Sunrise Hopes Dawn Is Near
Firm's Troubles Grow as Economy Puts Pressure on Assisted Living

By Michael S. Rosenwald
Washington Post Staff Writer
Monday, December 22, 2008

Paul Klaassen and his wife, Terry, founded Sunrise Senior Living based on a business model he discovered growing up in Holland and visiting his grandparents at the verzorgingstehuizen, where staff members helped elderly residents shop, cook, and do laundry.

The idea behind the verzorgingstehuizen -- translation: assisted-care home -- was to provide dignified residences and services for seniors who were frail but not needing constant nursing care. In 1981, the Klaassens opened their first such facility in Northern Virginia, then proceeded to open mansions for seniors all over the country, becoming the dominant player in a new industry called assisted living.

But when Paul Klaassen stepped down last month as chief executive of the McLean company, the business he founded with sentimental memories of his grandparents was on the verge of buckling under the weight of an accounting scandal, a Securities and Exchange Commission investigation, shareholder lawsuits, and, according to analysts and even Sunrise officials, an unquenchable quest for growth that led the company to expand too fast.

Now, as Sunrise faces the worst economic downturn in the industry's history, the company's troubles have reached their peak. It has violated covenants of a $95 million credit line because its cash-flow-to-leverage ratio is out of line, the result, in part, of spending around $300 million to handle the accounting scandal investigations and pay for projects that aren't performing well. Sunrise executives have told investors the firm has enough money to operate through Jan. 31, though analysts say it is more likely Sunrise will rework its debt than file for bankruptcy reorganization.

Sunrise executives, in trying to dig out of this hole, are also reflective about how they got in it. Asked whether the company tried to grow too fast, Mark Ordan, who recently replaced Klaassen as chief executive, said: "Sure, looking back. That's the beauty of being the new CEO -- you can look back. Another question would be: What would have happened if those things worked out? Then people would have said they were a bunch of geniuses."

In the past few years, Sunrise expanded to Germany -- a country unfamiliar with the high-end assisted living concept -- and now finds itself with several facilities that are barely half full. It also entered the complicated hospice business, buying a company that federal investigators began looking into a year later because of alleged improper Medicare billing by the previous owners. Sunrise bought six senior living facilities in Florida that have suffered because of the soft real estate market. And it tried to get into the luxury condo business for seniors.

What led Sunrise to these deals-gone-bad and its current crippled condition is largely a function of two factors, according to analysts, the company's executives, and a review of its regulatory filings. One is that Sunrise's business model, which Ordan said was influenced by former board member Bill Marriott, depends on the company rapidly adding more and more facilities. The other factor is the daily distraction and time spent dealing with investigations surrounding the company's accounting.

While Sunrise's competitors primarily own and operate their facilities, Sunrise's business model is different, and in many ways it is like Marriott International's approach to the hotel business. Instead of owning properties outright, Sunrise partners with developers and real estate investment trusts, who then pay the company management fees. In many cases, Sunrise takes a small ownership stake -- typically around 20 percent -- and when the value of that investment rises with good operating results, the firm and its partners sell or refinance the properties. Sunrise typically retains some interest in the properties and continues to manage them.

"They really depend on this management and development model to constantly produce new facilities and develop joint ventures," said Jeffrey Englander, a Standard & Poor's analyst who follows the company. "To get the kind of growth to service their debt, they have to keep growing the business this way."

But analysts and company officials say the firm ran into trouble while dealing with an accounting scandal and investigation. In 2006, Sunrise disclosed accounting errors which later forced the firm to restate nearly a decade's worth of financial results, reducing profit by $173 million. Last December, a special committee of the board of directors found that "inappropriate accounting" had occurred. Three senior executives, including the president, were forced to leave. "The entire senior team that was in place during the years covered by the pending restatement is now no longer with the Company," Sunrise said at the time.

