty. This recapture — or repayment of tax credits — can be severe in amount.

In practice, upon receiving an allocation of tax credits, developers are in the position to bring in equity capital through a ready market of investor funds — typically provided directly from corporations or “tax credit funds,” which have been established as vehicles through which corporate investors can pool their funds to invest in multiple properties. The developer will have structured the property ownership interest as a limited partnership in which it, or an affiliated entity, is the general partner owning 1 percent (or less) of the economic and tax benefits associated with the property, with the investors owning the residual 99 percent (or more) share of these benefits.

Therefore, over the 10 year tax credit delivery period, the investors are receiving 99 percent of the tax credits delivered by the property. As part of the transaction to sell the investors the 99 percent interest, and, hence, the tax credits, the developer typically guarantees the investor that the tax credits will be delivered and that any tax recapture will be reimbursed by the developer.

Tax Credit Property Restrictions

In order to receive tax credits, as mentioned above, the developer must rent the property to qualifying tenants at qualifying rental rates throughout a 15 year period. However, these may not be the only restrictions that are imposed on the developer and property.

The tax credit application process in a given state often requires that the developer agree to additional restrictions above and beyond the 15 year restrictions imposed by the Tax Code. In addition, in order to receive subsidies through various federal or local agencies, developers are often required to abide by further restrictions. For example, deed restrictions can be brought into play with such deed restrictions not allowing the conversion of the “affordable property” to a market rate property or restricting to whom the property can be sold to at the point of disposition.

If the property’s ownership entity has been qualified as a non-profit enterprise and is receiving an exemption from the local municipality from the payment of ad valorem taxes, then the property is faced with a self-imposed constraint.  Often, such tax exemption is critical in the profitable operation of the property. Therefore, a loss of the tax exemption can be devastating to the economics of the property. Any sale of the property must take this into account. Subsidy programs, whether through the Department of Housing and Urban Development (HUD) or through other entities or enterprises, often come with extensive regulatory compliance obligations. These obligations come at an expense and in many forms. Developers with properties that participate in such programs often require personnel to ensure that compliance is taking place and to provide the requisite reporting expertise needed.

When Trouble Arises

Typically, multifamily developments are financed within special purpose entities which have some form of nonrecourse debt associated with the property purchase or development. This is normally the case with tax credit partnerships. However, the tax credit delivery and tax credit recapture guaranties are not non-recourse. Further, the absolute dollar amount of these guaranties can be quite large and it can be questionable as to the guarantor’s ability to make good on its guaranty.

In such cases, the limited partners “take it on the chin,” as they must come out of pocket to reimburse the tax credit recapture (or at the very least have the recapture amount offset against tax credits being received by them from their other tax credit investments). As limited partners invest under the reasonable expectation that they have, by definition, “limited liability,” this requirement to repay recapture amounts can be unexpected and dramatic.

Simply selling the property is problematic. A sale of the property can trigger a full recapture of tax credits, unless the purchaser is willing to indemnify the seller for this exposure. Further, the regulatory agencies, including the tax credit allocation authority, referenced above, will often have restrictions on a sale of the property, making such a disposition significantly more of a problem than with a market rate property. If the owner/operator is a 501(c)(3) entity, the disposition can be even more difficult.

Suffice it to say, when trouble arises with a tax credit property, the tax implications and regulatory restrictions cause the workout to be significantly more involved than that encountered with a market-rate property.

Recent Example

The recent case of ABC Housing Co.¹ provides an example of what can go wrong in the case of tax credit properties. ABC Housing Co. was a not-for-profit apartment owner/operator, which amassed interests in a large number of apartment complexes. These properties included properties acquired through the issuance of tax exempt bonds, properties purchased utilizing conventional financing, and properties that had received allocations of low income tax credits under Section 42 of the tax code and had been syndicated with outside investors.

Troubles Facing ABC Housing Company

Due in large part to over-leverage and overly optimistic projections of expenses, serious cash flow problems developed, which eventually resulted in the Company being forced into bankruptcy. The Company struggled in bankruptcy. As in many cases, issues arose between the competing interests and motivations of creditors and management. It struggled with a complicated web of company owned interests in more than 100 special purpose entities (SPEs) that had been established to facilitate the company’s ownership of apartment properties and for use as investment vehicles.

It also struggled as senior management departed the company. Further, its apartment properties struggled. Generally speaking, debt financing was non-recourse and was on properties owned within the non-debtor special purpose entities.  However, in an effort to keep the “kingdom” afloat in the years leading up to the bankruptcy, cash resources at the ABC Housing Co. were depleted and properties at the SPE levels were, in many case, deprived of needed capital expenditures.

Actions of the Appointed Chapter 11 Trustee

After a lengthy period of time, a Chapter 11 trustee was appointed who brought in experienced bankruptcy counsel and a seasoned financial advisor. In the division of duties, the financial advisor was charged with determining which properties offered value to the estate and then determining how to best realize this value.

For the most part, the analysis and resulting recommendations were straight-forward and consistent with those found in traditional multi-family operations. Non-recourse debt at the special purpose entity (owner) level limited the exposure of the debtor entity. However, the issues involving the syndicated tax credit properties were complicated. Each of the tax credit properties were owned by a limited partnership.² Tax credit funds had acquired the 99 percent limited partnership interest in each case, with ABC Housing Co. — or an ABC Housing Co. — owned LLC, owning the 1 percent general partner interest.

Each of the partnerships had separate partners and a separate partnership agreement dictating the rights and obligations of each party. Additionally, partnership agreements were unique in form, but generally speaking, provided for certain guaranties by the general partners which included, among other provisions, a guaranty to reimburse the tax credit partners for any tax credit recapture incurred.

Further, in most cases, there were separate guarantees executed by the Company wherein it guaranteed the obligations of the general partner. Thus, although ABC Housing Co. was not, in most cases, a general partner, through separate guarantees it assumed the guaranty obligation of the general partner for tax credit recapture.

The limited partners asserted extensive claims in the bankruptcy. A large portion of these were contingent claims emanating from the various guaranties by ABC Housing Co., including those related to the reimbursement of limited partners for tax credit recapture. These claims, if allowed in full, would have significantly diluted the distributions available to other creditors.

The claims were complicated and difficult for the parties that were not experienced with the IRS provisions relating to these low income housing tax credits. The key point was that the bulk of the tax credit investors’ claims were contingent- recapture had not yet occurred. The justifiable concern was that the debtor, in realizing that there was little or no value available in its equity interest in the various partnerships, would choose to essentially hand over the keys to limited partners or lenders. This in turn could result in large recapture liabilities to limited partners.

