Wednesday, January 06, 2016

Responding to Forest City's critique of my Barclays Center loss analysis, and drilling down on the Prokhorov loan (and transaction value)

Barclays Center developer Forest City Ratner takes exception that my analysis that the arena took a $9 million loss in FY 2015. And I take exception, in response.

Spokesman Joe DePlasco emailed me to suggest the arena was doing better than portrayed:
A few points where we believe you are not interpreting the numbers correctly:
The $13.8 [million] interest expense was interest on a loan made by owners of the arena so it is the equivalent of monies paid to ourselves.
The $33.3 [million] finance lease obligation is the GAAP [Generally Accepted Accounting Principles] representation of the debt service but if you look at the more detailed report you will see that the actual cash payment was $29.3 million.
Finally, the $33 million depreciation is a non-cash transaction and has no impact on the cash flows of the arena.
Let me address these from bottom to top, in order of complexity.

Yes, ignore depreciation

The last one is simple. I ignored the $33 million depreciation figure, which is a typical calculation for capital investments as they age. So I didn't misinterpret it.

In describing the Barclays Center's fiscal results, I followed arena developer Bruce Ratner's formulation, subtracting revenues from income, then subtracting payments for financing.

He once expected about $35 million a year in profit after subtracting interest payments, but instead saw a minor gain before depreciation in FY 2014, and a $9 million loss in FY 2015, as shown in the excerpt below.
2014 and 2015 results, with my annotation; click to enlarge
Main interest expense: the PILOT bonds

As shown above right, there's a $33.3 million interest expense for the "financing lease obligation and other." Yes, as the underlying document (the 2015 Consolidated Financial Statements) explains, the cash payment on the tax-exempt arena bonds, paid via PILOTs (payments in lieu of taxes) was $29.3 million. 

But , as noted in the excerpt below right, the document explains that the arena operator, as part of the PILOTs, must pay an extra 10% over debt service and put it in escrow for operating and maintenance expenses. So the additional $4 million was not optional.


Yes, it's money kept as an asset, in escrow.  But the arena operators are supposed to fund that escrowed account from annual revenues. It's not something Ratner could have put in his claimed profit pile.

So I think it's fair to count it as a cost for the year. The Consolidated Statement of Operations sure does.

Second interest expense: the internal loan

The more complicated--and tricky--issue regards, as DePlasco put it, "The $13.8 [million] interest expense was interest on a loan made by owners of the arena so it is the equivalent of monies paid to ourselves."

That was part of an unrated 11% loan that minority partner Mikhail Prokhorov made to the arena operating company, originally $75.8 million and now worth $136 million. They needed that money to build the arena.

From 2012 Forest City Investor Day presentation 
It has never been paid off, as far as I can tell. The compounding loan may have contributed to the below-cost valuation of the arena, $825 million, upon Forest City's sale last month of its share to Prokhorov.

Let's consider DePlasco's statement.

If Forest City Ratner's Nets Sports & Entertainment (NS&E), for years described as the 55% owner of the arena, and Prokhorov's Onexim Sports & Entertainment (OS&E) were simply paying themselves, why would they be piling 11% interest on it each year?

And why would ratings agency Standard & Poor's, in a May 2010 research note, offer its assessment of consolidated annual debt service coverage for the arena project?

That described the arena's responsibility to pay off both the $511 million in tax-exempt PILOT bonds, which got an investment-grade rating and lower interest rates, plus $96.2 million of refinanced debt (the approximate value of the Prokhorov loan at that time), which got no rating.

In other words, S&P was concerned whether the arena would generate enough revenue to pay off both loans.

Graphic from 2009 Official Statement for arena bonds
Standard & Poor's at the time estimated that debt service coverage would average 1.78x for the two pieces of financing, and 2.12x for the PILOT coverage alone. We now know that PILOT coverage in 2015 barely hit 1.29x.

Looking at ownership structure

And who is "ourselves"? The loan originally came from a Prokhorov affiliate, with NS&E taking 55%, its proportionate share in Brooklyn Arena LLC.

But even if an affiliate of Prokhorov were lending the money, that doesn't mean that affiliate doesn't get repaid.

The loan was supposed to be repaid out of arena revenues or, as apparently happened, the interest was simply added to the loan principal.

The owners of the arena did not have an equal, static financial relationship. Otherwise Prokhorov would not have pledged a cash-plus-financing payment last month to take over Forest City's 55% share of the arena and the company's 20% share of the Brooklyn Nets.

As stated in the Consolidated Financial Statements, Brooklyn Arena fully owns Brooklyn Arena Holding Company (ArenaHoldCo), which fully owns Brooklyn Events Center. The members of Brooklyn Arena are NS&E and OS&E, with a 55% and 45% ownership interest, respectively. That's reflected in the graphic above, from the 2009 Official Statement for arena bonds.

