Part one: Zell's big gamble

Aside from the business suit he was wearing, which he joked was rented for the occasion, Sam Zell was never more himself than when he appeared at a New York lender conference in April 2007 to hawk his $8.2 billion buyout of Tribune Co.

Slinging one-liners and a couple of his trademark expletives, the self-assured billionaire held a crowd of potential backers in thrall as he explained why he was willing to bet his reputation on a transaction that other major investors had passed on.

"Nothing like inviting a rock star to a bank meeting," quipped Jimmy Lee, the vice chairman of JPMorgan Chase & Co., as he introduced Zell to a standing-room-only crowd.

What Zell said to his Wall Street audience about buying a media company almost mattered less than who he was — the I-don't-care-what-you-think real estate magnate from Chicago who had just sold his office building portfolio at the top of the market for an astounding $39 billion.

When one of the attendees asked what might crop up to make it difficult to close his exotic two-step transaction for Tribune Co., Zell offered his own brand of reassurance.

"You know, s--- happens, OK?" he said, according to a transcript of the conference. "So anything is possible. …"

It turns out Zell was right.

Far from becoming his latest financial triumph, the buyout of Chicago-based Tribune Co. devolved into Zell's most public failure — a messy product of the unchecked Wall Street deal-making and aggressive financial engineering that soon would threaten the American economy.

Pressed by restive shareholders and revved up by a growing bubble in the corporate lending market, the company's leadership and a group of sophisticated Wall Street bankers embraced Zell's vision, piling the company with a total of $13 billion in debt.

Despite signs that Tribune Co.'s newspapers and television stations were under growing pressure from a slowdown in advertising revenue, the executives and their bankers were confident that Zell could make the deal work by selling off key pieces of Tribune Co. and reinvigorating the rest with the kind of entrepreneurial spirit that had helped the billionaire generate his fortune.

Instead, Tribune Co. toppled into bankruptcy court less than a year after the sale closed, where it remained mired for four years. Zell's hand-picked chief executive, Randy Michaels, was pushed out amid a cloud of scandal, having failed in his attempt to transform an old-media conglomerate into a fast-moving digital competitor. And the company, whose local assets include the Chicago Tribune, WGN-Ch. 9 and WGN-AM 720, lost crucial time in its quest to develop a new business model.

Many participants were richly rewarded. A group of Tribune Co. executives got close to $150 million in cashed-out stock and other payments triggered by the deal, while the company's banks and advisers collected almost $280 million in fees — the kinds of compensation that helped drive the record boom in corporate buyouts that preceded the global economic collapse. But there would be significant costs, too. The deal blew up for the banks, and many of its architects face litigation aimed at clawing back their gains.

The only ones who truly may have something to smile about are the members of a powerful industry set up to profit from the inevitable boom-and-bust cycles on Wall Street. They include the massive investment funds that buy and sell the debt of troubled companies like Tribune Co. and the army of lawyers and other bankruptcy professionals who follow them around, charging as much as $1,000 an hour.

The complex legal snarl that resulted from the Zell deal subjected the company to an epic bankruptcy battle among these "distressed debt" gladiators that will likely sap its coffers of more than $500 million in legal and other professional fees. When the company emerged from Chapter 11 on Dec. 31, 2012, two of the players, Oaktree Capital Management and Angelo, Gordon & Co., ended up in control of the company along with JPMorgan, lead lender of the buyout.

Amid a torrent of criticism directed at the Tribune Co. deal, Zell — who declined to comment — defended himself by saying his plan ran into a "perfect storm." And few doubt that the transaction failed in part because nobody could predict what was coming.

The financial crisis hit with full fury in 2008, just months after the Tribune Co. deal closed, setting off a near-collapse of the economy and freezing the credit markets, which, in turn, prevented Zell from selling assets to pare the debt. At the same time, the digital media revolution gained steam, drawing advertising dollars away from companies like Tribune with a vengeance.

But interviews with several dozen participants in the saga and an examination of thousands of pages of court documents show that the Tribune Co. buyout was not just a victim of circumstance. It was propelled by many of the same forces that caused the economic collapse in the first place — an enormous credit bubble inflated by unregulated financial engineering.

