Part one: Zell's big gamble
In the summer of 2007, a complicated deal to buy Tribune Co. and take it private reflected all the dangers of an easy-money era when caution was pushed aside
After months of scrutiny but no acceptable offers, the auction for Tribune Co. was sputtering to a halt. Left with no other option, the board gave FitzSimons and his team permission to develop their own plan to take the company private by spinning off the broadcasting business.
'The Grave Dancer'
In late January 2007, court papers show, Todd Kaplan, an investment banker stationed in the Chicago office of Merrill Lynch, reached out to Zell, whom he had been advising on deals for years.
Zell had decided not to pursue the Tribune Co. transaction a few months earlier, seeing no upside in bidding against a throng of private equity giants. But now that the company had been deemed damaged goods, Kaplan suggested it had fallen into Zell's sweet spot: a complex financial puzzle that others had abandoned as unsolvable.
Zell, who coined his own nickname, "The Grave Dancer," to describe his fondness for investing in downtrodden companies and real estate, cherished his status as an iconoclastic, motorcycle-riding outsider. His estimated $4 billion fortune allowed him to thumb his nose at the slow-moving corporate establishment, whose many rules and protocols he viewed with open disdain.
The culture at his own investment firm, Equity Group Investments, was proudly freewheeling and fast-paced. His seasoned group of finance specialists competed to come up with the cleverest ways to invest his money, and each shared in both the profits and the losses as participants in the deals they generated. Current and former EGI employees said Zell put extraordinary trust in them to find the investment angles others had missed. The intellectual challenge, they said, was as invigorating as it was daunting.
When Kaplan called, Zell was on the verge of pulling off one of the most spectacular deals of his career.
Amid the buyout fever of 2006, Zell had ignited a bidding war for Equity Office Properties, his investment trust that was the nation's largest office building landlord. For months, Zell had expertly played two firms against each other until, finally, private equity giant Blackstone Group took the prize with a $39 billion bid that was about $3 billion above where the auction had started. Documents show Zell's take was more than $1 billion.
The Tribune Co. transaction became his next challenge.
After Kaplan's call, Zell decided to take another look and assembled a team led by Bill Pate, his No. 2 at EGI, and Nils Larsen, who had helped Zell turn a huge profit on an investment in radio company Jacor Communications.
The deal team quickly built a set of spreadsheets to model how much debt the company could handle and what return an investment might generate.
They saw all the problems the private equity bidders stumbled over. But then they saw something else — an ingenious way to reduce Tribune Co.'s tax burden through an obscure corporate structure that had been used against them by a rival bidder for a bankrupt waste-to-energy company.
Taxes were a special problem for anyone hoping to take control of Tribune Co. by using a lot of borrowed money. Federal income taxes reduced the company's cash flow each year by hundreds of millions of dollars, limiting the amount available to pay interest. And while the company boasted many prize assets like the Chicago Cubs that could be unloaded to pare down the acquisition debt, selling them piece by piece would trigger huge capital gains taxes because Tribune Co. had owned most of the assets for so long.
The Zell team's brainstorm was to take the company private and convert it into what's known as an S-Corp ESOP, a Subchapter S corporation owned by an employee stock ownership plan. Because an ESOP is officially a retirement vehicle, the structure immediately eliminates corporate income tax. It could also grease tax-advantaged transactions to buy and sell assets.
For the first 10 years the S-Corp was in place, any straightforward asset sales would trigger capital gains taxes just as they always had. But after that 10-year period, the company's cost basis in its various assets would be "stepped up" to current valuations, eliminating capital gains if they were sold.
That meant if the new owners could afford to carry the assets for a decade, they could then unwind everything tax-free. But the Zell team also saw that they could manipulate the tax advantages to sell some assets even earlier, giving them added flexibility to manage the debt load. They began dreaming big. They even contemplated using the tax shelter to go after a trophy asset like NBCUniversal, one source said.
"It's a gift that gives into a lot of different pockets," one of Zell's lieutenants said of the ESOP idea. "The 10-year tax structure sort of supercharged it."
Pate and Larsen didn't ignore the fact that Tribune Co.'s main source of revenue – advertising — was weakening. But they were certain they could help find ways to improve performance. Even when they ran scenarios assuming significantly steeper ad revenue declines than management was projecting, the numbers still worked, given expectations of as much as $1 billion in tax savings.