6

BIDDING WAR

CORPORATE TAKEOVERS ARE undeniably fascinating. Call it corporate theater. Or a big-monied soap opera entitled As the Merger Turns. After all, they often feature strong personalities, power, greed, and intrigue. And, oh yes, money, lots of money. As in billions of dollars in cold hard cash.

Nearly twenty years after the largest takeover in corporate history—the $25 billion RJR Nabisco purchase by Wall Street leveraged buyout artists Kohlberg, Kravis, & Roberts in 1988—the blow-by-blow account of the $39 billion auction and sale of Zell’s Equity Office Properties is fascinating stuff.

This battle pitted two of the most dominant financiers in the world against one another. On one side was the richest man on Wall Street, the Ivy League-schooled Stephen A. Schwarzman and his buttoned-down, Park Avenue-based private equity shop known as the Blackstone Group. On the other sat a longtime friend of Zell’s, Steven Roth, the street-smart, Brooklyn-born, tough-talking head of Vornado Realty Trust, another major office building owner. Each sought Sam’s bulked-up prize, but after four months of bidding one-upmanship, only one would reward Zell with the billions he was seeking.

While real estate industry veteran Roth preferred to deal with the day-to-day bidding process himself, Schwarzman tapped into his own resident real estate deal maker, Jonathan Gray, to handle Blackstone’s bidding. Gray, a Chicago native, had earned a well-deserved reputation for creating enormous value for Blackstone. No major deal involving commercial real estate happened without his knowing about it, or instigating it.

Gray had his eye on EOP for some time. He well understood the growing disconnect between the company’s basement-level stock price and the value of its prime office buildings, which were literally climbing sky-high. He knew this firsthand after buying two other office REITs, Trizec Properties Inc. and CarrAmerica Realty Corp.

Still, Gray was slightly distracted as the fall of 2006 approached. He was smack-dab in the middle of his own megadeal, a $20 billion takeover of Hilton Hotels Corporation. When that deal ran into a few snags (Blackstone later reconstituted the deal and bought Hilton for $26 billion in July 2007), he was ready to track down an offer for EOP.

Though he knew it would be a megadeal of extreme proportions, Blackstone had the clout to raise whatever money it would take to buy the company. And Gray’s experience told him there would be plenty of ready bidders salivating at the prospect of snapping up EOP’s iconic buildings if they were ever to go up for sale.

Then and there, the hunt was on. And this time, Zell would be in the enviable position of seller rather than buyer.

KNOCKING ON THE DOOR

Potential suitors first flirted with EOP at the end of 2005. EOP’s stock price was hovering around $30 a share, and like many REIT executives, Zell was openly perplexed at the low valuation.

While Wall Street stock analysts were certainly walking all over themselves to see who could cut the most value from Zell’s real estate holdings, he was mindful of the public nature of his businesses and the thousands of shareholders who owned a stake in them. That helps explain why he shunned takeover defenses in any of his companies. And he believed that if someone made what he referred to as a “Godfather” offer, or one that was substantially higher than your projected valuation, then it had to be seriously considered.

Zell’s own internal analysis valued EOP at a share price in the high-$30 range. And he’s a stickler for knowing the value of his holdings on a moment’s notice. That explains why valuations are conducted about every ninety days on all of his real estate companies. This became an especially important point during the EOP sale process.

Over the next few months, a series of potential buyers came knocking, but none reached the formal offer stage. Then a breakthrough came in August 2006 when Blackstone’s Gray approached Zell’s advisors at Merrill Lynch about making a deal. Gray was proposing to buy EOP for $40 to $42 a share and sell off a third of the assets to another large public office company.

The overture drew a tepid response. “Our attitude has always been that if an offer came and was marginally better, that’s probably not something we would consider,” said Zell. Still, the offer effectively meant that EOP was “in play,” meaning it would quickly draw attention from other buyers. Blackstone knew this, and Zell began his favorite deal dance, playing hard to get. Remember that the commercial real estate markets were at their absolute historical zenith, and Zell played his hunch that Blackstone, and hopefully a few other buyers, would continue to dance with him, but on his terms.