This machinery had for years reliably generated billions in wealth for financiers and corporate executives alike. But the volume of money flowing through the system encouraged them to take ever-greater risks. So even as some recognized that a rollicking era of cheap-money capitalism was drawing to a close, many thought they could squeeze out one more high-wire deal, especially if an investor of Zell's caliber was involved.

One legacy of Zell's Tribune Co. transaction is that it captures the very moment in the summer of 2007 when the machinery began to seize up and shift into reverse, exposing the mania for what it was. Until then, the world's deal-makers were content to keep going, brushing aside the warning signs in pursuit of more profit.

As Charles Prince, then-chairman of Tribune Co. financier Citigroup Inc., told the Financial Times in July 2007, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

Pressure at the top

For Chicagoans, the corporate drama that unfolded inside Tribune Tower on Michigan Avenue would have been unthinkable when the first rumblings of a crisis appeared in 2006.

Not only was Tribune Co. a financially sound pillar of the Chicago corporate establishment, its history and the city's were tightly interwoven. The company's flagship newspaper traced its influence to a heritage that included the declaration "Chicago SHALL rise again" after the 1871 fire, and through the years the newspaper was a reliable booster of commerce and Republican politics. Dennis FitzSimons, who became Tribune Co.'s chief executive in 2003, enjoyed the support of his board. And big blocks of Tribune Co. stock rested in friendly hands, including the Robert R. McCormick Foundation, a company-affiliated charity.

But one early lesson of the Tribune Co. saga was that no CEO or company is insulated from the sweeping power of modern financial markets. By 2006, FitzSimons had come under pressure from an assortment of anxious shareholders fed up with a stock price that had languished for two years.

Tribune Co.'s newspapers and its television stations were suffering from the profound changes in advertiser behavior that were starting to rock the entire media industry. FitzSimons had seen the company's stock price rise to a peak of around $52 a share in 2004. By April 2006 it had plummeted 46 percent.

A native of Queens, N.Y., FitzSimons had risen through the television business to become one in a long line of conservative, by-the-numbers corporate chieftains who had run Tribune Co. over the decades.

He had surrounded himself with a proud group of mostly homegrown managers who were well-regarded on Wall Street for their ability to produce results. Yet as advertisers started defecting from traditional media properties, critics began to see shortcomings in FitzSimons and his team.

They charged that he lacked a bold vision for how to transform the company. Tribune Co. had won plaudits for investing in job search site and other digital efforts to capture some of the classified advertising revenue that was shifting online. But as the company struggled to meet the onslaught of new competitors like Google Inc. and Yahoo Inc., many observers viewed the Tribune Co. team as overly bureaucratic and unimaginative: strong operators, not clever innovators.

FitzSimons, who declined to comment, also had to cope with the legacy of a frustrating $8 billion deal in 2000 to merge with Los Angeles Times parent Times Mirror Co. The merger produced a bitter culture clash between the two companies that resulted in FitzSimons and his team being demonized in Los Angeles as zealous cost cutters despite the need to rein in spending at the Times Mirror properties.

That was distracting, but the more significant threat to FitzSimons' security was the growing unrest among the extended clan of legendary former Los Angeles Times publisher Otis Chandler. The Chandlers had controlled Times Mirror until the merger and held the second-largest block of Tribune Co. stock, after the McCormick Foundation.

They were furious that the family fortune had been diminished under FitzSimons' watch and frustrated that exiting their position required cooperating with Tribune Co. to dismantle two partnerships the family had put together to limit taxes.

Then in June 2006, the Chandlers brought matters to a head by launching a public campaign for FitzSimons' ouster. The CEO and supporters on the board pushed back. But what became clear in the following months was that even some longtime shareholders had had enough of the status quo.

The Chandler uprising gained energy from the biggest boom in debt-fueled finance since the corporate raider days of the 1980s. Just as the explosion in mortgage-backed securities was creating a gusher of money available to eager homebuyers who were increasingly less qualified for the loans, similar "structured securities" called collateralized loan obligations, or CLOs, were inflating what turned out to be a bubble in corporate lending.

Banks were funding ever-larger transactions on increasingly easy terms, making it seem as if any deal was possible. And as big Tribune Co. investors like John Rogers, of Chicago-based Ariel Investments, and Brian Rogers, at T. Rowe Price in Baltimore, looked around for ways to boost the value of their long-held stakes, they saw companies across the economy taking on debt to cash out shareholders either through buyouts or big special dividends.