The Resolution

The ultimate resolution with respect to the tax credit properties was a negotiated settlement wherein the limited partners agreed to substantially limit their claims in return for the debtor agreeing to maintain its general partner interest in the respective partnership for a limited period of time in order to provide for an orderly transfer of its partnership interest in a way that minimized the likelihood or impact of a recapture event. Further, during this period of time the debtor agreed to use its best efforts to cause the general partners to continue to fulfill the regulatory obligations of the respective partnerships.

This resolution provided for a mitigation of the allowed claims in the bankruptcy which was in the best interest of the limited partner-creditors as the distributions on their claims would have been substantially less than the actual damages that they would have incurred from the recapture event. Further, the settlement avoided dilution in the distribution to the other unsecured creditors in the case. The resolution was a somewhat counter-intuitive as it did not provide for an increase in equity for distribution to creditors. Rather, it provided for a decrease in the total claims and an increase in the distribution to remaining creditors.

To be clear, there were and continue to be numerous other issues involved in this bankruptcy. Notwithstanding, an understanding of the tax implications of the plan being imposed and of the regulatory obligations relating to the properties involved in the estate was critical in advancing the plan.

Summary

Tax credit property owner/operators have unique rules governing their actions, and are subject to unique requirements from the various regulatory authorities involved with their respective properties. These rules and regulations must be dealt with adeptly in a workout scenario.

A successful workout of a tax credit property owner/operator, therefore, requires multiple layers of expertise. Guidance should be sought from experts with specific experience in the tax credit property arena. Such a team includes a financial advisor, a real estate broker, and legal counsel — with the financial advisor and real estate professionals having specific expertise in dealing with tax credit properties.

In other industries or subgroups within real estate, using just one of those experts may be sufficient. In this tax credit real estate niche, the experienced team will be critical to unraveling all of the unique aspects of each project’s financing, ownership, deed restrictions, ownership restrictions, and countless other variations.
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¹ The actual name of the not-for-profit housing development has been changed due to privacy issues.
² In some of the partnerships, the limited partners owned in excess of 99 percent and the general partner less than 1 percent.

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Focus Management Group has prepared an economic industry overview and restructuring strategy discussion to assist stakeholders in their review of portfolio poultry industry operators.

For a copy of our detailed analysis, download the PDF.

Executive Overview

The U.S. poultry industry exhibits many unique characteristics, which combine to create challenges for stakeholders seeking to develop turnaround or restructuring strategies for poultry companies. This Paper seeks to provide the reader with an overview of the poultry industry, and to provide insight related to turnaround and restructuring considerations in this niche market.

Our study analyzes the changing relationships between broiler prices (chickens raised for meat) and feed costs, and assesses the resulting complex decisions facing poultry processors regarding flock management, further processing, optimal bird weight, etc. We also identify how the interaction of key performance indicators can serve as a pivotal tool in determining the viability of a poultry operation. In the case of non-viable operations, we discuss at length the factors that must be addressed when considering a poultry processor liquidation.

Finally, the Paper outlines in detail how potential fluctuations in the commodities markets in 2012 may result in additional margin compression for poultry processors, exacerbating an already challenging situation existing today in the U.S. poultry industry.

Industry Overview

• The U.S. poultry industry is highly concentrated: two poultry processors represent 40% of the market, and over 90% of the market is captured by two dozen companies. Exports represent 20% of broiler production. A majority of exports are shipped to Russia, China and Mexico.
• Poultry prices are not determined in publicly traded markets, in contrast to markets which establish prices for commodities such as corn, cattle and hogs. Though the establishment of a poultry futures market has been attempted in the past, all such efforts to date have failed.
• Instead, prices for poultry are negotiated between individual suppliers and purchasers, with average daily prices being reported to the Georgia Department of Agriculture, which then posts these prices, effectively creating the “market price” for poultry.
• The U.S. poultry industry is currently experiencing a period of increasing input costs (feed) and increasing output prices (meat). However, price increases for outputs have lagged input cost increases, thereby creating financial distress for many industry participants.
• Feed costs fall outside the direct control of industry participants. For example, the price of corn (a major feed component for the poultry industry) has risen in recent years in part as the result of increased demand for corn arising from ethanol production. While industry participants are able to vary their feed component mix within set parameters, during times when all feed components increase in price, the net impact to poultry producers will be reduced profitability.
• Poultry processing improvements have produced faster time to market and larger bird weights, (currently 47 days and 4.5 pounds, respectively). These improvements have been in response to steady increases in poultry consumption from 48.0 lbs/person in 1980 to a peak of 86.0 lbs/ person in 2006. However, recent increases in meat prices have caused total consumption per person to drop from the 2006 peak to 83.6 lbs/person in 2010.
• The poultry industry is currently in distress. Bankruptcies, liquidations and consolidations are becoming ever more frequent. The survival of the industry’s participants will depend upon their individual ability to maximize efficiency and minimize cost until equilibrium can once again be achieved between feed costs and poultry prices.

Turnaround & Restructuring Alternatives

• When analyzing the performance of a poultry processor, it is important to differentiate between the impact of day-to-day management decisions and the impact of larger macroeconomic factors. Critical to any performance recovery is an understanding of the root cause of financial performance problems.
• Turnaround success is centered on understanding the operating performance of the individual poultry producer. Throughput is a key element to reducing production costs. Availability of throughput metrics, including downtime, yield per line per hour, etc., is critical to evaluating turnaround and restructuring options. Also, critical is an understanding of vendor and customer contracts and their impact on cash flow.
• The Focus Poultry Performance Matrix provides a unique tool for understanding the combinations of performance which can result in a poultry producer achieving success. The output from this Matrix, when coupled with analysis of a poultry producers’ various metrics, contracts, etc., provide stakeholders with an ability to assess the likelihood of an industry participant attaining these combinations of performance that result in positive financial performance.
• Restructuring measures may be required if a financial and operating performance turnaround cannot be achieved under prevailing conditions. Such restructuring options include both in-court and out of court alternatives, ranging from direct lender negotiations to Chapter 7 liquidation.
• Turnaround and restructuring options in the poultry industry are complicated by the existence of potentially millions of live birds in production at any point in time. It is not possible to immediately close an operation that is struggling or failing. Careful planning is required in order to avoid significant loss of value.
• The industry-specific characteristics outlined in this Paper create diverse challenges for poultry processors and their stakeholders. Continued increases in feed cost, combined with lagging market prices for poultry products and reduced consumption, have created margin stress on all aspects of the industry.
• In the face of such margin stress, processors and their stakeholders must quickly and carefully examine all factors affecting operating throughput to obtain advance warning of possible liquidity issues.
• Failure to closely monitor poultry producers for signs of negatively trending performance metrics, and rapidly address issues identified at poorly performing operations, can result in unnecessary loss of collateral and/or recovery to stakeholders.
• The output from this Matrix, when coupled with analysis of a poultry producer’s various metrics, contracts, etc., provide stakeholders with an ability to assess an industry participant’s likelihood of attaining those combinations of performance that would result in positive financial performance.

