Ratings agency S&P (citing Nets' deal) joins Moody's (citing Islanders) in warning that Barclays Center bonds verge on junk

Mikhail Prokhorov may have gotten a record-setting valuation in the sale of the Nets--partial, so far--to Joseph Tsai, but apparently there was a sweetener in the deal--and that may be putting bondholders at risk, according to the ratings agency Standard & Poor's (S&P). 

The sweetener--instead of the arena operator keeping all food and beverage revenues from Nets games, it would only keep 30%--advantages the team owner, and offers less to the arena operator and thus bondholders expecting secure payments, according to S&P.

On 4/20/18, the ratings agency affirmed the debt rating of the Brooklyn Arena Local Development Corporation (the state entity that issued the debt) of BBB-, just barely within "investment grade" and above junk, but with a negative outlook, indicating that the rating was unstable. 

Crain's New York Business first wrote about this yesterday, with the headline Barclays Center bonds are just about junk. Note that ratings agencies are paid by issuers, and generally have been accused of gentle treatment.

Update: NetsDaily advanced the story, suggesting that the original lease was unfair to the team owner:

Underlying the change, say those familiar with the deal, is the NBA’s requirement that the arena and team financials be “unstapled,” as one source called it. The Nets lease has always favored the arena. That didn’t matter much when Prokhorov owned 100 percent of both, but with Tsai buying 49 percent of the team —and having an option to buy a controlling interest in 2021— the league wanted a more arm’s length arrangement. The lease, noted one source, is now market rate, that is, in line with other NBA leases.

By the way, the ratings just one notch above investment grade have always been par for the course with the arena bonds, in 2009 and again in 2016. What's notable is that the the rating has remained consistent despite a much lower cushion (aka debt service coverage ratio, or DSCR) to pay off bonds.

Still, some clouds

Interestingly enough, S&P did not weigh in on the impact of the New York Islanders--last in the league in attendance, with attendance steadily dropping. By contrast, rival ratings agency Moody's on 10/5/17 revised its rating outlook on the arena bonds, rated Baa3 (again, just barely above junk) to negative, based on the financial implications of the Islanders. (I wrote about the Moody's assessment last December, in two articles for The Bridge.)

In other words, the two clouds over the arena--financial impacts of the Islanders and the Nets--have yet to be combined in one rating.

The Moody's assessment

From the Moody's press release 10/5/17:

The change in rating outlook to negative reflects weaker than expected financial performance for fiscal year (FY) ended June 30, 2017, owing to a drop in revenues and cash flow caused by the attendance and related ticket sales decline at the New York Islanders (the Islanders) home games held at the Barclays Center. The rating action factors in our belief that similar financial underperformance will continue for the next 12 to 18 months owing in large part to the contractual arrangements between the Islanders and the Barclays Center. Specifically, weak financial performance during FY 2017 was in large part driven by the Barclays Center's obligation to make fixed annual payments to the Islanders for an anchor tenant guarantee fee.

Moody's calculated that the arena's debt service coverage ratio (DSCR)--the amount of cash available to pay off debt--declined to 1.31x during fiscal year 2017 from 1.51x in FY 2016, and was estimated to drop even further to 1.07x for the fiscal year ending this June. 

That's barely enough cash to pay off debt, and Moody's had previously expected DSCR closer to 1.8x--nearly twice as much cash as needed. Moody's noted that arena managers forecast a different figure, citing a cushion of cash.

The anchor tenant guarantee has been modified, since the Islanders will split the next three seasons between Barclays and the Nassau Coliseum, and that financial impact has not been analyzed. Indeed, it's something of an unknown, at least until we see whether the arena can fill those newly open dates.

Moody's warned, "The rating could be downgraded if the Barclays Center were to lose the Islanders as a tenant, and they are not replaced with other events, thereby negatively affecting premium seating, sponsorships or other forms of revenue, resulting in weaker DSCRs that originally anticipated."

The S&P assessment

From the S&P press release, 4/20/18, regarding the new deal:

To bridge the gap in revenue loss, a reserve account was established with a portion of the sale proceeds (estimated to be $345 million). A top-off mechanism was also created to utilize residual cash flow that would be otherwise distributed to the sponsors back to the project in the event the debt service coverage ratio (DSCR) falls below 1.38x based on the arena's calculations.
Our preliminary view of the net impact of the changes is that the reserve size and mechanics of the top-off provisions, along with our own operating assumptions for the arena and methodology for calculating DSCR (which differs from the project), may lead to a decline in coverages well below our previously forecast minimum DSCR of 1.35x. 

In other words, S&P--perhaps using different assumptions, and/or perhaps not focusing on the Islanders--has not lowered its DSCR estimate to that of Moody's. Still, S&P might willing to lower the rating before the coverage ratio dips too much:

A downgrade would be warranted if ratios fall consistently toward 1.3x against our former expectation of 1.35x. We could remove the rating from CreditWatch negative if we conclude the sale's provisions (to establish a reserve account and provide additional support to substitute for lost revenues) provide for forecast DSCRs that fall toward the top of the 1.2x-1.4x range under our calculations. 

That said, S&P seems to be taking the long view, since it says 1.35x was the minimum "we were previously expecting in 2041." So there may be time to adjust the rating.

Note that the previous ratings action from S&P was a 5/22/17 assessment in which the ratings agency affirmed the BBB- rating on the bonds, which were issued in 2016, replacing bonds sold in 2009 with financing at a lower interest rate.

As I've noted, the performance of the arena has been such that the lowered interest rate significantly helped the arena operator escape financial dangers.