The troubles caused significant backlash from shareholders, including the powerful Service Employees International Union Master Trust. Sunrise also disclosed that the SEC had opened a formal investigation into the firm's insider stock sales, the timing of stock option grants and its accounting practices. That investigation is still open, and Sunrise executives said they are cooperating fully.

"This was a two-and-a-half-year process that was very disruptive for operations," said Jerry Doctrow, an analyst for Stifel Nicolaus. "It limited their ability to raise capital through the sale of property. It was sort of a cloud that hung over them."

Ordan, the new Sunrise chief executive, concurred. "During the investigation it was obviously a period of distraction," he said. "People who would otherwise be attending to the business are spending time with investigators or are being asked to leave."

It was around this time that Sunrise decided to head to Germany, purchase the hospice chain and the senior living facilities in Florida, and enter the luxury condo business for seniors. The latter effort was particularly expensive. Earlier this year, the company said it was abandoning its condo plans except for a project that was near completion in Bethesda. The write-off: more than $40 million. As of Oct. 31, the Bethesda condo had sold nine of 240 units, according to a Sunrise filing with the SEC. Ordan said sales traffic has heated up recently.

The effect of the poor deals, according to Ordan, was that Sunrise lost valuable capital on projects that didn't turn a profit while causing the company to grow its overhead through the hiring of a significant amount of employees. "That's an unfortunate confluence," he said.

And then the economy tanked, and the company's operating flexibility weakened. An example of this came in late October, when the weak credit market forced Health Care REIT to terminate a deal to buy a 90 percent stake in an Arcapita joint venture with Sunrise. The deal would have netted Sunrise $41 million to $51 million and could have put the company in compliance with lenders behind its credit line.

Now Sunrise executives say they are working to refinance about $150 million in loans, including the $95 million line of credit. Analysts say the firm will also need to raise as much as $350 million in 2009. Sunrise is largely abandoning further development efforts, which has resulted in $84.2 million in write-offs for the nine months ended Sept. 30, according to SEC filings. Shareholders appear nervous. Last month, the firm's shares traded as low as 27 cents. A year ago, Sunrise was trading at $31.98.

Ordan, 49, is well known locally and in the banking community. He was previously chief executive of the Mills Corp., overseeing its sale to Simon Properties. He has also been chief executive of Fresh Fields, which was sold to Whole Foods. Ordan started his career at Goldman Sachs, which is now working to help Sunrise raise money. He said his theory on working with banks is that "if a pencil breaks at Sunrise, I call the banks to tell them about it."

Ordan said the company, which recently announced plans to lay off 160 workers not involved in resident care, will focus almost exclusively on maximizing revenue at its more then 450 facilities.

But analysts and industry observers say that will be a difficult task. The nation's assisted-living industry is now weathering its most severe economic downturn ever with the predominant source of its growth -- people selling their houses so they can afford the move -- vanishing amid the credit crunch and plunging home prices. Nine out of 10 people use private pay sources like home sales and retirement accounts for assisted living. Sunrise has dozens of facilities in states hit hardest by the housing downturn.

"With the housing market downturn we are experiencing, homes aren't moving as quickly so what you are seeing in the marketplace is that some folks are delaying their decisions to move in for as long as they can," said Dave Kyllo, executive director of the National Center for Assisted Living. "We don't really have precedent or a reference point to know how bad it could get."

The concern among analysts is that if occupancy softens too much, cash flow will slow even more, either because fewer people will be moving in or the firm will have to lower rates to attract more customers. Such a scenario is likely weighing heavily on Sunrise's efforts to renegotiate its credit terms, analysts said.

"Getting any kind of financing is difficult now, and the terms are much more stringent than they were in the past," Englander said. "If demand softens, clearly that could affect rates and cash flow, which is what the lenders are lending off of."

Englander said the company could be forced to borrow at higher rates, then if cash flow slows even more because of the economy Sunrise would have to take on more debt at even higher rates and with more onerous terms. "They will have to keep taking on additional debt to fund operations and that debt service will continue to pressure the bottom line," he said.