When Bank of America credit officer Dan Petrik and his team sat down in early 2007 to analyze Sam Zell's plan to take control of Tribune Co., their numbers showed that the complex deal failed to meet five of the bank's 10 lending guidelines.
There was too much borrowed money, too little collateral and the overall risk rating that BofA assigned to the transaction was below what the bank liked to see, according to its preliminary analysis. Petrik had never worked on a deal so weighed down by debt. He couldn't remember doing a transaction that had missed so many lending criteria.
Yet within a week, BofA was prepared to move forward as a lender. The appeal, Petrik said, was $40 million in potential fees, the bank's lucrative history with Zell and the chance to cultivate Tribune Co. as a new client.
"The fees are a one-time transaction," Petrik explained in a court deposition. "But a relationship could last a lifetime."
Billions in losses and four years of bankruptcy later, Zell's takeover stands as a dramatic illustration of what happens when companies and deal-makers are driven by one of Wall Street's recurring, superheated investment cycles.
Some of the nation's most sophisticated banks — JPMorgan Chase, Citigroup, Merrill Lynch and BofA — clamored to get involved in the $8.2 billion Zell deal. Then, together with Tribune Co.'s top leadership and advisers, they pushed ahead despite mounting evidence that the company's business was deteriorating.
How did this group of elite professionals convince themselves it made sense to load Tribune Co., which owns The Baltimore Sun, with a total of $13 billion in debt?
The answer lies partly in the broad financial bubble that overtook the markets in the years leading up to the global financial crisis.
Just as easy credit pushed up the homebuying market to unsustainable levels, corporate deal-making had gone into overdrive, fueled by ready access to borrowed billions. Among bankers, shareholders and corporate executives, the market steadily raised expectations for profits. That eroded lending standards and made even the most exotic deals seem plausible.
At that moment, no one involved in the Tribune Co. deal could have known the economy was on the brink of collapse. And under better circumstances, Zell's deal might have worked.
But the crucial question isn't whether it could have worked. It's whether the deal presented a reasonable risk, the kind bankers and executives are paid to assess.
By the time Zell and Tribune Co. had found each other, the sheer volume of deals getting done had altered Wall Street's judgment of what was reasonable. What made Zell's Tribune Co. transaction unique was that it straddled the point when unbounded optimism changed to fear overnight, demonstrating in real time the destructive force of inflated expectations.
When Zell's proposal hit the table in early February 2007, most of the bankers close to Tribune Co. had never seen anything like it.
The complex plan was designed to take Tribune Co. private at $34 a share and place the company in the hands of a Subchapter S corporation owned by an employee stock ownership plan. Called an S-Corp ESOP for short, the structure would eliminate the company's income tax burden and boost cash flow, making it possible to carry more debt.
"Even people who had been (doing deals) for 25 or 30 years looked at it and said, 'Huh?'" one Tribune Co. adviser said.
The transaction would nearly triple the company's total debt load, from roughly $5 billion to $13 billion — a burden that dwarfed industry peers' and put enormous new pressure on the company to perform. But if Tribune Co. could sell key assets like the Chicago Cubs and maintain cash flow at properties like the Chicago Tribune and the Los Angeles Times, Zell, management and the company's new employee/owners stood to profit handsomely.
The problem was, Tribune Co.'s financial performance was weakening. Almost 40 percent of its revenue came from California and Florida, markets hit hard by the brewing real estate crisis. Cash flow was on its way to a 12 percent first-quarter decline. Analysts were warning that the accelerating drop in industry advertising revenues was more than a cyclical downturn. It was a fundamental change in which advertisers were abandoning print for the Internet.
Against this backdrop, Zell proposed pushing Tribune Co.'s debt burden to more than nine times its cash flow. That was aggressive even by the standards of the ballooning leveraged loan business, where the average debt ratio had climbed to 6.2 times cash flow in 2007 from 4 in 2002, according to Standard & Poor's Capital IQ. What's more, Zell was backing his bet with an equity investment of only $315 million, which amounted to a 2.4 percent down payment — again, thin by market standards.
Zell made no pretense that the deal wasn't risky. Instead he argued that his plan made the risk tolerable. Besides the tax savings from the ESOP structure, Zell made it clear he wouldn't hesitate to cut costs or sell assets to manage the debt.
For the banks, the appeal was straightforward: As money from outside investors flooded into the market for highly leveraged loans over the previous few years, they had grown accustomed to making millions doing as many deals as possible. The bank's role was to act as an intermediary — make the loan, collect a fee, then move the risk off the bank's balance sheet by chopping it up and selling it to a syndicate of other investors.
