A rendering of the project that was planned to replace the Public Safety Building. (BizSense file)
“Insufficient due diligence,” turnover in management and “inadequate in-house real estate expertise” were contributing factors to VCU Health’s costly exit from an ill-fated downtown development, according to a third-party review presented Wednesday.
The report from the law firm that conducted a monthslong review found that the health system’s handling of the proposed redevelopment of the city’s Public Safety Building “followed a pattern of prioritizing mission, vision and values over financial terms.”
That was among other findings presented to the boards for the health system and Virginia Commonwealth University in a closed meeting Wednesday that stretched four hours. A joint task force of both boards voted to release the presentation from national law firm Saul Ewing to the public.
The review represents the first accounting of the aborted project that has cost VCU Health at least $80 million, including a $73 million payment to exit the project.
The health system has said it decided to exit the project – a $325 million redevelopment of the 3-acre site at 500 N. 10th St. – in light of challenges arising over the course of the pandemic and the financial obligations that came with the deal. Those obligations put VCU Health on the hook to pay more than a half billion dollars in rent over a 25-year lease.
The review found that the health system also assumed risks with its lease, which was made with an LLC tied to Oak Street Real Estate Capital, now a division of New York-based investment firm Blue Owl Capital.
Those risks resulted in the $73 million payment, which was made through a defeasance process that wound down the deal before anything was built and unwound a $425 million loan secured by the LLC. The City of Richmond, which had sold the site for the project to the LLC for $3 million, took back the property in February as part of the defeasance for zero dollars.
It wasn’t until May that VCU Health revealed the sizable defeasance payment, in response to Freedom of Information Act requests from Richmond BizSense.
Heightened scrutiny of the payment and the original deal followed, including from former Virginia Gov. Doug Wilder – a VCU professor and namesake of the university’s L. Douglas Wilder School of Government and Public Affairs – who called for a state investigation into the payment and for the VCU Board of Visitors to fire Michael Rao, president of the health system and the university.
‘Impossible to build as designed within the budget’
The review was initiated by Rao in September as the defeasance was playing out. It analyzed emails and attachments between certain health system and university employees involved in the deal.
The review focused on the period from February 2020, when the project was spawned out of the unsuccessful Navy Hill project, to mid-2021, when the original deal was memorialized through a multiparty agreement that committed VCU Health to more than $617 million in rent. It also put the health system on the hook for any project cost overruns as well as real estate tax payments to the city that continue to be made.
The review from Saul Ewing, which was retained in November 2022, also analyzed select agreements and documents and involved interviews of health system board members, current and former health system employees, and current VCU employees.
Findings included that the project “was impossible to build as designed within the budget,” with site conditions restricting the number of parking spaces possible, hyperinflation costs impacting the project and the pandemic affecting demand for office space. Lease terms for subtenants The Doorways and Ronald McDonald House of Richmond also were cited as budget challenges.
The review noted a “long-standing desire by VCU to acquire the property,” an “institutional eagerness for the property” that “continues today,” and a “‘Get it done’ attitude at the project’s outset. It notes that the health system’s deal was negotiated during COVID, describing it as a “time of great stress” with other pressing issues stemming from the pandemic.
It also scrutinized the health system’s project management, describing its chief financial officer at the time as a “de facto project lead” working closely with the university’s vice president for government relations, “with others called in on an ‘as-needed’ basis.” The presentation from the law firm also refers to “developer issues” without elaboration, “city relationship considerations” and an “urgency to move forward.”
The review noted that the project was negotiated over the tenures of three health system CEOs “with different management styles,” as well as amid departures of the CFO and general counsel.
The report does not identify the individuals by name but refers to health system CEOs Marsha Rappley, who retired in early 2020, interim Peter Buckley, and Art Kellermann. The latter joined the health system months after the project was proposed and signed the multiparty agreement after less than a year on the job.
Kellermann resigned last November at the request of Rao, according to a statement from Kellermann that accompanied an announcement from Rao of the leadership change. The announcement did not specify a reason for the change.
Other observations from the review included a lack of analysis about whether to continue with the project during the negotiations, and “insufficient due diligence” with no site survey and “limited third party advisors assisting, with advisors called in late.”
The defeasance started playing out in mid-2022, when VCU Health decided to exit the project after developer Capital City Partners filed a scaled-down version of the plan that dropped the building height from 17 stories to seven, involved research space instead of office space, and showed only half the 1,200 structured parking spaces originally planned.
Better communication, project management recommended
The review included recommendations for VCU and the health system, calling for the boards to improve culture “to foster open communication,” establish project management teams and require management to use third-party advisers in “high risk and/or high dollar” transactions.
The review also recommended that the health system board enhance membership orientation and annual education, address conflicts of interest at the board level and operationally, and ensure that board composition “includes relevant expertise, including financial expertise.”
Wednesday’s release included a statement from VCU and VCU Health that said the project “became infeasible due to a combination of macroeconomic factors felt across the entire real estate sector.” The statement cited factors including “historic levels of commercial office vacancy rates, inflation and supply chain constraints and interest rate increases.”
“The VCU Health board made the most fiscally prudent decision to exit the project and incur a one-time defeasance payment of $72.9 million,” the statement said, adding that a goal of the third-party review was “to evaluate its processes and identify important opportunities for improved governance and decision making based on best practices.”
The statement added that the defeasance payment was made using VCU Health reserve funds and did not involve university funds or state revenue. It said the payment “allowed VCU Health to avoid far greater financial obligations and problems in the future.”
‘It’s going to drive a lot of changes’
After the closed meeting, Rao and VCU Health interim CEO Marlon Levy told reporters that the review would lead to “immediate changes” that would be implemented soon.
“It’s going to drive a lot of the changes we look at as a health system board,” Rao said. “It’s a very strong report. It’s clear. It’s not a million words but it is absolutely clear about things that will, candidly, help going forward.
“This is obviously something that’s serious to us, so we wanted them to take a really close look at what was going on,” Rao said of the review. “All these things happened, and the bottom line is we needed to know, with some guidance from the committee that was representative of the health system board, what happened.”
Added Levy: “The goal is to understand what are the organizational lessons, how can we as a health system organization perform better.”
Levy said a key lesson from the review is a focus on team-based behavior and decision making.
“That almost seems like a business school trope, if you will, but I think it’s important to be reminded of that,” Levy said. “The other big lesson is perhaps a little more scrutiny moving forward on the financial implications of transactions.
“I think in hindsight a lot of the decisions that were made around this potential project were really driven by mission, values. Perhaps not enough emphasis was placed on the financial implications of the decisions made,” Levy said. “One of the lessons is to lead with the mission, lead with the values but don’t forget the finances.”
Levy added that the review showed the health system was faced with “what in hindsight turned out to be what’s described in the business world as a black swan event: completely unpredictable effects of the pandemic, the spiraling cost of construction, supply chain constraints.”
“The decision to unwind really wasn’t a decision between a good decision and a bad decision. It was really what is the least bad of all the options in front of us,” he said.
Asked about Wilder’s calling for Rao’s dismissal and putting the blame for the situation squarely on him, Rao did not address the question directly.
“I continue to have tremendous regard for Governor Wilder,” Rao said. “He is an icon who has encouraged so many of us that we can make anything happen in this country.”
VCU, the university, is now pursuing a new and more expensive project for the Public Safety Building site: a planned $415 million VCU Dentistry Center to replace two School of Dentistry buildings on the nearby MCV Campus.
BizSense reporter Jack Jacobs contributed to this report.