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The explosion of condominium construction from 2002 to 2007 is contuing to create some unique problem loan situations today. Following the real estate market collapse in 2007, countless condominium developments have run into financial distress and failure due in part to collapsing demand and resultant oversupply of such units in the market. Initially most lenders worked with existing ownership to attempt a restructure, yet many condominium towers remain incomplete, units remain unsold, and condominium home owners’ associations (often referred to as “HOA” or “COA”) deficit operations continue.  The common thread is that lenders are being asked to fund failed condo development completion costs and owner associations operating deficits, yet a positive performance outcome continues to elude all parties.

A recent example that illustrates this situation involved a lender to a condo developer with two related buildings in a resort area.  The 40 unit buildings were originally developed to be condominium mid-rise towers appealing to the second home or investor purchaser.  In this example, both buildings were completed in 2007.  Currently, Building One has 15 units sold and 25 unsold units.  Building Two has sold eight fractional share ownership units and the remaining fractional shares are unsold.  The lender has been working with the owner from 2007 to 2011.  The buildings are currently being leased by the night as vacation rental properties.  The lender is not receiving interest or principal payments and is being asked to fund ongoing operating shortfalls.  In addition, the wear and tear on the collateral is continuing and deferred maintenance is accruing.

For this lender, it is difficult to imagine an appropriate workout strategy.

How does a Lender approach this problem?

Unfortunately outcomes which result in lenders recovering their total outstanding loan balances in failed condo developments are rare. Typically a lender must make difficult choices in such situations.

The first question to be answered is “At what price would this project clear the market?”  This requires the lender and its advisors to actively pursue a third party buyer to determine the market floor.  Before additional decisions regarding funding operations and collecting interest can be made, the lender needs to understand the true current value of the property – the cash price a buyer would be willing to pay in today’s economy.

The second question relates to the market price established in answering the first question, namely “Is the lender able to absorb any loss required to clear the market at the third party price?”

If the answer to the second question is “no” then the lender will need to fund operations and employ management talent to ensure the collateral is maintained.

If the answer to the second question is “yes” then the lender should evaluate the outlook for market conditions and offset any potential gains associated with a hold strategy against operating costs which will need to be funded during the hold period.  If the lender perceives a positive net gain over the hold period, the lender may elect to hold the asset for a period of time and fund operations.  If the lender perceives an additional net loss, the lender should move to sell at the current market price.

At What Price Would the Project Clear the Market?

Lenders are required by law to receive FIREEA-compliant appraisals on real estate held as collateral.  During the recent real estate downturn many appraisals established values with the caveat that the highest and best use of a particular property would be to hold the property until more normal market conditions return.  More normal market conditions, in this case, means there are more willing buyers active in the marketplace.  The appraisal, therefore, establishes a value of an illiquid asset, while the lender is interested in the value at which the collateral can be converted to cash.  As a result, lenders need to consider other avenues for testing values.

One approach is to request a Broker Opinion of Value (BOV).  The key to this approach is to engage a broker that has specific experience in the collateral’s product type, comparable sales in this product type and geographic market, and marketing successes. Another approach is for the lender to review its own loan portfolio for recent sales of the product type in the geographic market. A third approach is to hire a Financial Advisor to consider all the aspects mentioned above, plus provide an independent view of the local market conditions.  This expands the review beyond an analysis of sales and re-sales, to include further analysis of market conditions and the operations of the specific collateral.  This approach also provides a smooth transition to the comparison of hold time, projected value, and ongoing operating costs.

Forecasting Operating Costs

Imperative to the analysis of hold time, project value and ongoing operating costs is the ability to effectively forecast operating costs.  Typically a development is run by a property management group (PM) hired by the original developer until such time that the management of the building can be transferred to the unit owners based on the condominium Declarations.  To assist in preserving value, the lender needs to understand the owners’ association operations.

While the property management group is purported to be a third party, the decisions that a PM makes are driven by the Board of Directors of the HOA – usually the original developer, who typically serves as the HOA president until the Declarations allow the transfer of management to the unit owners.  As a result of this symbiotic relationship, the level of deferred maintenance may not be openly shared with the lender.  Perhaps maintenance on the elevators or the roof (two areas difficult to assess) has not occurred and is negatively impacting recovery value.

Other potential problem areas are association dues and real estate taxes.  The owners’ association manager should know which owners are delinquent in the payment of association dues, property taxes, etc.  Often the original developer is one of the owners who is delinquent on association dues.  This can result in reduced recovery to the lender as units sell, because unpaid association dues must be remitted to the HOA or COA upon sale of a unit.

The board of directors of the HOA instructs the owners’ association manager and influences the operating rules of the association, which establish cost structures and maintenance plans.  A developer may be keeping HOA or COA dues artificially low to reduce the payments upon sale to the HOA or COA.  However this creates a situation where operating costs may be unfunded and pushed to the lender.  Alternatively, the HOA or COA dues could be increased to bring more cash in from the third party owners immediately, while reducing future recoveries from unit sales.

Often, the Board of Directors for the owners’ association needs to be formed and brought up to compliance with the Condominium’s Declarations.  Condominium laws are different in each state and regulations regarding proper management of an owners’ association often require a professional manager to ensure compliance.  Legal counsel skilled in condominium law may need to review the current status of issues facing the owners’ association.  These areas can result in legal fees which developers may elect to avoid, thereby creating legal problems that Lenders are left to solve in the future.

Analysis of Hold Times, Values and Operating Costs

The lender or the financial advisor needs to use the information described above to develop a graph comparing hold times to net values.  The table below is an example of the outcome of this type of analysis.

The example represented in the graph above depicts a property with a current market value of $7 million and a current debt balance of $9 million.  It assumes that the market value will improve rapidly during years four through seven.  It also assumes that debt and holding costs will increase by 10 percent per year.

This type of analysis helps illustrate the challenge which lenders have to resolve regarding the difference between current appraised values and market clearing values, and the costs to carry real estate assets.  In the example above, if a Lender believes these assumptions for market changes are real, the Lender would likely opt to incur the holding costs for the next 5 years in order to have an opportunity to sell at break-even or at a gain in years 6 and after.  The key risk lies in the assumptions used to determine market appreciation, compared to the hold costs.

