FEBRUARY ISSUE: February 16, 2015

By Gail Kalinoski, Contributing Editor

For American Realty Capital Properties Inc., the world has changed drastically since Feb. 7, 2014. On that day, ARCP completed the acquisition of Cole Real Estate Investments Inc., creating a $21.5 billion net-lease REIT, the largest of its kind. Nicholas Schorsch, ARCP’s chairman & CEO and the architect of its swift rise, touted the $11.2 billion Cole deal as an “epic transaction.”

Only a year later, Schorsch and other top executives are gone in the wake of last fall’s revelations of accounting irregularities. Resignations, lawsuits and falling stock prices followed thoat disclosure in rapid succession, along with rumors of federal investigations. The question remains: What’s next for the net-lease juggernaut?

The answer will have far-reaching implications, but it may not be forthcoming anytime soon. “They’re still unraveling this puzzle. It took three years to build it. How long is it going to take to unwind it?” asked Brad Thomas, a REIT specialist and editor of “The Intelligent REIT Investor” newsletter. “It’s a mess.”

Both before and after the Cole merger, Schorsch built ARCP with an aggressive, rapid-fire series of acquisitions. Other 2014 deals of note included the $1.5 billion sale-leaseback transaction involving the Red Lobster chain.

But the momentum stalled on Oct. 29, when ARCP disclosed a $23 million accounting error in its financial statements for the first half of 2014. Worse, it turned out that the mistakes had been intentionally covered up. Lisa McAlister, ARCP’s chief accounting officer, and Brian Block, the firm’s CFO, left immediately. ARCP’s stock tumbled as low as $7.38 per share before climbing back above $9 by the end of the year. Stock values in other parts of Schorsch’s real estate empire—like RCS Capital Corp., which trades as RCAP, also took a hit.

On Dec. 15, Schorsch stepped down as ARCP’s executive chairman and from the ARCP board of directors. He also left the boards of the non-traded REITs managed by Cole Capital, which had been acquired in the Cole merger. William Stanley, the lead independent director, took over as interim chairman & CEO. Two weeks later, he resigned from 11 non-traded REITs and direct investment programs. Schorsch remains as chairman & CEO of AR Capital.

While analysts and investors had been calling for Schorsch to resign from ARCP, the departures of two other top executives—David Kay, who had been named CEO only on Oct.1, and Lisa Beeson, the firm’s president & COO—came as a shock to most.

Analysts Weigh In

CapitalOne Securities Inc. analyst Christopher Lucas told CPE that Kay had reiterated his intention to stay with ARCP during a NAREIT event in early November. Paul Adornato, an analyst for BMO Capital Markets Corp., concurred. “We thought Kay had rolled up his sleeves and was attempting to turn around the company,” he wrote in a December investors’ report. “We also appreciated Kay’s desire to be as transparent as possible by meeting/speaking with investors and analysts during this period in which ARCP lacks clean financials.”

J.P. Morgan analyst Anthony Paolone suggested that Kay’s and Beeson’s resignations may have been hastened by a $50 million defamation lawsuit filed on Dec. 18 in New York State Supreme Court by McAlister. She alleges that Schorsch directed her and Block to move numbers around to hide the accounting errors. She claims she was a whistleblower and was fired for pointing out the errors. In his Dec. 18 investors’ report Paolone wrote that when Stanley was asked why Kay and Beeson were let go, he responded that “the board was taking actions as the investigation was unfolding. Given the claims made in McAlister’s complaint, we surmised that either the board knew this lawsuit was coming and would impugn Kay’s credibility to do his job and/or the investigations going on at ARCP uncovered evidence that Kay knew more than previously thought.”

In addition to McAlister’s defamation lawsuit, numerous class-action lawsuits have been filed on behalf of investors alleging securities fraud, and there are reports of probes by the U.S. Securities and Exchange Commission and the Federal Bureau of Investigation. Following its own review, Moody’s downgraded ARCP’s credit ratings to junk status because of “continued uncertainty.”

One thing analysts and accounting experts agree on is that ARCP will have trouble moving forward as a viable company until it issues clean financial statements.
“The one thing they need to do to really get rid of this cloud of uncertainty is to get clean financial statements out that everybody can stand behind,” said Robert Rostan, a CFO and Principal of Training The Street, a corporate training provider, as well as a certified public accountant.

Rostan, a specialist in assurance and advisory services for public companies, speculated the accounting error was probably just a mathematical mistake made far worse by the effort to hide it. “They should have come clean,” he told CPE.

Moreover, the steady stream of complex deals undertaken by ARCP in a brief period likely compounded the problem. “The likelihood of making mistakes is tenfold when you’re making lots of large acquisitions like this,” said Rostan.

Next steps for ARCP include submitting financials for the third quarter of 2014 and for the full year, both due in March. The firm’s bank lenders granted a waiver and extension, a significant step that Rostan finds encouraging. Lucas noted in a late December report that the waiver and extension also comes with some restrictive conditions: a reduction in the revolving credit line for ARCP to $3.6 billion, elimination of the $25 million swingline facility and suspension of the dividend until the financials are filed.

Inevitable Sale?

For Lucas, ARCP’s various challenges point in one direction—the auction block. “While we see value in the company’s assets … we continue to view the ultimate outcome to the ARCP saga as a sale of the company,” he wrote.
Adornato of BMO Capital Markets noted in his report that there could already be interest in ARCP’s assets. “Most of ARCP’s portfolio would be desirable to other net lease investors (public and private) at the right price,” he wrote.

Whatever the outcome, ARCP 2.0 will look very different from the behemoth that Schorsch built. Possible moves could include spinning off Red Lobster as a REIT or spinning off the industrial and office properties and creating a REIT from the remaining retail assets, comparable to National Retail Properties.

Thomas said the only REIT he views as a potential buyer for the entire ARCP portfolio is Realty Income Corp. ARCP’s 3,900 assets vary widely among retail (62 percent), office (23 percent) and industrial (15 percent). Realty Income is an intriguing possibility because it is due for “another dividend spike,” Thomas said. “The only way for Realty Income to really move the needle is to buy larger portfolios.”

Private equity firms, too, are taking an interest. Corvex Management L.P., run by managing partner Keith Meister, reported in a Dec. 29 SEC filing that it had acquired 7.1 percent of ARCP’s outstanding shares.

Word of Corvex’s investment finally bumped ARCP’s share price over the $9 mark and earned a public thumbs-up from its board of directors. Bloomberg reported that Corvex talked to the ARCP board about adding a representative from the firm to the board and about ways to increase the REIT’s value.