An Untapped Investment Environment for Hedge Funds
Neil Finnegan 12/20/2010
My name is Neil, and I am addicted to sports. There, I said it. Whatever it is, where it is, who it is, it doesn’t matter. If there are two teams or two individuals competing I will watch it. Even as I finish this paper I am witnessing a spectacular implosion by the New York Giants against the Philadelphia Eagles, this one will be talked about for years to come.
What is worse is I have no intention of finding a cure for this “problem.” When I was preparing to move to New York from Ireland I remember people asking me what will miss most about home. The one thing I was worried about was the time difference, would I still get to see Manchester United on weekends and what was I going to during the week when games were kicking off at 3 pm EST. Sad, I know, but what can I do, I have an addiction that I live with every day of the week.
If only there was a way to treat sports teams and individuals as stocks and shares, maybe then I could use my knowledge to make some cash.
But wait……has this already been done? Did it really take me all this time to realize that financial institutions and individuals are already playing this game? Have hedge funds in particular already shown an innovative side and identified this alternative asset class in pursuit of returns that outperform stocks and bonds?
These are the questions I will attempt to answer over the course of my paper and I will also try and identify a couple of scenarios where I think equity may be undervalued.
Firstly I want to talk about perhaps one of the most high risk items you can find to invest in – a person. A fund with a high risk tolerance will look for certain characteristics in an asset class -volatility, irrational behavior, unreliable and exposed to so many macro-economic factors. Egotistical sports stars have these characters in abundance. All you have to do is find the right time to buy, outline your exit strategy, and sell before Mr. Superstar stops hitting grand slams or making 3 point shots from the half way line. Once you’re done with player X you find player Y, simple.
In recent years the issue of third party ownership in the soccer world has reared its ugly head. Apart from the complications of who actually owns the player there is also an ethical question to be asked. The morals of the situation are probably a subject that could be covered in a separate paper at a later date, so for now I will stick to the business side of things.
The chief instigator of this phenomenon is Mr. Kia Joorabchian, an Iranian born British educated fund manager who “represents” some of the most talented soccer players in the world. The co founder of American Capital, the former trader has taken everything he has learnt from the fund world and applied the same investment principals to the soccer world.
In 2004 Joorabchian found Media Sports Investments which is a London based international investment fund. The first move of the fund was to enter one of the most fascinating soccer markets in the world – Brazil. Brazil and South American soccer fascinates me; it is probably the one soccer region in the world where soccer is still soccer. By that I mean, it is still pure, untouched by capitalism and Rupert Murdoch, the continent offers a no frills experience to watch soccer.
The strategy of the fund was not obvious at the time. Hiking up ticket prices was not an option as attendances were already low, TV revenue was non existent so a big piece of that cake would be worthless. The pan South American competition, Copa Libertadores is not exactly awash with cash either.
The strategy of fund would be the players, buy and sell, just like Joorachablin would do with stocks whilst he traded at the New York stock exchange. The fund took over Corinthians, a Brazilian football club and the fund would purchase the players that Corinthians could never afford. The players would be bought by the fund, play for the team and then sold whenever the fund stood to make a profit.
The most successful trade was that of Carlos Tevez. Widely regarded as one of the best young players in the world, the Argentinean was traded to Corinthians from Boca Juniors (Argentina) for $22 million in 2004. An unprecedented amount of money for a transfer in South America.
So now the fund had a presence in the soccer world, but the problem was that this asset that they had just acquired was not in the correct market. Europe is where the cash is and Europe is where they went when Tevez was traded to West Ham United in London, England. A number of impressive seasons with West Ham and then Manchester United led the Argentinean to Manchester City, and this is where the return was made.
During the period with West Ham and Manchester United MSI maintained the economic rights over Tevez, meaning they could trade him whenever they seen fit and collect a percentage of his salary.. Manchester City were the team to who looked to end Joorachablins involvement but it did not come cheap. The bill to cancel this 3rd party ownership was estimated to be $70 million in the summer of 2009. That is a return of 218% in 5 years.
And there is evidence that such a policy that has been used elsewhere. For years Portugal has been the destination of choice for young South American players, particularly Brazilians. Apart from the cultural similarities the football is less physical than the type played in northern European countries, allowing this superior technical ability to flourish.
The First Portuguese Football Players fund was setup in 2004 with the intention of investing in football players. With 3rd party ownership legal in Portugal the fund was able to go about its business without being shrouded in secrecy, unlike Media Sports Investment.