Conclusions

Condominium workout situations are not easy – either for the lender, the developer, or the current unit owners.  Lenders are confronted with seemingly impossible to overcome property development situations – complicated to unravel, difficult to understand, expensive to fund.  The use of a third party financial advisor provides an opportunity for a second set of eyes with established property management skills to review all aspects of a condominium project and provide risk assessments related to the current operations, as well as future operating assumptions.

Focus Management Group (Focus) is serving as Financial Advisor (FA) for Downey and is guiding the hospital through its Chapter 11 bankruptcy proceeding. In this capacity Focus has worked with Downey to improve the overall revenue cycle management, computer system capabilities and management reporting of the hospital.

A key component of a revenue cycle management process is the implementation of a contingency plan to provide ongoing revenue cycle capabilities during unforeseen events such as natural disasters or vendor problems. In the case of Downey, this contingency planning work became critical to Downey’s success when the hospital decided to replace its revenue cycle management supplier. It was this successful planning and implementation work that resulted in Downey receiving MedAssets’ “Best Practice Award for Rapid Implementation.”

The Problem and the Solution

Prior to fully converting to MedAssets for its revenue cycle management platform, and following an evaluation by Downey and Focus of various vendors for this contingency planning service, Downey began utilizing MedAssets as a “hot back up” as an integral component of its contingency plan. An additional benefit of this contingency plan is the increased certainty provided to Downey’s asset-based lender Midcap Financial that cash flows would continue uninterrupted.

Focus’ extensive experience in revenue cycle management allowed Downey to make an informed decision regarding contingency providers. Downey and Focus visited MedAssets operating sites, viewed specific reports and systems, and evaluated work inflows and outflows. During this review, Focus worked with Downey to assess MedAssets’ claims management capabilities, including its process for handling denied claims. The MedAssets platform differentiated itself by providing real time views into the reports and the metrics that would be used by Downey management to gauge performance. Following the decision to use MedAssets for the contingency plan, Focus worked with Downey to set up MedAssets as the “hot back up” and to test the systems and procedures.

Less than two months after the “hot back up” contingency plan was established, Downey elected to switch to MedAssets for full time revenue cycle management support. A full conversion to MedAssets was accomplished in 72 hours with no interruption to patient billing – and therefore no interruption to Downey cash flow.

Ken Stropel, Chief Executive Officer of Downey, commented, “Contingency planning is an imperative when it comes to the financial management of a hospital. MedAssets and Focus rose to the occasion to provide the support required for our lender and the hospital in a cooperative and timely fashion.”

Lessons Learned

The need for contingency plans in any industry is critical. Given the level of reliance on electronic data management today, hot back up sites and contingency plans have become a necessity.

The experience of Focus, specifically in the revenue cycle management process for health care providers, enabled Downey to make a highly successful transition to a new revenue cycle service provider – even with the concurrent complexities associated with Downey’s ongoing bankruptcy proceeding.

Contact Us

For further information regarding revenue cycle management or any aspect of health care operations and financial management, contact Focus’s health care team James Hopwood, Dan McMurray, Edmund King,  or Juanita Schwartzkopf  by calling 813-281-0062.

For further information regarding contingency planning and analysis, contact Focus’s business operations team Bob Riiska, David Tolly or Mike Grau.

Focus Management Group (Focus) is serving as Financial Advisor for Downey and is guiding the hospital through its Chapter 11 bankruptcy proceeding. In this capacity Focus has worked with Downey to improve the overall revenue cycle management, computer system capabilities and management reporting of the hospital.

A key component of a revenue cycle management process is the implementation of a contingency plan to provide ongoing revenue cycle capabilities during unforeseen events such as natural disasters or vendor problems. In the case of Downey, this contingency planning work became critical to Downey’s success when the hospital decided to replace its revenue cycle management supplier. It was this successful planning and implementation work that resulted in Downey receiving MedAssets’ “Best Practice Award for Rapid Implementation.”

The Problem and the Solution

Prior to fully converting to MedAssets for its revenue cycle management platform, and following an evaluation by Downey and Focus of various vendors for this contingency planning service, Downey began utilizing MedAssets as a “hot back up” as an integral component of its contingency plan. An additional benefit of this contingency plan is the increased certainty provided to Downey’s asset-based lender Midcap Financial that cash flows would continue uninterrupted.

Focus’ extensive experience in revenue cycle management allowed Downey to make an informed decision regarding contingency providers. Downey and Focus visited MedAssets operating sites, viewed specific reports and systems, and evaluated work inflows and outflows. During this review, Focus worked with Downey to assess MedAssets’ claims management capabilities, including its process for handling denied claims. The MedAssets platform differentiated itself by providing real time views into the reports and the metrics that would be used by Downey management to gauge performance. Following the decision to use MedAssets for the contingency plan, Focus worked with Downey to set up MedAssets as the “hot back up” and to test the systems and procedures.

Less than two months after the “hot back up” contingency plan was established, Downey elected to switch to MedAssets for full time revenue cycle management support. A full conversion to MedAssets was accomplished in 72 hours with no interruption to patient billing – and therefore no interruption to Downey cash flow.

Ken Stropel, Chief Executive Officer of Downey, commented, “Contingency planning is an imperative when it comes to the financial management of a hospital. MedAssets and Focus rose to the occasion to provide the support required for our lender and for our hospital in a cooperative and timely fashion.”

Lessons Learned

The need for contingency plans in any industry is critical. Given the level of reliance on electronic data management today, hot back up sites and contingency plans have become a necessity.

The experience of Focus, specifically in the revenue cycle management process for healthcare providers, enabled Downey to make a highly successful transition to a new revenue cycle service provider – even with the concurrent complexities associated with Downey’s ongoing bankruptcy proceeding.

Contact Us

For further information regarding revenue cycle management or any aspect of healthcare operations and financial management, contact Focus’s healthcare team: James Hopwood, Dan McMurray or Edmund King  or by calling 813-281-0062.

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As much as a troubled borrower and its lender might like to part ways, finding a new lender to take out the existing lender at par may be a difficult objective to accomplish. Finding a way to successfully navigate these long-term workout situations could represent the difference between a costly write-off for the lender and a successful loan restructure with a rehabilitated borrower. Turnaround professionals are able to assist in these long-term workout situations by serving as a bridge between the two parties.