His hunch was right. Three months later, Blackstone came knocking again, this time with an offer of $47.50 a share, all in cash. Zell was openly shocked at the number and the EOP board agreed it was worth pursuing. Zell and Gray began a series of nonstop negotiations, which produced a price of $48.50 per share. On November 19, 2006, Zell and Blackstone signed their merger agreement and set a closing date of February 7.

While the outside world marveled at the size of Blackstone’s offer and the surety of its purchase, Zell knew better. He wanted to press for more. To Zell the experienced deal maker, this was only the beginning of what he hoped would be a protracted auction process that would extract even more value not only for himself but also EOP’s shareholders.

Over the intervening months, Zell fully expected to see more bidders step up to the plate. The goal was to create an auction among highly competitive bidders, which would ultimately yield a higher purchase price. But even if he didn’t get a penny more, cashing out at $48.50 was not so bad.

Zell’s negotiating style is best described as blunt. He dissects the facts and figures, and he also looks for any angle, any loophole, that he can leverage to his advantage.

In this instance, Zell put his legal training to good use, giving himself an enviable bargaining position thanks to a key provision he installed in the Blackstone agreement. Every megadeal includes what is known as a breakup fee, or a negotiated sum that the seller (Zell) agrees to pay the original suitor—in this case Blackstone—in the event that another bidder offers a better deal and the new purchase is finalized. It amounts to compensation for the original bidder’s time and expense, sort of a salve for having to walk away.

“The real negotiation at that point was not so much about price but about a focus on the breakup fee,” Zell noted. Normal breakup fees in merger transactions average between 2 percent and 3 percent of the sale price, an amount that is significant enough to discourage the seller from siding with a competing buyer. But the fact that Blackstone clearly wanted what Zell was selling more than he wanted to sell it allowed him to strike a hard bargain, amounting to only a .91 percent breakup fee.

Zell’s unique ability to assess every angle of a transaction brought into sharp focus two key points. First, in Blackstone he was facing a tough negotiator and a well-connected Wall Street powerhouse. Zell was well aware that Blackstone had the ability to impede an auction if it so desired, simply by tying up monies that potential bidders would need.

“Now I’m sure there is no question that Blackstone is above reproach,” Zell opined in his typical tongue-in-cheek manner. “The fact that they decided to finance their $32 billion offer with 16 banks at $2 billion instead of 3 banks at $10 billion might have suggested perhaps they were thinking that if they could get 16 banks for $2 billion each there weren’t going to be a lot of fucking banks left to finance a competitor. At a certain point in the transaction I was forced to remind them of that provision.”¹ This included a tense face-to-face breakfast with Blackstone’s Jonathan Gray in New York.

Zell also carefully stacked most of the cards in his favor, as he turned up the pressure on Blackstone with a strict confidentiality agreement. Immediately following its purchase, Blackstone was keen to sell off many of EOP’s buildings as quickly as possible to pay down the exorbitant debt Blackstone was heaping on the company. Initially, Zell prohibited Blackstone from talking with potential buyers to prearrange sales ahead of the closing, because he felt that would taint the sales process.

As the clock ticked nearer to the February 7 closing deadline, Zell started getting antsy. December came and went with no serious counteroffers. Not content to wait, Zell’s inborn sense of humor and proclivity for the unconventional had him goading his old friend Roth, at Vornado, to step into the bidding war. Roth and Zell had held numerous conversations over previous months about merging their companies, but now Zell needed to see some concrete interest. He sent Roth a cheeky note, reading, “Roses are red, violets are blue, I hear a rumor, is it true?”

It was a simple tactic that seemed oddly out of place for a multi-billion-dollar deal. Yet it was indicative of Zell’s direct style. And it worked. The next day, Roth replied, “Roses are red, violets are blue, I love you Sam, my bid is $52.”² That $52 a share offer was structured with 60 percent of the purchase in cash and 40 percent in Vornado stock. Roth would keep half of EOP’s buildings on the East Coast and divvy up the rest to investment partners Starwood Capital Group and Walton Street Capital.

Unfortunately for Vornado, the calendar read January 17, and the February 7 deadline for closing Blackstone’s deal was only three short weeks away.