Looking at the documents

Consider this passage from the arena's 2014 Consolidated Financial Statements, which describes the loan as starting at $75.8 million in 2010, reaching $94.4 million by 2012, and $122 million by 2014:
Loan from Affiliate
On May 12, 2010, ArenaHoldCo entered into a $75,842,086 loan agreement with an affiliate of OS&E (the “Loan”). On September 7, 2012 NS&E purchased a 55% interest in the Loan plus accrued interest and fee to date. The Loan bears interest at 11% per annum, compounded monthly. There is also a loan fee (the “Fee”) of $1,000,000 payable at maturity. During the Arena’s construction no interest was payable, and became part of the Loan principal. When the Arena opened on September 28, 2012 the Loan, together with interest accrued, totaled $98,428,908. Interest is payable monthly, provided the Company meets certain distribution requirements in accordance with the Company’s operating agreement. The Loan matures annually on June 12th and automatically extends for one year until the Loan is refinanced with a third party. As of June 30, 2014, accrued interest is $20,898,835. Total interest for the year included in Interest expense for the Loan is $12,688,224.
That $12.7 million figure cited in the line above is the "Interest expense - related party" from the 2014 results. The loan explanation continues:
Based on the borrowing rates on loans with similar terms and maturities, the estimated fair value of the Loan from affiliate at June 30, 2014 is approximately $122,000,000.
In the next year, the loan grew by another 11%, a year's worth of interest.

The 2015 Consolidated Financial Statements contained the same passage as above, except accrued interest had grown to $34,707,303, total interest for the year was $13,808,468--the figure cited by DePlasco--and the estimated fair value was approximately $136 million.

So it doesn't look the loan was paid off.

Was loan "effectively paid off"?

Interestingly enough, speaking at a Forest City Enterprises Investor Day in October 2012, Forest City Ratner executive Jim Lester said Onexim put through part of an 11% mezzanine loan "at the initial time of closing" and "we've effectively paid it off."

Well, "effectively paid it off" does not necessarily mean the same as "actually paid it off."

The recent documents show the interest accumulating and the loan value growing.

It's possible--and I speculate, based on the following information--that, in exchange for forbearance on the loan, Prokhorov gained equity in the arena even as the Forest City-controlled Nets Sports & Entertainment maintained official 55% ownership.

Consider the slide above right, from the Investor Day presentation.

As of 2012, the value of Onexim Equity and Mezzanine Loan Principal was $255.2 million, while the NS&E Equity and Mezzanine Loan Principal was $171.6 million.

The combined value of equity+principal is $426.8 million, with Onexim holding 59.8% of the value, and NS&E holding 40.2%. That, obviously, does not match the 45%/55% split that has long been described, and suggests a more complicated division between equity and payments/income.

If the $98,428,908 loan (the value in September 2010) were split 55%/45%, or $54.1 million/$44.3 million, and those sums subtracted from the total Sources in the chart above, the Onexim ($201.1 million) and NS&E ($127.3 million) split of $328.4 million would be 61.2%/38.8%.

Funding becomes equity?

The 2010 report from Standard & Poor's noted that the Prokhorov loan financing structure "allows this loan and any accrued interest to be refinanced by debt." Also, if Onexim funded shortfalls in paying for land acquisition, it could receive additional equity--the net worth of the business--in the arena.

And that may have been what happened, with the NS&E equity share declining, though the full details are unclear. (I asked Forest City about this yesterday morning, but didn't hear back.)

If so, Prokhorov's increased equity did not necessarily translate into control. And while profit and loss are usually proportional to the equity share, in this case they were not. Again, this bears further analysis.

Looking closely at equity

Note my annotations below of the Consolidated Statement of Members Equity for both the 2014 and 2015 financial reports.

As of June 30, 2013, NS&E had only 35.77% of the equity, not 55%. It did absorb 55% of the net loss in FY 2014, all of which attributable to depreciation. Subtracting the proportionate share of loss from equity, by June 30, 2014, NS&E had a lower percentage of equity: 33.67%.


However, after absorbing 55% of the net loss in the following year--attributable both to depreciation and to financing costs--NS&E retained only 30.4% of the equity, as shown in the graphic below. That was worth $74.4 million.

The bottom line

As explained above, I think it's unwise to say that the financing cost was merely a meaningless internal financial transaction.

Also meriting more analysis is this ultimate bottom line of the sale.

Consider this passage from the press release upon the sale of Forest City-controlled shares in the arena and team to Prokhorov:
The transaction values the team at approximately $875 million and the arena at $825 million, inclusive of debt for each asset. NS&E currently owns a non-controlling 20 percent equity interest in the team and a 55 percent equity interest in the arena. Forest City owns approximately 62 percent of NS&E. NS&E expects to receive proceeds from the transaction in a combination of cash and notes receivable of approximately $285 million at closing. The notes receivable are expected to approximate 75 percent of the total proceeds, bear annual interest at 4.5 percent, and be payable in three to five-and-one-half years from the date of closing.
A 20% interest in a team valued at $875 million is $175 million. A 45% interest in an arena valued at $825 million is $371.25 million, or a total of $546.25 million.

NS&E didn't get anything near $546.25 million. Rather, it's getting $285 million, divided into $71.25 million in cash (25%) and notes worth $213.75 million (75%).

It's is interesting that the cash Prokhorov paid approximated the value of NS&E's equity in the arena. Of course the role of debt complicates the valuation, so this all deserves a deeper analysis.

2 comments:

  1. Anonymous9:22 AM

    The revenue doesn't seem to add up. If the only events held were Nets games (reportedly ~700k fans over 41 regular season & 3 playoff games) then they suggest that the average fan paid only $13 per ticket per game, and $10 in concessions per game. What am I missing here?

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  2. No, revenue is split with the Nets, for example. Nets pay minimum 10%. See Consolidated Financial Statements linked above.

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