In today’s lending climate, finding a replacement lender is a difficult process for underperforming companies, or those experiencing financial distress, to undertake and achieve. As much as a troubled borrower and its lender might like to part ways, finding a new lender to take out the existing lender at par may be a difficult objective to accomplish. As a result, incumbent lenders are often finding themselves in long-term workout situations that test the patience of all parties. Finding a way to successfully navigate these long-term workout situations could represent the difference between a costly write-off for the lender and a successful loan restructure with a rehabilitated borrower.

Turnaround professionals are able to assist in these long-term workout situations by serving as a bridge between the two parties. Lender and borrower fatigue often creates an environment wherein the two parties fail to communicate effectively with each other. The turnaround consultant serves as an independent third-party mediator of the conflict.

The Initial Work Authorization

Lenders dealing with underperforming or defaulting borrowers often make the borrower’s retention of a turnaround professional a condition of entering into forbearance agreements. Lenders may be instrumental in developing the work scope expectations for the turnaround firm. The scope of work developed may be critical to the success of a long-term workout strategy. Critical to any long-term workout is the measurement of performance to plan. Both the lender and the borrower must believe each party is fulfilling its obligations to the other.

The Weekly Cash Flow & Budget

In all cases, a weekly cash flow must be created. The lender should require the development of a weekly cash flow for at least six months, and preferably one year. The weekly cash-flow budget should be established and performance should be measured against that budget. A weekly budget to actual, a cumulative budget to actual, and a roll forward 13-week cash flow should become part of the weekly communication between the lender and the borrower. In addition, exception reporting for expenses greater or less than a prescribed dollar amount or percentage should be reported weekly. A reset time period for budget updates should also be established. The budget must be an anchor against which performance is measured.

Explore Sources of Additional Funds

In a long-term workout, the need for additional cash often occurs. The lender needs to know that all possible sources of cash inflows have been explored. The turnaround consultant should seek out all sources of cash that do not involve the lender increasing its outstanding loan balances. Provide Support for the Operating Decision Making – The borrower will typically be required to make some difficult personnel and operating decisions. It may be necessary for the company to contract and right size its cost structure in order to eliminate cash burn. The turnaround professional is able to assist the borrower in identifying these actions, and then can work to implement the strategies.

Implementing the Plan

Long-term workout situations often require an initial influx of resources to lead and support the workout strategy. The turnaround professional can provide resources through a variety of methods.For example, a chief restructuring officer (CRO) role can be added to the organizational chart, with the turnaround professional filling that role. The CRO implements the agreed upon recovery strategy and then turns the company back to the owners to manage, albeit with ongoing oversight and enhanced reporting to the lender.

As an alternative, the owners may ask the turnaround firm to assume other key roles within its organization to augment perceived weaknesses in its management structure — whether that be as operating officer, financial officer or executive officer. The turnaround professional assists the company in finding the replacement person to fill that position long term, but serves in that role during the initial phase of the long-term workout.
While turnaround firms have been used for decades, their role has generally been specific to a desired outcome of finding a new lender or equity structure.

Ongoing Reporting & Performance Monitoring

Critical to any long-term workout is the measurement of performance to plan. Both the lender and the borrower must believe each party is fulfilling its obligations to the other. The borrower needs to understand that financial reporting to the lender during this time will be enhanced — especially in situations where the lender is providing additional funding or extending repayment terms. In turn, the lender needs to be provided with evidence that the workout plan is being implemented and the performance of the company is stabilizing or improving.

In addition to weekly cash-flow reporting, timely preparation of monthly financial statements will be critical. Additional reporting of key indicators for the business, demonstrating progress to plan, may be required. For example, if there have been issues with accounts receivable collections, a key indicator may be a summary of the accounts receivable aging prepared on a weekly basis. Or, if overtime has been a historic problem, a key indicator would likely include a summary of regular time hours and overtime hours weekly.

Successful Outcome

The measurement of success in a long-term workout can take a year or more to reach. During this time it will be critical for both the borrower and the lender to attempt to work together for the betterment of both parties. The turnaround professional should develop the strategies to implement, and then the measurement tools by which to gauge progress. While turnaround firms have been used for decades, their role has generally been specific to a desired outcome of finding a new lender or equity structure. In this new economic reality, the turnaround firm becomes involved with the borrower and the lender for a more extended period.

The initial involvement should include cash-flow planning, cash resource review and operational change review. After that initial assessment and plan development, the next phase of the long-term workout becomes specific to the turnaround situation, but in all cases requires enhanced reporting of financial and operating prog¬ress to the agreed upon plan.

The Goal

The successful turnaround plan implementation also provides a proven track record for the borrower to use as it transitions to a new lender. While the time frame required to achieve that transition may be longer than hoped, the enhanced reporting and tactical decision making should offer a higher probability of successfully rehabilitating the borrower, and finding a replacement lender, over the long term.

By Mike Grau and Juanita Schwartzkopf

The idea of relying on a 363 sale as a means of asset recovery can be a daunting prospect to a secured lender. What if no bidders attend? What if the stalking horse bid is the only bid? What if the debt is not covered by sale proceeds? What if there is a disagreement among lenders in a syndicated loan about whether or not to make a credit bid?

Just as debtors will use every available option to steer the sale process to their own benefit, lenders should also play offense, not defense, in order to realize the best result. A well laid out plan for a successful 363 sale starts before the petition date and may later include strategic DIP financing and making a credit bid.

What is a 363 Sale?

A 363 sale is the disposition of a debtor’s assets outside the ordinary course of business under Section 363 of the United States Bankruptcy Code. It allows for a stalking horse bidder as a means of establishing a valuation floor and has a number of advantages for both buyers and secured creditors:

• If the assets have been properly marketed, the sale can often be driven to close within approximately a month from the  time of the bankruptcy petition date.
• The buyer may take title to the assets free and clear of liens and encumbrances.
• The buyer may be able to argue that it can take the title free of any successor liability claims.
• The buyer has the ability to “cherry-pick” favorable contracts and leases by including them in the sale.
• There is a broad scope of assets which can be sold via a 363 sale, including tangible assets and intangible assets wherever located.
• The secured lenders have the right to credit bid for their collateral in an effort to influence the outcome of the sale.
• A secured party can still challenge a 363 sale if the sales process is not conducted properly, if there is self-dealing, or collusion among bidders.
• The sale will be approved by the bankruptcy court after notice and a hearing, and will not be subject to attack as a fraudulent transfer.