The market for selling loans was red-hot because of an influx of a new type of buyer — managers of collateralized loan obligations, or CLOs, the corporate lending equivalent of the mortgage-backed securities that were inflating the real estate bubble. This created a huge demand for new loans that fed on itself. As volume rose, the deals got bigger and riskier.
The banks "were climbing over themselves to get into this deal," former Tribune Co. general counsel Crane Kenney said in a deposition.
Tribune Co. had already promised its two investment bankers, Citigroup and Merrill Lynch, that they could provide financing for any deal they drummed up. But since Zell had never worked with Citi, his team reached out to JPMorgan and BofA, where the Chicago billionaire had long and lucrative relationships.
JPMorgan jumped at the chance to get involved, according to court documents. It worked furiously to complete its initial analysis and documentation in five days, a process that often takes weeks.
Petrik, who declined to comment, said in a deposition that Zell's team gave BofA added incentive: If the bank could move quickly, it might be able to unseat Citi, giving it access to as much as one-third of the potential $208 million in lender fees. That ignited a scrap between the two banks; eventually both got a piece of the transaction.
Although the market for corporate deals was raging, there was nothing easy about the Zell transaction. In emails, Merrill Lynch banker Todd Kaplan likened the process of solving its technical problems to "wrestling an octopus."
Documents show that some on the deal teams were alarmed by the company's financial performance and worried that the transaction wouldn't sell to outside investors. It didn't help that the deal was structured to close in two steps, at least six months apart, exposing it to potential changes in the market's appetite for risky deals.
Julie Persily, a leveraged finance specialist at Citigroup who initially called the buyout's complex structure "silly," was convinced that the only reason competitors were so enthusiastic about it was that Zell was a longtime client, emails show. Her boss, Chad Leat, had even complained that friends were "laughing at him" for trying to fund such a precarious transaction, according to one Persily email.
But Wall Street exists to do deals, not dwell on why they can't get done. "As problems got solved, it became clear this could happen," said one banker. "So it's a little like a snowball."
It helped that Zell had powerful allies at JPMorgan, the bank he chose to lead the transaction.
JPMorgan declined to comment for this series, but two of its former bankers said Jamie Dimon, the bank's chairman, and Jimmy Lee, the vice chairman, took a keen interest in making the buyout work. At one point, documents show, Dimon suggested that if the market was worried about Zell's small equity contribution, JPMorgan should invest some of its own money alongside Zell's as a show of confidence. That didn't work, but emails show Dimon's deal team got the message that "Jamie will want to find a way to play."
To solve the equity problem, Tribune Co. and the deal's architects reframed it. In presentations for the rating agencies and, later, for potential investors, they pushed a concept some bankers called "synthetic equity," sources said. This effectively bolstered the equity side of the balance sheet by adding in a number of items including the expected $1 billion in S-Corp tax savings as well as more than $2 billion in Tribune pre-buyout debt that would be pushed down the payout ladder by the new loans.
Under this formulation, the new Tribune Co. would have debt of a little more than 7 times cash flow, rather than a more onerous 9.1 times.
The idea was to make owners of the buyout debt more comfortable: In the event of a default, there appeared to be enough of a cushion in the capital structure for them to get paid back in full. But there was much less certainty for the owners of the pre-buyout debt or the company itself, since that "junior" debt still required interest payments and would eventually have to be paid off, putting strain on the company as a whole.
As the bankers moved ahead on the deal, Tribune Co. management was working through its own ambivalence. Chief Executive Dennis FitzSimons and his team had earlier proposed a smaller restructuring that would pay shareholders less and presumably leave management in control.
Some Tribune Co. executives said they relished the idea of working with Zell and believed he might truly be able to energize the company. But FitzSimons "went hot and cold" on the new proposal, worried that "it was doable but (with) a lot of debt," Citigroup investment banker Christina Mohr said in court papers.
What was clear was that all of Tribune Co.'s top management had powerful incentives to restructure the company, including the potential for a big payday.
Documents show that the company's top 38 managers received almost $150 million in payments triggered by the deal, including various incentive and severance packages, as well as cashed out restricted stock and options. FitzSimons alone walked away with a total of more than $40 million, including proceeds from stock holdings accumulated over his career at Tribune Co.
The Zell proposal created an incentive program intended to give a large group of Tribune Co. managers "phantom stock" worth 5 percent of the company, which tracked the value of the ESOP shares. Those shares ended up valueless, but documents show that a much smaller group of top executives also got phantom shares worth 3 percent of the company that vested earlier than the rest and included cash-out provisions.