Not surprisingly, the most profitable football club for the fund was FC Porto. Perennial participant in the Champions League, Porto were able to showcase their players on the biggest stage of them all. Much like a hedge fund would stress test a new trade on the market, Porto would pit their young players against the best in Europe and quite often these young players would not be out of their depth.
So a combination of talented young players, playing on the biggest stage of them all guided by a certain Jose Mourinho set the scene for this fund to make some astute investments. The fund would purchase a percentage of the player’s economic rights, anything up to 25% and then profit on any sale.
Much like any economy, the sports world is cyclical. A franchise spends years creating a team able to compete at the highest level and when they reach the summit what is there left to be achieved? This is exactly what happened with Porto, not only were they able to compete in the Champions League but in 2004 they actually won it, and suddenly each member of the team was sought after by the European heavyweights. The cycle was complete and the team was to be broken up and rebuilding process would begin. Like any asset that is in demand the price goes up and Porto sold these assets in the summer of 2004 and 2005 for a combined total of well over 100 million Euros and the fund made a return of 33%.
This type of return has not gone unnoticed in the hedge fund industry. The Football Fund, launched at the beginning of 2010 is an arm of the hedge fund company London Nominees Ltd.
By investing in clubs with huge growth potential and players who offer the chance to generate excessive returns the fund provides an absolute alternative to traditional, equity based asset classes. Add in a 2 year lock up, a 2% management fee and a 20% incentive fee and you have the first ever football hedge fund!
But this fund in my opinion is fatally flawed. Not because of the strategy being employed, but because of the personnel being consulted on potential investments. If I was going to invest in a hedge fund I would want to know that I am investing in knowledgeable personnel who are at the top of their field experts in the industry. The Football fund does not have these components.
Instead of advisors who are at the cutting edge of the football world the people advising the fund have not been relevant for the past 10 – 15 years. With all due respect to Bryan Robson, Peter Reid and Jim Smith they are not exactly amongst the aristocrats of football academia. None of them have coached at the highest level in 10 years, they don’t come across as articulate in their TV punditry roles and their knowledge of the current game is limited. When investing in a football hedge fund, this is not the caliber of personnel I would want to be relying on.
To but it in American sports terms, who would you want advising a potential basketball hedge fund, Phil Jackson or Isaiah Thomas?
But ignoring this fatal flaw for the moment, what area will this fund look to invest in. I have already discussed the profits that can be made by investing in individual players economic rights, and I am sure the football fund will look to profit in the same way. Another potential investment is the potential for clubs to grow and generate extra revenue.
A strong case can be made for Borussia Dortmund. One of the most famous football teams in Germany whose average attendance for home games is 80,000.. The second highest in Europe behind FC Barcelona. For so long this “blue chip” German team has been conspicuous by its absence from the Champions League. Where exactly have they been for the last 10 years?
Having first floated on the Frankfurt stock exchange in 2000 at 12 euro per share the club went on an ill-advised spending spree. The money generated by this floatation was squandered on inflated transfer fees and excessive salaries being paid to players that were well past their prime. A combination of poor financial decisions and miss management almost led the club to relegation from Germany’s top flight, an unthinkable scenario for one of the biggest clubs in Germany. Could you imagine the Chicago Cubs being demoted to AAA baseball!
Despite avoiding relegation the club found itself on the brink of bankruptcy in 2005, and if it was not for understanding creditors and bank managers agreeing to defer rent on the stadium until 2007 the club may well have ceased to exist.
The situation in 2005 is a typical distressed debt scenario that a hedge fund will look to profit from. A company runs into financial difficulty due to poor management and an under-performing product and as a result liabilities are exceeding assets. The balance sheet requires restructuring so why would a hedge fund not invest in the bonds of Borussia Dortmund? Just because it is the sports industry does not mean it should be avoided.
One of the most important factors to consider when investing in a companies debt is future cash flows. The company needs to be in a position to generate cash flows in order to meet their debt obligations.
If it was 2005, and a hedge fund was looking to implement a distressed debt strategy I think it would be hard to find a safer bet than Borussia Dortmund for a number of reasons.
The first is the fans, and the exploitation of these fans. Soccer fans are often more loyal to their teams and their beer than they are to their spouses. 80,000 people attend every game and they are not going to stop attending due to the involvement of a hedge fund. In this area Dortmund have been particularly poor in generating revenues, as the below graph shows.
