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A merger deal aimed at reaping huge tax benefits soon became a casualty of the declining economy, credit crisis, and its own leverage.
b) Purpose of the Paper
The purpose of this paper is to analyze the problems facing leveraged buyouts when such buyouts go wrong in the face of declining economic conditions.
c) Overview of the Paper
This paper starts with the analysis of the facts related to the acquisition of Tribune by Mr. Zell in a deal aimed to gain large tax advantages. It then analyzes how the deal collapsed as well as its consequences on the company, shareholders, and staffs.
Facts of the Case
In the face of economic recession of 2007-2008, it became difficult for many companies to remain liquid enough to meet their financial obligations. Some companies collapsed while others sought for mergers to ensure their survival. One of the most affected companies was Tribune, a publishing company, which had gained popularity in the United States over the years. On April 2, 2007, the Tribute (Tribute Corporation) announced the acquisition of its publicly traded shares in a multistage transaction prized at $8.2. The corporation owns 23 television stations, 9 newspapers, 25% of Chicago Cubs baseball team and Comcasts Sports Net Chicago. The main source of revenue came from publishing accounts, which accounted for 75% of total revenues. The remaining revenues came from entertainment and broadcasting. Between the year 2004 and 2006, circulation and advertising revenues at firms three largest newspapers fell by 9%. Consequently, Tribunes stocks fell by more than 30% despite aggressive efforts to minimize costs.
Consequently, the firm secured an acquisition plan with specialist Sam Zell to turn around the company, where he would acquire the company and become the CEO. The deal entailed a two-stage transaction, in which Zell would first acquire a 51% controlling interest (126 million shares), then a backend merger that would acquire the remaining shares would follow. In the initial stage, Tribune commenced a 126 million shares cash tender offer for $34 per share, amounting to $4.2billion. Sam Zell provided $250 million of $315 million in the form of subordinated debt, then additional borrowing would cover the remaining amount. Stage 2 of the deal started when regulatory authorities approved the deal. This stage involved ESOP buying the remaining shares at $ 34 per share, which amounted to $ 4billion. Consequently, Zell delivered his pledge of the remaining $65 million. ESOP purchased most of the shares through debt, which the firm guaranteed on behalf of ESOP. Mr. Zell, on the other hand, got a 15-year warrant enabling him to acquire 40% of newly issued common stock for the funds he provided at a set price of $500 million (Sherman, 2010).
After December 2007, the company would channel all employee pension contributions into ESOP as Tribute Stock. Eventually, ESOP would hold and control all the stocks. In addition, tribute transformed to a subchapter S corporation from a C corporation, which allowed the company to avoid paying corporate income taxes. However, the company would still pay taxes on proceeds arising from sale of assets held within ten years after the conversion (Kaplan, & Stromberg, 2008).
The conversion of Tribune removed $348 million of current yearly tax liability. Subchapter S corporations do not pay any corporate taxes. However, they pay all profits to shareholders directly, who in turn pay taxes on their share of the profits. In this case, Tribute would be tax-exempt since ESOP, the sole shareholder, does not pay taxes (Kaplan & Stromberg, 2008).
In an attempt to lessen Tributes tax burden, it announced entering a partnership with Cablevision Systems Corporation. In this case, the latter would acquire 97% of Newsday at a price of $650 million. However, Tribute was not able to make a sale for Chicago Cubs. A sale was expected to bring $billion and Sports Net Chicago in the face of the 2008 debt crisis. With the worsening economic conditions, TV and newspaper advertisers' revenues continued declining, thus diminishing firms ability to pay its debts. Consequently, the company filed for bankruptcy protection by means of Chapter 11 as it tried to restructure its business while seeking reprieve from its creditors.
This is a leveraged buyout (LBO), which refers to an acquisition of a target company through debt funding. Financial buyer or the acquirer invests very small amount of capital comparative to the overall purchase price and uses leverage to pay the remaining amount of the consideration. In the case of Tribune acquisition, Zells actual cash contribution was less than 4% of the sale price of Tribunes shares (Kaplan, & Stromberg, 2008). Debt financed the purchase of almost all Tributes stock. The transaction left Tribune with a debt burden of $13 billion, a level at which the debt was 10 times EBITDA. This exceeded 2.5 EBITDA average in the media industry. Annual debt repayment, including the principal and interest, reached $800 million, which was almost three times what the company was paying before the acquisition. ESOP was not legally responsible for the debt secured by Tribunes asset despite the fact that the former owned the Tribune.
When planning to undertake an LBO, both the acquirer and sponsors should conduct a thorough LBO analysis to ensure that the overall burden does not lead the company to the point where it is not able to meet its obligations. The first step of the analysis involved developing operating projections and assumptions for the company to come up with EBITDA and resources available to replay the debts over investment period of usually three to seven years (DePamphilis, 2010). However, Zell and his sponsors did not make the analysis, which consequently resulted in the overburdening the company with debts. In fact, it only took one year for the company to sink into bankruptcy due to the inability to pay its debt obligations.
From the onset of the deal, one would think that Mr. Zell intended to help the company recover from its financial problems (DePamphilis, 2009). However, the details of the deal and the eventual bankruptcy of Tribune prove the opposite. There was a general trend of declining revenues for the company due to overall decline of the printing industry. For this reason, Mr. Zell could not pay for the takeover through equity. He chose to use subordinated debt, which meant that in the event of a bankruptcy, he had priority over other creditors and staffs of the company. This meant that he would be the eventual beneficiary of the deal.
Tax schemes initially intended to save the company from its tax liability did not make any sense to Tribune because it had one shareholder, ESOP, which happened to be tax-exempt. This meant that all funds generated by the company ended up with the shareholder in full.
Mr. Zells acquisition of Tribune was initially intended to save the company from its stagnation caused by reduction in revenues from their main newspapers, among them Chicago Tribune, Los Angeles Times, and Newsday. However, this merger put the company into debt to the point where the company could not pay interest and principal of the debt arising from acquisition deal (Gaughan, 2010). Mr. Zell and his sponsors benefited a great deal after the bankruptcy of Tribune since they had secured their debt. The staffs and other creditors of the company, however, became the largest losers of the deal. Since Mr. Zell had secured his debt, the staffs would get their share after his pay. This is a clear illustration of problems faced by firms heavily funded by debt.