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The O&M bump: NY official claims arena bond refinancing didn't benefit Prokhorov (it did)

It's a rather astounding footnote to the $493.7 million refinancing last August of bonds for the Barclays Center, which are paid off by the arena operating company, now owned by Mikhail Prokhorov's Brooklyn Sports & Entertainment (BSE).

A New York State official said publicly that refinancing at a lower interest rate didn't benefit Prokhorov, because the savings get put into a separate fund for arena maintenance and capital improvements.

Not quite. That lowers Prokhorov's obligation. Everyone else reported the refinancing as a benefit, as noted in the Bloomberg headline above right, "Barclays Center Refinancing Saves $90 Million for Prokhorov."

After all, according to the arena lease between the state landlord, the Brooklyn Arena Local Development Corporation (BALDC), and tenant Brooklyn Events Center (parent of the arena operating company), the tenant must pay for operations and maintenance (O&M).

Operating & maintenance over the past four years
The decreased debt payments just mean that the arena's required payments in lieu of taxes (PILOTs), which are split between a large debt service payment and a smaller O&M payment, can now supply extra O&M funds.

By raising O&M payments via PILOTs from some $3 million to more than $11 million, that lowers the arena company's responsibility to otherwise pay remaining O&M costs, which totaled between $33.6 and $35.7 million over the arena's first four years, as noted in screenshot at right.

I sent my conclusions in this article to Empire State Development, the state authority overseeing the project and formal owner of the site, asking if they agreed Prokhorov benefited. The response, as detailed below, was to evade that question and to argue that the state also benefits.

The lost opportunity

It strikes me as a lost opportunity. After all, had New York State been more of a public steward, some of those expected savings--some $90 million, over time--might have been diverted to the public interest.

Remember, the original Memorandum of Understanding (MOU) between developer Forest City Ratner and city and state entities regarding the arena said that the arrival of a second professional sports team would mean "additional rent." That didn't happen--and the MOU was non-binding. This was another missed opportunity to use negotiating leverage.

The PILOTs plan

Let's recap: the arena is nominally owned by the state, via the BALDC, to enable tax-exempt bonds, and then leased to an operating company, which, rather than pay the public, makes PILOTs to pay off construction financing.

The PILOTs contain two sub-funds: the main one pays off construction debt; a smaller one is set aside for O&M. The PILOTs total increases slightly each year, so when the refinancing lowered debt-service payments--see 2017 below in the chart I created--that left more cushion for O&M.

Chart by Norman Oder, Atlantic Yards/Pacific Park Report, using bond documents

For example, 2017 PILOTs are about $34 million. Before refinancing, debt service would have been $30.9 million. After refinancing, debt service was lowered to $22.8 million. That potentially means about $8 million more for O&M.

The arena lease states:
Tenant shall pay, as agent of Landlord, certain utility, building systems, insurance and Capital Improvements costs (the "Landlord O&M Costs") that Landlord receives from ESDC from the O&M Fund (or be reimbursed therefrom), with Tenant responsible for any cost exceeding the amount of such costs actually received by Landlord from ESDC with no recourse to any other funds of Landlord.
News and analyst coverage

As Bloomberg reported 8/16/16, in Barclays Center Refinancing Saves $90 Million for Prokhorov, "Charles Mierswa, chief financial officer of the Nets and Barclays Center, said the amount is based on present value savings, or the current worth of a future stream of cash flows."

Ratings agency S&P, in an 8/9/16 statement, said the "proposed refunding results in substantial debt service savings of about $3.4 million, on average, over the debt term," but front-loading means about $6.6 million savings a year for the first ten years, then $1.6 million a year through 2044.

(By my calculation, extrapolating from the charts in the Office Statement issued a week after S&P's statement, the savings appear larger, as shown in the charts.)

Obfuscation by the state

Empire State Development (ESD) Senior VP Marion Phillips III, speaking to the 9/20/16 meeting of the Atlantic Yards Community Development Corporation (AY CDC), which is set up to advise the state authority (at about 1 minute into the video), described it deflectingly:
"The PILOT payments for the bonds do not change. The savings that will come… will actually just go towards the PILOT payments. The excess of that, or what we call the profit, actually goes toward a fund for the maintenance and the upkeep of the Barclays Center. Those funds are maintained at Mellon Bank; they are the trustee of the funds on behalf of BALDC."
No one queried Phillips, who is also President of the AY CDC.

A week earlier, at the 9/13/16 Atlantic Yards/Pacific Park Community Update/Quality of Life meeting, Phillips called it the refinancing a "very common sense approach to make a good business decision."

Queried how the refinancing helped Prokhorov, he said, "Actually it doesn't, because the bonds are repaid by PILOTs. Whatever excess there is from lowering the interest rate goes into a reserve account, held at Mellon Bank, a trustee appointed by ESD, that money goes into reserve to pay for maintenance of the building."

"It doesn't benefit Prokhorov in any way?" he was asked again.

"Not to my knowledge," he responded. (I audiotaped the meeting.)

The PILOTs fund and its disbursements

According to the 2009 and 2016 Offering Statements (aka prospectus) for potential bond purchasers, the PILOTs fund contains two sub-funds: one for debt service and another for O&M. See chart at right, and click to enlarge.

The debt service part is funded first. Only when there's enough of a cushion to leave 10%--more than $3 million this past year--in the PILOTs fund can the overage go to the O&M fund.

So, if the overall PILOTs remain the same, a smaller amount of debt service leaves more money for operations and maintenance.