From a secured lender’s standpoint, there are certain things it will be able to control and others that will be beyond its control during the process leading up to a 363 sale. For one, the debtor may stonewall attempts to engage in a 363 sales process. In addition, while a secured lender often participates in the sales process, it is the bankruptcy court which sets the bidding procedures and often a bankruptcy trustee or court-appointed investment banker or sales agent who spearheads the marketing efforts. In most cases however, the secured lender generally can indirectly control the timing and direction of the sale process via influencing the debtor’s funding availability.

Venue can also impact a sale strategy as different jurisdic­tions often have their own local rules, customs and procedural protocols dealing with key issues such as bidding procedures and timing. As a matter of practice, some jurisdictions allow 363 sales to proceed faster than others. Understanding these dynamics can help lenders better anticipate and manage challenges as they arise.

What if the debtor refuses to agree to a 363 sale?

The Bankruptcy Code does not allow a secured lender to file a motion for a 363 sale – this can generally only be accomplished by a debtor or a trustee. A typical argument used against a 363 sale by company management is that such a process would disrupt critical customer and vendor relation­ships and impair the enterprise value of the business. Man­agement might also argue that opening up the sales process to strategic buyers would divulge sensitive information to competitors who have no intention to act in good faith or make a bona fide sales offer.

Management might also threaten to resign for any number of reasons. While these types of strong-arm tactics may make for good theater, the trajectory of the business, a debtor’s operating metrics and  cash flow trends and the terms of a debtor in possession financing arrangement almost always dictate the proper course of action and corresponding timing.

Lenders generally rely on the rights and remedies outlined in their post-petition loan and security agreements to steer the narrative and effectively force the issue. Communication with manage­ment, both early and often, is the key in this regard. Any post-petition financing arrangements should be drafted with an eye towards the ultimate goal of a 363 sale.

Formal evaluation of the management team is also necessary to de­termine whether or not poor management represents one of the underlying causes of the debtor’s distress. If so, then the threat of management resignations becomes a much more hollow threat. Seasoned turnaround professionals can immediately parachute into interim management roles and provide stability.

Can management be provided with financial incentives to cooperate?

In cases where the management team is clearly important to the process, things may be more complex. Prior to the bankruptcy reforms instituted in 2005 under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), it was common­place for debtors to seek court approval for Key Employee Retention Plans (“KERPs”) that involved any combination of retention payments, bonuses and/or severance payments to the CEO, CFO, executives and other insiders. Those days are largely gone, however, as BAPCPA created an amendment to the Bankruptcy Code, Section 503(c), in an attempt to limit these payments to “insiders” (directors and officers).

However, there is still a legitimate need to retain talented managers to help a debtor through the bankruptcy process, and retaining these managers can serve the secured lenders’ interests as well. Courts will allow compensation from “incen­tive” plans tied to specific performance benchmarks, but not if they are easily achievable.

There have been other devices permitted by courts, such as the assumption of executive pension plans, the assumption of employment contracts, or having a retention plan funded by the secured lender or other non-debtor party.

What type of pre-petition planning is important?

When deciding if a 363 sale strategy should be pursued, a secured lender should come to a conclusion regarding the ongoing enterprise value of the business versus the liquida­tion value of the assets. This might involve the assistance of financial advisors or internal resources (e.g., capital markets groups within the lending institution) to look at things like:

• Normalized EBITDA run rates
• Value drivers and trends specific to the debtor’s business
• Recent and comparable sales multiples elsewhere within the debtor’s industry.

Additionally, understanding a debtor’s cash flows prior to a bankruptcy filing is extremely important, particularly when it comes to establishing timelines leading to a 363 sale. A secured lender who has access to well-prepared cash forecasts and a good grasp on cash burn rates has instant leverage, for example, in negotiating terms of a DIP financing arrangement that contemplates a 363 sale. Lining up financial advisors in advance of the petition date will also generate a good head start on making fully informed credit decisions.

What are some of the issues to consider with respect to structuring DIP financing?

Section 364 of the Bankruptcy Code provides the statutory framework for debtor-in-possession (“DIP”) loans. While it is possible for courts to authorize DIP financing secured by unencumbered estate assets, junior liens or even priming liens on property of the estate (subject to adequate protec­tion provisions for existing creditors), the combination of highly leveraged balance sheets and the uncertainty in the credit markets over the last few years has made it much tougher for debtors to obtain DIP financing.

With this backdrop and the sometimes contentious circum­stances leading to a bankruptcy filing, secured lenders are often wary of extending DIP financing. The Bankruptcy Code does, however, provide lenders with certain incentives and protections to do so. In most cases, the existing pre-petition lender strongly considers financing the debtor during the case as a defensive measure to protect its position and maintain going concern value. In structuring the DIP financing, lenders can go on the offensive and use the DIP financing negotiations to help dictate the terms of the 363 sale process. In this context, lenders can control the timing of the sale by only agreeing to provide funding for a limited period and by imbedding milestones for the sale process in the financing arrangement. While debt­ors always want DIP financing with the fewest strings at­tached, they are often reluctant to take too hard of a stance because of their poor bargaining position, the lack of alternative funding and the need for operating cash while in bankruptcy.

After the filing, official committees may also object to DIP financing terms perceived to be over­reaching or dictating a 363 sale too early in the process, but they too must weigh the consequence of a debtor with no operating cash.

In addition to negotiating for additional collateral, tougher covenants and better pricing, secured lenders can use DIP negotiations to impact the sale process itself. One effective tool is to draft a DIP financing agreement with a shorter loan term, which creates a time deadline and inherent pres­sure for a quick asset sale. At a minimum, the DIP financing agreement should explicitly state the lender’s right to credit bid and right of last offer in any sale.

What is the so-called “loan-to-own” approach?

The “loan-to-own” approach is a strategy em­ployed by hedge funds, private equity groups or other stra­tegic investors in recent years to effectively acquire own­ership of a company’s assets by purchasing the distressed debtor’s senior secured debt — often at a discount. In this scenario, the new lender is then in a position to quickly pressure the debtor into a 363 sale and, via credit bidding, effectively convert its position from debt to equity.

One of the perceived advantages to this strategy is that investors who pursue a loan-to-own scenario can then cred­it bid at the full face amount of the debt (not the discount­ed amount actually paid) and thereby create an artificially high bidding threshold which will discourage a competitive bidding process.

While this approach has been effective in many cases, there are risks involved as well. Historically, loan-to-own strate­gies have been challenged on multiple legal fronts, including breach of fiduciary duty, equitable subor­dination claims and attempts to re-characterize the debt as equity. However, in one recent case (In re DBSD North America, Inc.) the U. S. Bankruptcy Court for the Southern District of New York issued an opinion prohibiting the use of a loan-to-own strategy. The fallout remains to be seen, but nevertheless this type of strategy should be used with caution.