When FitzSimons and 10 others, including Don Grenesko, the chief financial officer, and Scott Smith, president of Tribune Publishing, eventually left the company, their vested phantom shares were cashed out at $17.7 million, documents show. FitzSimons, Grenesko and Smith declined to comment.
Still, there was trepidation.
James King, a former Tribune Co. human resources manager, questioned the deal's math in a March 24 email to then-company treasurer Chandler Bigelow. "If I am reading this right," King wrote, "we have a pretty narrow band of success under the ESOP — i.e. if we are off plan by 2% we have no value in the ESOP for five years. Are there dynamics at work I don't understand?"
Bigelow, who is now the company's chief financial officer, responded that King was correct.
At one point in March, documents show, FitzSimons put the brakes on the Zell proposal after celebrated Wall Street attorney Martin Lipton warned him that the deal might stall amid potential opposition in Washington. FitzSimons invited Zell to breakfast and told him he wanted to pursue the management-sponsored alternative, documents show.
Soon after, Zell talked to Tribune Co. board member William Osborn, the former Northern Trust chairman who led a special committee formed to oversee the Tribune sales process. Osborn told FitzSimons to keep working on Zell's transaction.
Osborn wouldn't comment, but several sources close to the discussions said that at a time when big shareholders were demanding a deal and sure to sue if they thought the board wasn't acting in their interest, Osborn felt compelled to fully consider the Zell deal, which promised the biggest payout.
Osborn, like the banks, also had confidence in Zell's ability to make the deal work. "We had in Mr. Zell ... somebody who had dealt with making real value out of assets," he said in a court deposition.
The deal was finally signed April 1 and, within a month, it was clear big trouble lay ahead. By May, as the credit markets began to slow down, the banks had won commitments from investors for only $3 billion of the $8.7 billion in new Tribune Co. debt they were trying to sell.
One investor, who asked to remain anonymous, said he initially scoffed when JPMorgan presented him with "this bogus book showing synthetic equity." In an interview, he said: "We're not stupid. That ain't equity."
To entice skeptical investors like this one to buy into the deal, the banks had to sweeten the terms, sacrificing their fee income.
"Since we launched two weeks ago the deal has struggled in the market," JPMorgan banker Peter Cohen emailed Dimon, the bank's chairman. "We have eaten away at the majority of our fees to get (it) over the finish line."
Seeking an escape
On a steamy late summer day, BofA's Petrik walked across Chicago's Loop toward Tribune Tower.
As the media company's financial results deteriorated, he had become increasingly unsettled. Tribune Co. had just reported a 29 percent plunge in second-quarter operating cash flow on a 7 percent drop in revenue. Publishing cash flow skidded 41 percent, making management's projections of a quick turnaround later in the year seem unrealistic.
Petrik was hoping for a clear-eyed analysis from CFO Grenesko on the slide. Instead, he recalled walking back to his office, "shaking my head, going, you know, this guy doesn't really know what is going on," Petrik said in a court deposition.
On July 26, documents show, JPMorgan's Lee met with Zell to tell him that step two had no chance in the syndication market unless he was willing to give it a boost. Earlier, Lee's staff had warned him in emails that JPMorgan was "totally underwater" on the Tribune loan and said he should press Zell for "1) More equity 2) Even more equity 3) More rate."
Lee's outreach to Zell was part of a broader exercise in triage at JPMorgan in reaction to danger signs throughout the economy. Two bankers on the Tribune Co. team at JPMorgan said that while Dimon put high value on relationships like the one with Zell, his first priority in the summer of 2007 became protecting the bank from lasting damage in its $32 billion portfolio of leveraged loans.
"Jamie was very aggressive about managing for the bank's book," said one of these bankers. "He was scrutinizing 'what did I sign up for that I can get out of and what did I sign up for that I can't?'"
Dimon knew Tribune Co. fell into the latter category. "(When we) sign a binding commitment, it's a binding commitment," he explained in an interview contained in court records. "That's why you have a bank."
As summer turned to fall, analysts from Standard and Poor's and Lehman Bros. issued reports publicly calling Tribune Co.'s solvency into question. That supported internal JPMorgan research suggesting Tribune Co. might be headed for trouble.
A "highly confidential" deal update from Sept. 10 included in court papers noted that based on two different measurements of value, Tribune Co. was "potentially failing solvency tests."
Documents show that Merrill and Citi also ran numbers suggesting that under various scenarios, the debt might leave Tribune Co. insolvent. Both banks declined to comment.
Legal experts say any threat of insolvency put the banks in a bind. Because they were contractually obligated to make the loans, they risked big lawsuits for breach of contract if they bailed out. But if the company landed in bankruptcy, they risked getting sued for lending to a company unable to shoulder the burden.