Piggybacking on the momentum built by the Chandlers, these investors and others politely but firmly prodded FitzSimons to avail himself of an opportunity to restructure the company to boost the lagging share price, according to sources familiar with those discussions.

"Part of what the available credit did was drive a substantial amount of shareholder activism," said Citigroup mergers and acquisitions specialist Christina Mohr, one of Tribune Co.'s advisers. "There was this drumbeat ... return capital to shareholders, use the debt markets, give us back something. ... There was just so much money."

Tribune Co. went up for sale in September 2006, counseled by Citigroup and Merrill Lynch. Almost at once, a group of the nation's richest private equity firms began to circle and look at the company's books.

What they quickly discovered was that the clouds gathering over the publishing industry made it difficult to put together a deal that made sense. Even as it slipped in performance, Tribune Co. produced more than $1 billion annually in cash that could be used to pay down debt. But it was unclear how long the cash flow would last amid evidence that the industry might be in a permanent state of decline.

None of the bidders could predict the dramatic advertising slide that was to come. Still, the future was so out of focus that none was comfortable loading the company with enough debt to fund the payout shareholders were looking for, according to several sources.

While no traditional media company had unlocked the secret to success in the digital age, some would-be bidders were unconvinced the Tribune Co. team had the chops to figure it out. "There was no game plan," one suitor said.

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.

That's when Zell's people stepped in.

'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.

The approach was vintage Zell. It allowed him to take control of an asset-rich company by using maximum debt and minimum equity, which would limit Zell's initial risk but magnify his potential return.

The ESOP also satisfied another of Zell's investment goals: aligning the interests of a company's employees and management by giving all of them an ownership stake in its success. The deal would use up the $60 million Tribune Co. had laid aside to match contributions to employee 401(k)s. But as employees received new shares in the ESOP each year, the potential upside could be huge as Zell gradually paid down the debt.

Some employees embraced the idea while others worried that the ESOP exposed future company retirement contributions to enormous risk. They also complained that despite the fact employees ultimately would own more than 60 percent of the equity, they would have no representation on the board.

But Zell's team expressed every confidence that the deal would pay off and had the potential to make employees wealthy.

"I've seen a lot of heavily leveraged transactions," Zell told potential investors at the April 2007 lenders conference in New York. "This is the only one I've ever seen where the value of the assets is measurably greater than the amount of leverage we intend to put on it. ... We expect to help make one plus one equal six, which is basically our historical methodology."

A bridge too far?

For the many bankers involved — and hoping to get involved — in the Tribune Co. transaction, Zell's appearance on the scene was energizing. The stalled auction had meant the loss of another golden opportunity to earn big fees from the credit boom. Zell's emergence restarted the engines.

Julie Persily, formerly co-head of Citigroup's leveraged finance unit, was intrigued when Larsen called in early 2007 to ask about financing the deal. She knew nothing of Larsen, but his boss was a Wall Street celebrity.

"I was in awe of him," Persily said of Zell in a 2010 court deposition.

Persily's job at Citi was to make highly leveraged corporate loans, collect big fees, then slice the debt into pieces that could be sold to outside investors. Zell was a high-volume borrower whom Citi had courted unsuccessfully for years. This was a chance to get on his A-list.

Yet the more she examined what the Zell team had in mind, the more she began to wonder what the bank might be getting into, according to court documents. The Zell deal was so complex that she feared investors might balk, leaving Citi exposed to losses.

Despite the gloom hovering over the traditional media business, Zell planned to take out billions in new debt to fund the buyout while investing only a few hundred million himself, the equivalent of a 2.4 percent down payment.

"I am unequivocally not on board," Persily wrote in an email to a colleague a week after her initial contact with Larsen, now CEO of Tribune Co. broadcasting.

The structure of Zell's deal, she wrote, seemed "silly."

Documents show that other deal participants also had misgivings. Jeffrey Sell, former head of JPMorgan's special credits group, noted that the deal was "another step in the 'irrational exuberance' you see at the end of the cycle."

But Persily, Sell and the other doubters were eventually swept up in the deal's momentum. They would have front-row seats to the misadventures about to unfold.

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