What is credit bidding and under what circumstances does it make sense?

Credit bids are provided for in Section 363(k) of the Bank­ruptcy Code and allow lenders, absent a showing of good cause, to make a bid up to the full amount of their secured debt in order to acquire the assets in exchange for satisfaction of the debt in the amount of the bid. Credit bidding essentially protects secured creditors against having their collateral sold for less than it’s worth, so having a good understanding of appraised values (fair market value, orderly liquidation value, and forced liquidation value) is a key component of determining how much to credit bid. Credit bidding makes the most sense in cases where the bids are coming in below the value of the collateral. There may however be arguments against a lender’s ability to credit bid, particularly if the validity of the lien is subject to dispute.

One of the challenges sometimes faced by courts is comparing an all-cash bid to a credit bid, especially since credit bids can also be mixed to include some cash component. Sometimes these mixed bids are necessary to trump an all-cash buyer who may be bidding on the secured lender’s collateral plus additional assets.

Credit bids with no cash component may also present issues with respect to the wind-down of the estate, which is diffi­cult if the debtor is administratively insolvent. This can also create some pressure for a secured lender’s bid to have a cash component or to provide funding for the wind down. Bankruptcy Courts are generally reluctant to approve sales where it appears that the process has been conducted solely for the benefit of a secured creditor. When that happens, the Court will generally not approve the sale unless the secured creditor funds administrative expenses, and in some jurisdictions, Courts may even require that a plan is funded.

What if some members of a loan syndicate object to a credit bid?

There have been a number of cases in recent years in which a majority of lenders in a bank group authorized the agent to credit bid, but some members of the group objected.

Although every case is different, courts have generally sid­ed with the majority, finding that a credit bid is neither a release of collateral nor an amendment to the credit agree­ment (as is often argued by dissenting lenders). In many of these cases, the courts have found that the credit bid is simply the exercise of a remedy and therefore permissible with majority consent.

These objections often revolve around core issues such as asset valuations and the overall financial condition of the debtor, and this is where good financial analysis is imperative in the pre-petition stages.

Credit bidding can also be complicated when second-lien debt holders are involved. Accordingly, similar to participation agreements, the issue of credit bidding should be contemplated when ne­gotiating inter-creditor agreements.

Successful 363 Sale – Example #1

In a recent case, company management advised its lenders that moving toward a 363 sale would disrupt vendor and customer relationships and could not therefore be pursued. In addition, management threatened they would leave if certain bidders were invited to the table, and that key vendors would cease supporting the company if those same bidders were approached.

After a six month delay using these tactics, the lenders were able to move the company to a 363 sale with a stalking horse bidder that had been selected by company management. Management assumed the sale would be approved with no additional bidders, which would result in the bank group taking a 30% write off and the management would retain its jobs.

During this time, however, the bank group and its advisors continued to pursue alternative buyers by keeping those potential prospects informed regarding the sale process.  When the 363 sale occurred, two alternative bidders were in place, resulting in a 100% recovery to the lenders, a 100% recovery to the unsecured creditors, and an ongoing lending relationship for the incumbent lenders with a new, credit worthy owner.

Lessons Learned:

The first key to a successful outcome is the development of an expanded potential buyer list. The process of developing an expanded potential buyers list should include:

• Lenders should look in their own portfolios for potential candidates within the same industry who might be interested in expanding.
• Lenders should look at their fund management relationships for potential candidates with acquisition guidelines matching the enterprise for sale.
• Financial advisors to the lenders should contact their resources for similar potential buyers.
• Financial advisors to the lenders should research competitors and suppliers for approaches to expand the buyer universe.

Another key to a successful outcome in a 363 sale is keeping potential buyers informed. Often management elects to exclude certain groups by not readily sharing information or by not returning phone calls quickly. The lenders and their financial advisors must monitor the sharing of information. The approach used in the above example was to develop a reporting mechanism that the company was required to use to let the lenders know:

• Who has been contacted (name, phone number, address, title).
• What their requests for information have been.
• When the information has been provided and in what format.

This reporting mechanism was submitted to the lenders weekly and the lenders or their financial advisors randomly contacted potential buyers to ensure their needs had been met.

Successful 363 Sale – Example #2

In another example of a successful 363 sale, it was discovered that within the universe of assets owned by the debtor, one particular type of asset – a television studio – was of most interest to potential buyers. By identifying this asset as one of significant interest, the lenders and their financial advisors were able to identify additional potential buyers and create more interest at sale. In this example, the 363 sale involved an aspect of the business whose value might have been discounted had the research with potential buyers not been undertaken. The 363 sale resulted instead in a full payout to the lender group and the unsecured creditors.

Lessons Learned:

Exploring the value of all potential assets is critical to identifying potential buyers and improving recovery. In the example above, the keys to a successful 363 strategy were:

• Identifying key assets of interest to potential buyers,
• Developing an expanded potential buyer list based on the identification of desired assets, and
• Keeping potential buyers informed.

Summary

While Section 363 sales can be challenging, a well laid out plan can help minimize the time it takes to conduct a sale — while maximizing the sales proceeds for secured lend­ers. Turnaround professionals, valuation experts, invest­ment bankers and other financial advisors can add substantial value if engaged early in the process. It is critical to canvass the widest population of potential financial and strategic buyers and attract interest with comprehensive financial analysis that is tailored to that end. In the context of marketing, due diligence, valuation or even structuring the transaction, seasoned financial advisors are generally integral to maximizing sale proceeds through a Section 363 sale.

By Lassiter Mason and Pete Dominici

It should be no surprise that the performance of the staffing industry is integrally tied to the state of the economy and rates of unemployment. And just like most other industries, staffing also has its own unique set of nuances that must be perfected in order to achieve success.

High demand for staffing services offers growth possibilities for such firms, as well as the ability to earn increased margins in markets where the demand for qualified candidates exceeds the supply of individuals with such qualifications. Conversely, low demand for staffing services, often synonymous with periods of high unemployment, requires staffing firms to strategically contract services and overhead to right-size costs and enable their survival.This article will outline the challenges staffing firms face in the current economy and the warning signs lenders should look for regarding staffing agency portfolio clients.

The Staffing Firm Business Model

Staffing firms may be thought of as brokers or “assignors” of manpower. Their purpose is to fix supply and demand imbalances in employment needs.

In a healthy or expanding economy, staffing services are frequently highly sought after. Companies in need of additional or replacement employees may not have the time or resources to locate, interview and vet candidates for open positions. Staffing firms manage these and other responsibilities in return for a fee.