The above chart displays the revenues generated by the op European clubs on match days.
Over the course of the 2008/09 season just 22 million Euros of revenue was generated on match days by Dortmund. Compare this to Liverpool and Tottenham Hotspur whose attendances average around 40,000 but generate twice the match day revenue of Borussia Dortmund and the scope for growth is enormous. A 5 – 10% increase in ticket prices could be implemented relatively easily. Fans will complain and protest but ultimately they will still buy up tickets. This was the case with the high leveraged buy out of Manchester United. Since the 2005 takeover ticket prices have gone up 30% , fans protest and complain but the stadium is still full every week. Call it exploitation or good business, one thing that can’t be argued is that it guarantees solid cash flows.
Another reason why I think this case would have been a safe bet and the company will be able to meet their debt liabilities without a problem is because the culture of the company has changed. The previous management team has been ousted and there is now a heavy reliance on youth instead of expensive veterans. This may well be due to the economic necessity of the situation but the heavy spending days of the past will never be revisited.
The above graph illustrate just how the companies culture has changed, over the first 4 years of the previous decade over 90 million Euros was spent on transfer fees and salaries. Since then the club has made a profit of 5 million, a massive shift in the clubs strategy.
Obviously The Football Fund was not around in 2005 and could not take advantage of this distressed debt situation. But what is the clubs situation in 2010 and is there a chance to profit from an investment.
A component advisor to the fund would recognize the current squad as being young and talented with massive potential to command a substantial transfer fee in the future. The team currently sits 10 points clear on top of the German national championship so participation in next seasons Champions League is almost guaranteed. This is the key – The Champions League. Participation can be worth up to 15 – 20 millions Euros annually. The likelihood is that this team will participate in The Champions League for the next 2 maybe 3 seasons. After 3 seasons the cycle will be complete, similar to the case of FC Porto!
A look at the current share price also reflects the expectation that the team will be successful over the next 3 -4 years.
The current price is 2.48 Euros and represents a YTD return of 140.78%. As far as I can tell the main reason for these excessive returns is the performance of the team and the anticipation that the team will qualify for the Champions League next season. Investors are buying into the stock because they feel that is a value investment. They feel the stock is undervalued and the potential for excessive returns are enormous.
To put things into context, the current share price of Ajax FC, a Dutch football team from Holland is 6.95 Euros. The Ajax story is somewhat similar to Dortmund. A massive team who underperformed for years and have only recently rebuilt themselves into a force.
When I compare Dortmund’s share price to Ajax and consider that Dortmund’s share price was once 12 Euros, I would have to conclude that this is an outstanding value trade.
As an alternative to investing in the company’s equity and going long, The Football Fund may also consider investing in the company’s debt.
In light of this I have put together a cash flow projection for the next 5 years.
But how risky is it to invest in these companies? In many ways it may be more efficient to invest in the stock of a sports team than that of GM or Boeing. These teams have local news outlets covering them every single day. Radio stations cover teams for hours and hours and sometimes TV stations coverage of a team or individual can reach ridiculous levels. (I’m looking at you ESPN and your coverage of Brett Favre over the last 4 years and the recent LeBron James circus)
If all this information is readily available could betting on sports teams and sports results be easier than playing the stock market?
Would it be possible to build statistical models to predict the result of a game and most importantly, strip away the emotional element of the decision making process when betting on sports.
5 years ago, Mark Cuban floated this very idea. His intention was to launch a sports betting Hedge Fund arguing that betting on sports results is easier than betting on the stock market.
The idea did not take off for a number of reasons but that did not mean that somebody else cannot implement the strategy.
Focusing on high frequency value trades in the sports markets The Galileo Managed Sports Fund was launched in April 2010. The fund is targeting an annual ROR of between 15 – 25 % and intend to charge 2% Management Fee and 30% Incentive Fee.
The fund will be betting on soccer, tennis, cricket, horse racing and golf, with plans to expand to the NFL and baseball over the next year.
Only time will tell if the sports market is a successful investment environment for hedge funds. My opinion is that The Galileo Managed Sports Fund will outperform The Football Fund, due to the sub standard consultancy at the hands of The Football Fund.
But conditions do exist for common hedge fund strategies to be implemented.
Value trades are on offer when investing in the economic rights of individual football players, a Distressed Debt trade could have been utilized in the case of Borussia Dortmund or a long position could have been undertaken in Dortmunds equity, and as I have just discussed high frequency trading is about to take off.