With all this in mind, documents show, JPMorgan's Tribune Co. deal team met Sept. 20 to discuss how they might defuse the situation. First, they decided to push Zell and the Tribune Co. board again for more concessions, including a pledge to sell another $2.5 billion in assets and add more equity and fees.
At the same time, the four bank deal teams decided to focus on the one soft spot in the credit agreement: a requirement inserted by lawyers for the board's special committee that the company pass a solvency test before the second step of the deal could close.
Tribune Co. had hired a solvency firm called Valuation Research Corp., which had already delivered a favorable opinion after step one and was working with the company on a fresh opinion that would add in the step two debt. Documents show the banks hired a rival solvency firm to help them analyze VRC's work and to look for places to challenge it.
VRC had been paid its highest fee ever to work on the Tribune Co. deal — $1.5 million — and had adopted a number of key assumptions that ultimately would come under withering scrutiny from an independent examiner's report ordered by the judge in Tribune Co.'s bankruptcy case.
VRC leaned heavily on the S-Corp. tax savings, a questionable move under normal valuation assumptions, the examiner found. The firm also based its conclusions on a new set of 10-year projections that Tribune Co. management had produced — numbers that were more optimistic than what VRC analysts had prepared.
As results eroded in 2007, management in October issued new projections that scaled back expectations for the first five years of the plan. But despite a falloff in actual results starting in 2004, the new projections still showed steady growth each year from 2008 through 2017. And except for the first year in the 10-year series, management predicted growth far outpacing earlier projections.
As analysts often do, executives applied the growth rate in the fifth year — 2012 — to the final five years, producing steady 2.4 percent annual revenue growth through 2017.
But 2012 was a presidential election year, when heavy campaign advertising significantly improves broadcast revenues. The examiner later found this to be especially problematic.
The projections for the Tribune Interactive division were the hardest to pin down with any confidence.
Former Interactive chief Tim Landon told the examiner his unit's growth was always assumed to be highly speculative. It depended on projects and possible acquisitions that hadn't been launched or completed. Yet despite a marked slowdown in the division's growth, the company projected it would more than triple in size by 2012.
Documents show that Landon, in retrospect, was surprised VRC hadn't adjusted the projections downward to reflect the uncertainty.
A series of internal VRC memos contained in court files shows that the firm had actually prepared its own five-year projections for the company that were much more conservative than Tribune Co. management's. By 2012, for instance, VRC expected Interactive to generate 27 percent less revenue than management did.
Yet in the end, the firm abandoned its own numbers and reverted to Tribune Co. management's. VRC officials declined to comment.
By December, documents show, JPMorgan had assigned Tribune Co. to its distressed credit unit. But despite the apparent weaknesses in VRC's opinion, the banks were unable to find an ironclad way to challenge it.
On Dec. 14, less than a week before step two was supposed to close, the four banks funding the deal held a lengthy conference call to discuss their obligations and where each stood. In notes that are contained in the bankruptcy file, Bank of America's Petrik kept track as a representative from each bank offered an assessment.
A JPMorgan representative said the bank hadn't yet decided but was leaning toward making the loans because the risk of not making them was greater.
Citi's Persily had "not yet landed," but she was leaning the other way since there was "more risk" if the company were to "end up in bankruptcy."
Kaplan at Merrill Lynch was "leaning not to fund" since it was "reasonable" Tribune was not solvent. Still, Merrill was "not planning on being a lone wolf."
Petrik didn't record BofA's leanings, but he noted without explanation that "if in good faith — good defense."
On the morning of Dec. 19, JPMorgan's Lee called Zell.
Despite the banks' pleading over the previous three months, Zell had never agreed to put in more equity. And Tribune Co., though it had earlier agreed to trim the debt by $500 million, had rejected various late-inning requests to restructure the deal.
Known as one of the pioneers of the syndicated loan business, Lee typically exudes the voluble self-confidence of a Wall Street heavyweight. But on this day, court records show, he was seeking assurances from a longtime client. He wanted to hear that Zell was committed to making the deal work.
"He said all the right things," Lee later reported to Dimon. In an email to another colleague, he wrote: "(Zell) could not have been any clearer and more confident that the company was solvent ... his reputation being totally on the line. ... I told him we were totally banking on him to make this work and he said 'I don't make commitments I can't keep.'"
That was good enough for Lee and Dimon. The next day, JPMorgan and the other banks closed step two.
Less than a year later, its media outlets still making money but burdened by too much debt, an insolvent Tribune Co. filed for Chapter 11 protection in U.S. Bankruptcy Court in Delaware.