The fee for a permanent placement position is generally calculated as a percentage of the employee’s initial year base salary. The fee for a temporary employee, called the staffing markup, is billed to the hiring company in addition to the employee’s direct wage, associated taxes and other benefits — collectively referred to as the employee’s direct cost.

Depending on the assigned employee’s skill set and the temporary position being filled, the staffing markup may range from 30% to 100% of the base employee wage. This sum of the employee’s direct costs and the staffing markup is called the client bill rate.

Working Capital Needs

Regardless of the state of the economy, staffing firms, by their nature, can require surprisingly large amounts of working capital. Whereas a typical manufacturing firm may be able to negotiate payable terms with vendors of 30 to 60 days, the “vendors” used by staffing companies are its contract employees, each of whom requires his/her checks weekly or even daily depending upon the type of work performed.

The client firms to which these contract employees are assigned generally demand credit terms of 30 days or longer, requiring the staffing firms to have sufficient liquidity to cover the gap between the cash outflow to the contract employee and the cash inflow from the client firm. During economic downturns, client firms frequently seek to stretch their payables as far as possible — however the staffing company is unable in turn to stretch its payment terms to its contract employees. The consequence for the staffing firm is a growing need for working capital.

As a rule of thumb, a staffing firm will generally need working capital of up to one month’s billings for each contract employee it brokers. For example, assuming all receivable collections are net 30 days, a staffing firm would require permanent working capital support of approximately $3,466 for a contract employee with a bill rate of $20/hour, working 40 hours per week.

$20/hr x 40 hrs/week x 52 weeks/year = $3,466 12 months/year

Based on this example, a firm with 500 brokered employees could potentially have a liquidity requirement of over $1.7 million. If collections become stretched, this amount would only increase. In today’s economy, many staffing firms are now seeing client collections pushed out to 60 or even 90 days — this has the result of doubling or tripling such firms’ liquidity requirements per contract employee.

Risks In the Staffing Industry

Staffing firms must carefully manage the risk of customer default. Economic downturns increase this risk substantially. Businesses with cash flow issues, or companies which are on the verge of collapse, may attempt to outsource labor needs and payroll liability to unsuspecting staffing firms. These distressed businesses could gain 30 to 90 days of labor before ultimately defaulting on payables due to the staffing agency.

Given current economic conditions, it is critical for the management of a staffing firm to have a clear understanding of the firm’s liquidity needs via the maintenance of weekly cash flow projections. Additionally, such firms must scrutinize their overhead and fixed cost structures including their brick and mortar components — as the needs of the various employment sectors change, so must the business model of the staffing firms. The inability or failure of management of the staffing firm to respond to the changing conditions around them can quickly lead to financial distress, which places stakeholders at risk.

What Lenders Should Look For

The typical method by which lenders provide credit to staffing firms is through asset based lending lines. Available credit is generally calculated using an advance rate formula of approximately 80% of eligible receivables under 90 days outstanding. The first and most obvious warning to any lender would be a material increase in the overall aging of a staffing firm’s accounts receivables as this would indicate potential collection problems and likely cash shortfalls ahead. However, the tracking of other metrics may give lenders advanced warning signs before significant collateral amounts become at risk, including:

Weekly trends in:

• Revenue and margin per assigned contract employee.
• Total number of assigned (active) contract employees.
• Total number of billable hours.
• Average hours worked per assigned contract employee.
• Average hourly bill rate per assigned contract employee.
• Average hourly pay rate per assigned employee.
• Average length of assignment.
• Customer concentration.
• Revenue and margin per internal employee.
• Internal employee turnover.

If not already in place, lenders should implement a staffing firm scorecard which includes the applicable metrics above. Persistent negative trends in any of these categories often precede cash flow problems by weeks or months, providing lenders with the opportunity to address collateral risk before it is too late.

A Staffing Company Turnaround

Focus was engaged to determine the current health of a staffing enterprise and provide recommendations to the stakeholders regarding exit strategies and continuing operations scenarios.

Focus developed a detailed business model, tracking all aspects of revenue, direct costs of revenue, field and corporate selling expenses, and general and administrative expenses.

Using this model, Focus prepared a 13-week cash flow forecast for the Company’s 18 locations and implemented a comprehensive cash management system. The weekly operational key metric system Focus developed allowed management and the stakeholders to monitor financial and operating performance.

Based on this information, Focus was able to determine that the company was a viable business and recommended to the stakeholders that an increase in their investment to fund operations until the sale of the business could be completed would result in a higher return to the stakeholders.

Focus led the Company through a bankruptcy filing and a 363 sale process. The company was successfully sold at a significantly higher value than the stakeholders expected, in part due to the detailed financial performance model and the resulting clearly established financial performance.

How Focus Can Help

Focus Professionals have extensive experience dealing with these and other intricacies within the staffing industry. We have provided operational and financial management assistance for a variety of troubled staffing firms.

To adequately protect collateral value, a lender needs to reach out to skilled professionals experienced in staffing, operations support and real estate management to successfully address a staffing firm work out situation.

In his capacity as Patient Care Ombudsman, McMurray will ensure the court is informed regarding the status and quality of patient care during Peninsula’s bankruptcy case and will alert the court and all interested parties should there be any decline in patient services. Additionally McMurray will ensure that patient records are managed in a manner consistent with Federal and State Law, regulation and industry standards. 

Focus Management Group, a nationwide business restructuring firm with significant expertise in the healthcare sector, will support McMurray in his role as Ombudsman in the performance of his responsibilities.

Peninsula currently operates a 173-bed acute care community teaching hospital campus encompassing a 200-bed, long-term care and rehabilitation center (Peninsula Center for Extended Care and Rehabilitation).  Peninsula also provides a full continuum of care including acute, rehabilitative, outpatient, diagnostic, primary care and wellness to the communities of the Rockaways, the Five Towns of Nassau County and parts of Queens and Brooklyn. 

McMurray has a proven track record of achievements working for healthcare systems, individual hospitals and medical institutions. He can be reached at 813-281-0062 or via email at d.mcmurray@focusmg.com.

About Focus Management Group
Focus Management Group provides nationwide professional services in turnaround management, insolvency proceedings, business restructuring and operational improvement with a senior-level team of 150 professionals.  Headquartered in Tampa, FL, with offices in Atlanta, Chicago, Cleveland, Dallas, Los Angeles and Philadelphia, the firm provides a full portfolio of services to distressed companies and their stakeholders, including secured lenders and equity sponsors.

For additional information about Focus Management Group, visit www.focusmg.com or call
800-528-8985.