For the first four years of arena operations, an average of less than $3 million a year went into the O&M fund. That should increase considerably.

A new cushion

Below, the annotated chart from the recent Official Statement describes how the O&M Fund was funded, and how it is expected to be funded going forward. The vertical purple bar shows how O&M reimbursement leaps after refinancing, from some $3 million to more than $11.3 million, as also described on the bar chart above.

Again, refinancing at a lower interest rate means lowered interest payments. So there's more room for payments into the O&M Fund.

How much into O&M?

Both the 2009 and the 2016 Official Statements are silent on how much should go into the O&M Fund, presumably because it fluctuates, and surely also because it's not the main source of funding for such functions. As noted above, the tenant is responsible for additional costs.

Further, as noted in the screenshot at right and reproduced below, the lease requires the arena to be maintained "in a first-class manner" by the operating company:
The Arena Lease Agreement requires ArenaCo to comply with customary covenants relating to the operation and maintenance of the Arena, including a covenant to maintain the Arena in a first-class manner (subject to ordinary wear and tear and obsolescence) and in compliance with the applicable League Rules. In addition, the Issuer has agreed to make funds available to ArenaCo for certain operating costs and expenses of the Arena from the... O&M Fund... established under the PILOT Assignment... ArenaCo is obligated to pay all maintenance, repair and operating expenses for the Arena. Provided that no Event of Default is continuing under the Arena Lease Agreement, ArenaCo is entitled to receive from the Issuer certain funds that the Issuer receives from ESD which ESD has received from the O&M Fund pursuant to the PILOT Assignment. These funds may be used by ArenaCo, as agent for the Issuer, to pay certain Arena operations and maintenance expenses, such as costs of heating, ventilation and air conditioning, utility and energy systems (including costs of gas and electricity), the costs of Builder's Risk and Property Insurance and capital improvements to the Arena.
(Emphases added)

The obligation is that of ArenaCo. If they get sufficient O&M funds, they can use them. That's why it's considered cash flow, in the chart above, that benefits the arena operator.

So it seems clear that the refinancing, by lowering the annual cost of interest, left more money for the O&M Fund, and thus freed ArenaCo from using its own funds for operations and maintenance.

Querying ESD

"So my conclusion, backed up by these documents, is that indeed the refinancing benefited Prokhorov significantly," I wrote in a query to ESD, asking for confirmation or disagreement. The response:
On August 8, 2016, the Brooklyn Arena Local Development Corporation (BALDC) approved the refinancing of bonds for the arena. There was and is no change to tenant’s obligation to make “Payments In Lieu of Taxes” (PILOT), and there was and is no change to tenant’s obligation to fully fund both arena bond debt service and arena operation and maintenance. Tenant is required to make regular deposits into accounts dedicated to fund both obligations. Any savings resulting from decreased debt service remain dedicated solely to operation and maintenance of the arena (or, at the option of BALDC, long term arena capital improvements). These operation and maintenance funds cannot be released without ESD review and consent, and ultimately benefit ESD as owner and landlord of the arena.
But ESD as fig-leaf owner and landlord doesn't collect any revenues. The savings from decreased debt service leaves more money for O&M and thus less of a burden on Prokhorov. Note that the ESD response did not address a benefit to Prokhorov.

More profit to Prokhorov 

Let's look again at that chart. Note that Net Cash Flow--or ultimate profit to arena operators--is calculated by subtracting PILOTs from net revenue, then adding the O&M reimbursement. For example, in the 2016-17 operating year, arena net revenue is $46 million, calculated by subtracting operating expenses from operating revenue.

That sum is then reduced by $34.026 million in PILOTs. Does that then leave only $11.975 million in net cash flow? No. Add the $11.265 million in O&M reimbursements and the total is $23.24 million, as shown in the chart.

The purple vertical bar shows the difference in O&M after refinancing

As footnote 2 states, the O&M reimbursement represents "the difference between PILOTs and aggregate net debt service, which will be used to pay Landlord O&M expenses under the Arena Lease."

Note: in 2015-16 and earlier, the Net Cash Flow should have been adjusted downward, in my calculation, by payment of interest on a loan advanced by Prokhorov. (Arena managers said that shouldn't be counted.) I last year calculated a $9 million loss in 2014-15, after factoring in a $13.8 million loan payment. I have since corrected and updated that: the nearly $3 million in O&M reimbursement, as well as the differential reports regarding the total PILOTs, suggests the loss was instead $5-$6 million. That Prokhorov loan no longer exists.

Declining debt service

Compare, in the charts below, from 2009 and 2016, the difference between the estimated debt service (a component of the PILOTs), and the PILOTs. I've color-coded similar years.
Estimated PILOTs and debt service as of 2009
As shown, in 2017, with some $34 million in PILOTs (green), debt service drops from $30.9 million to $22.8 million. In 2020, with $36.2 million in PILOTs (mustard), debt service declines from $32.9 million to $24.8 million. In 2025, with $40.3 million in PILOTs (red), debt service drops from $36.6 million to $28.5 million. That leaves more money within the PILOTs for O&M costs.
Estimated PILOTs and debt service as of 2016
A significant gap, especially in the early years of the refinancing, becomes visible, as further shown in the chart I showed above and reproduce below. Again, that leaves more for O&M, and saves Prokhorov from paying for it.

Interestingly enough, those savings are front-loaded, and the gap closes somewhat by 2026. As shown, by 2030, PILOTs are $45 million, with debt service reduced from $40.9 million to $37.5 million.