Extended Stay examiner: acquisition hurt capital, ability to pay debts

By Caroline Salls

Pittsburgh, April 8 - Extended Stay, Inc. examiner Ralph R. Mabey reported Thursday that the company was "left with unreasonably small capital with which to operate" and was unable to pay its debts as they came due as a result of Lightstone's 2007 acquisition of Extended Stay, according to a filing with the U.S. Bankruptcy Court for the Southern District of New York.

Mabey said the structure of the cash management agreement related to the acquisition and the composition of budgets under that agreement "created a system that was fundamentally flawed and incapable of properly managing the cash flows of an operating business enterprise such as Extended Stay."

"In addition, the significant increase in the amount of post-acquisition debt, and the relatively insignificant amount of equity that was invested in connection with the acquisition, placed an undue burden on the debtors' operations, and did not allow for a reasonable amount of fluctuation in the debtors' financial results," Mabey said in the report.

In addition, the examiner said the auction process may not have been completely transparent, and the assets sold may not have received adequate exposure to the market.

Mabey also said it appeared that little due diligence was performed to determine the purchase price, evaluate the terms of related loan agreements or analyze the level of debt Extended Stay could reasonably manage.

"The largest single factor impacting the balance sheet was the amount of debt, and here, the debt level resulting from the acquisition was significantly higher than the initial analysis of other companies and REITs in the hospitality industry," the examiner said.

Also, Mabey said neither the acquisition agreements nor the loan agreements required the buyer to make additional capital contributions into Extended Stay as needed.

"Without any mechanism to require its owners to contribute capital when needed, Extended Stay would be forced to seek capital through other sources, such as debt, which would likely come at a significant cost, given the [company's] leverage ratio," Mabey said in his report.

The examiner said his financial advisers found no evidence that the company performed monthly analyses of its projected cash flows and other capital needs.

"Given the low working capital needs of the hospitality industry, cash from operations would be used for debt service, capital expenditures, corporate costs, and other non-property level expenses," Mabey said in the report.

"Therefore, Extended Stay should have evaluated its cash needs on a monthly basis to determine whether it could meet its working capital needs."

Potential claims

Based on his analyses, the examiner said "it does not appear that Extended Stay had adequate capital to fund its operations and survive economic downturns in the business."

Mabey said the company could have fraudulent transfer and unjust enrichment claims in connection with the acquisition.

He said the potential fraudulent transfer claims arise from the belief that the acquisition parties knew or should have known the effect the transaction would have on the company by saddling it with unserviceable debt.

Mabey said the company could have unjust enrichment claims because the sellers and their professionals retained a total of $1.7 billion for which Extended Stay received nothing of value.

In addition, the examiner said the company could also claim illegal distributions and breach of duty in connection with the acquisition.

Extended Stay, a New York-based owner and operator of mid-priced extended stay hotels, filed for bankruptcy on June 15, 2009. Its Chapter 11 case number is 09-13764.

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