Fortunately for Zell, he now had another offer with which to twist Blackstone’s arm to extract a higher bid. He gave Gray a quick call and suggested that Blackstone increase its bid to $54 all cash with no contingencies. In exchange, he would raise the breakup fee to $500 million. “We convinced them that was a prudent decision on their part, amended the agreement, increased the breakup fee and we got the deal to $54 all cash,” said Zell.³

It appeared that Vornado was punted out of the game. But only three days before the deal closing, all hell broke loose. As the rest of the world was enjoying Super Bowl Sunday, just as the second half of the game was starting, Zell received a surprise call from Roth—Vornado threw a $56 offer on the table. Though the price was certainly right, time was about to run out. Because Vornado was a publicly traded company, it would take quite a bit longer to approve the purchase, including approval from the Securities and Exchange Commission.

Zell’s hand, however, had not been fully played. He knew full well how much Blackstone coveted EOP’s assets. He pushed the envelope, and Gray’s patience, to the wall, telling Gray he would hike the breakup fee to $700 million and allow Blackstone to start talking to potential buyers.

Ultimately Vornado bowed out of the contest, and the deal closed at $55.50, all cash. In the end, Zell had managed to extract a 15 percent premium from Blackstone over its original bid months earlier. And his legend reached epic proportions. “In a postmortem, it is all about certainty. It is all about eliminating the options and intelligently assessing risk as it should be,” said Zell matter-of-factly.⁴

It is also about great timing. This high-stakes game of corporate chicken was conducted during the height of the lending frenzy brought on by Wall Street’s powerhouses. Consider its dynamics. Here was a whopping $39 billion deal, the largest corporate takeover in history at the time, in which the buyer, Blackstone, put up only $3 billion of equity—less than 10 percent of the final purchase price. There was $32 billion of debt, and the investment banks put up $5 billion of bridge or short-term equity.

In the end, Blackstone earned a hefty 60 percent return for its investors. At the same time, Zell looked like both a genius for selling at the top of the real estate markets, but also like a fool for allowing anyone other than him to earn a 60 percent profit. This is a point that Zell quickly dismissed, noting that Blackstone had taken an extraordinarily bold risk to earn its reward.

Zell saw a narrow window of opportunity to quickly reap what he had spent decades sowing. He was proven right, as less than a year after the EOP sale, the financial markets had begun to go into a full lockdown mode.

WORK TO DO

Spending $39 billion was surprisingly easy in early 2007, but recouping it would be another story, and Jonathan Gray had some work to do to beat the ticking debt clock. To make the EOP deal work, he was arranging piecemeal sales of some of the company’s prime assets even before it closed. Legendary New York developer Harry Macklowe purchased eight of EOP’s buildings in the Manhattan office market for $7 billion on the same day Gray was closing Blackstone’s deal to buy EOP. That bit of gambit saved Blackstone some $200 million in New York City and state transfer taxes.

The ink had barely dried on the sales contract before Gray was playing sales director for the bidders salivating for a piece of EOP’s pie. First in line was Macklowe. That deal would go south quickly on him, though, as the commercial real estate markets took a nose-dive in late 2007 and Macklowe was forced to sell his prizes at a significant loss.

Gray continued to up the pace, taking advantage of the red-hot office sales market to unload 19 buildings in Washington, D.C., and 17 more in Seattle to Beacon Capital Advisors for $6.35 billion. Another group of 17 buildings in Portland, Oregon, were sold to Shorenstein Co. for $1.2 billion. In less than a month after closing the largest corporate takeover in history, Gray had managed to pay down more than a quarter of the debt. Six months after the closing, he had orchestrated the sale of more than 60 percent of the assets and recouped 70 percent of its purchase price.

For Zell, the Blackstone transaction finally vindicated his much-maligned purchase of Spieker Properties in 2001. By selling out, all of EOP’s holdings were essentially valued at $54 a share versus the $29 a share he paid for Spieker. At least that’s one way of looking at it.

After the Blackstone merger, even though Zell’s pockets had been richly lined with preposterous amounts of cash—an estimated $1.1 billion—he was not shy to lament on the frothy nature of the proceedings.

To Zell, the demand for his properties had little basis in reality. It was more a function of who had the most money to spend and who could spend it the fastest. Though Zell had established a track record for owning quality properties, it mattered little to the market of early 2007. The frenetic pace of deal making and the long lines of potential buyers left little time to actually see what was inside. Instead, it was all about doing the deal.