Financial strength can be elusive for enterprises dedicated to what they consider to be nonprofit principles.
By Jack Cumming
Financial strength can be elusive for enterprises dedicated to what they consider to be nonprofit principles. This is a challenge for many senior housing enterprises, but especially for the tax-exempts. Tolerance for negative net assets may be seen by some as a matter of controversy, but most agree that a strongly positive balance sheet is best.
The fundamentals are simple.
For a business to exist it must have revenues greater than expenses or it will fail when its capital runs out. That means that rehabilitating a business to strengthen it financially requires assuring that pricing is sound and sustainable within the market the business serves and that costs are constrained within pricing.
If these principles are ignored, and if resort is made to the luck-of-the-draw (or what some churches characterize as faith-based budgeting), then we put at risk the promises, contractual and otherwise, that the business has made.
History can be instructive. Pacific Homes was a charitable corporation formed in 1929 for retired Methodist clergy and lay leaders. Pacific Homes filed for bankruptcy on February 18, 1977. It wasn’t pretty.
Residents had to pay much more than they had anticipated. Some had to move out. A lawsuit against the Methodist Church cost the Church $21 Million. A CBS 60 Minutes broadcast was particularly damaging leaving the impression in the minds of many that CCRC residents might be evicted due to managerial financial mismanagement.
Rehabilitation Is Possible
The story ends well, though. New leadership was brought in. Pricing was increased to cover costs. On March 18, 1999, Pacific Homes was able to repay the Methodist Church in full. While most of the industry increased rates by 2% to 3% a year, Pacific Homes regularly increased rates by 4% or more. Today, the successor organization into which Pacific Homes was merged has one of the strongest balance sheets in the industry.
From this it’s evident that just as a family budget can be brought into balance by painful measures, e.g. deferring college obligations, so can a senior housing enterprise. It may likewise require difficult decisions and drastic actions.
If the market has shifted, then changes may have to be made to find the market. If there’s an excess of villas, they may have to be sold apart from the original continuing care business model. If the buildings are so rundown and dilapidated that sales are failing, then it may be necessary to find a capital investment to rebuild, repurpose, and restructure.
For tax-exempts, finding needed capital may require conversion to for-profit so that investment capital can earn a sufficient return. In short, every case is unique but ignoring mounting problems – as Pacific Homes did for many years – hoping that the economy (or other exogenous interventions) will turn things around is more than foolhardy. It’s unconscionable. It may even bring executives and directors into conflict with a developing area of the law which is concerned with passivity in the face of deepening insolvency.
The Not-For-Profit Conundrum
Not-for-profit organizations may find these challenges particularly difficult to address. To begin with, they do not typically have the same financial orientation as do investor funded organizations. Tax paying organizations are accountable to the providers of their equity capital.
In addition, some people believe that not-for-profits may be slower paced giving priority to consensus-building, deliberation, and process over action and getting things done.
Moreover, corporations with negative net assets may be more prevalent among tax-exempt senior housing organizations than otherwise for two reasons: (1) Tax-exempts don’t have access to the ownership equity capital markets, and (2) the prevalence of entrance fees gives them money which they can divert to secure debt financing.
A third reason, which is less obvious, is that tax-exempts have access to the tax-exempt debt market. Since many investors like to avoid taxes on their investment income, investing in tax-exempts is popular. That creates a capital pool looking for investment opportunities and senior housing is an attractive outlet. The supply of tax-exempt debt capital outruns the availability of equity capital needed to secure it.
Entrance fees are paid as partial consideration for a lifetime contract. As such, they are paid in anticipation of future performance obligations to which the senior housing enterprise is committed. Under accounting principles, that is also how entrance fees should be booked.
Such principled accounting does not preclude the funds being invested in such enterprise activities as debt reduction in the interim between payment and use. Contract obligations merely require that sufficient liquidity be maintained to meet obligations as they come due. While there may also be equity considerations, they exist in the moral-ethical realm beyond both accounting and law.
The first moral-ethical question that the tax-exempts need to confront is whether it is appropriate to place entrance fee proceeds, paid in anticipation of future benefits, at risk as “ownership-type” equity capital to shield more senior debt investments.
A second, and related moral-ethical question is whether the use of entrance fees as though they were “ownership-type” leveraged equity investments should convey some kind of ownership, perhaps in the form of voting membership in the tax-exempt enterprise. A third moral-ethical question is that alluded to above, i.e. maintaining equity among generations and cohorts of like situated entering residents. This third issue, though, does not directly impact the financial soundness of the enterprise and is beyond our scope here. An enterprise focus subordinates individual concerns.
Time Is of The Essence
Experience shows that once the strength of a balance sheet begins to weaken, the pace of weakening can accelerate. Those numbers people with the proverbial green eyeshades will explain that financial results – whether trending positively or negatively – tend to follow an exponential curve. That tendency, they will add, is attributable to compounding. Now most people get lost when words like “exponential” or “compounding” come into the conversation. Still, these are immutable financial forces that bring peril when ignored.
The necessary conclusion, therefore, is that if an enterprise for which you share responsibility shows signs of trouble, i.e. if the excess of assets over liabilities is narrowing, or if the excess of revenues over expenses is no longer enough to provide a fair return, boards and their executives should act quickly to develop strategic options to restore sound operations with positive (or at least acceptably stable) trends.
Often, it’s difficult for in-place management to bring the necessary objectivity and will-to-action to the situation. Managers may have positive, though impractical, values that allowed the situation to develop in the first place. Hence, it’s customary to bring in outside analytical observers to advise on options.
Investment banking firms like Goldman Sachs are skilled at such analyses as are consulting firms like Bain Capital, McKinsey and Company, or the Boston Consulting Group. Many accounting firms also offer strategic consulting (Deloitte is particularly well-regarded) but there is a lingering question whether consulting creates a conflict of interest for an audit firm. Directors of enterprises – not-for-profit or investor funded – are well advised to retain outside consultants at regular intervals to take a hard look at the company’s business model, performance results, and future prospects.