Part two: Warning signs

As pressure built to make a deal, an army of bankers and Tribune Co.'s top executives saw red flags but forged ahead — with huge fees and other payments and incentives

January 14, 2013|By Michael Oneal and Steve Mills, Chicago Tribune reporters

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.

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