Introduction
Dry powder in private equity has swelled since 2013 to almost $3 trillion. With this record amount of dry powder and recent run-up in asset prices, firms are eyeing alternative assets to capture uncorrelated returns and diversify their portfolios. Over the past decade, sport franchise values have skyrocketed and grown rapidly when compared to nearly every other asset class. Continual increases in long-term television rights and media rights renewals have pushed professional sports team values to record levels. However, these sky-high team valuations have posed a challenge to limited (minority) partners seeking liquidity. It has been a struggle for these owners to find buyers who are able to purchase their franchise stakes and tolerate the potential risk of operating losses and capital calls. As a result, leagues have adjusted their regulations and opened the floodgates to allow institutions to take advantage of this elusive investment opportunity, despite fan pushback.
The best example being in early 2021 with the European Super League and the disarray it caused among fans. The idea was motivated by money, since each founding member stood to gain approximately $400 million, not including any commercial income they would generate throughout the season. Fans saw this as a greedy move made by Wall Street that sacrificed tradition for the opportunity to generate additional profit, which led to the proposal quickly being scrapped. However, private equity deal activity within the realm of sports has just begun to heat up, with Dyal Homecourt Partners investing in the Phoenix Suns, Fenway Sports Group acquiring the Pittsburgh Penguins, and Arctos Sports Partners purchasing a 13% ownership stake in the Golden State Warriors. Further, several first time funds are being established for the sole purpose of sports investments, with other institutional investors tailoring their funds to meet requirements set out by leagues. With all this investor attention and dry powder, what does private equity mean for fans’ experiences? Will Wall Street once again put profit before people and wreak havoc on sports?
History of Private Equity Investment in Sports
Private equity firms are investment managers that deploy capital to acquire ownership in companies not publicly listed on stock exchanges. Historically, pro- fessional sports franchises were largely owned by sole proprietors and families. As the popularity and value of the franchises grew, ownership of sports franchises became syndicated through local affinity. At one point, institutions like newspapers and entertainment conglomerates owned majority stakes in professional sports franchises, but were forced to sell due to internal governance, which led to diminished franchise values in the marketplace. North American leagues subsequently disallowed institutional investors from acquiring ownership stakes in teams for the better part of a decade.
Over the past 18 months, the lockdown measures imposed by the COVID-19 pandemic have forced leagues to halt gameplay, which has significantly impacted revenue streams with obsolete game-day revenues and deterioration of media and merchandise revenue. As a result, sports teams have been strapped for cash and needed to find new sources of capital, which is one of the catalysts for the recent change in ownership regulations. In addition, several North American leagues have opened doors to institutional capital and loosened restrictions because of rising sports team valuations, which have made selling minority stakes challenging due to a limited buyer pool. The sports and live entertainment industries are also in the middle of several prolific industry trends, which require additional capital in order to fully capitalize on high growth opportunities. Leagues have taken an innovative approach to allow for private equity firms to make investments in multiple teams and leagues through specially designed institutional funds.
Why Invest in Sports?
When comparing major sports teams to stock market indices, it’s evident that the growth of sport franchise values have outpaced annual market returns, while historically being more stable investments with a high degree of predictability and When comparing major sports teams to stock market indices, it’s evident that the growth of sport franchise values have outpaced annual market returns, while historically being more stable investments with a high degree of predictability, unlike any other alternative asset class.
Sports platforms are an attractive investment for private equity firms because of strong industry tailwinds and stable cash flows. The market opportunity for investments in professional sports franchises and all of their related assets in the 5 major North American sports leagues and the premier global sports platforms around the world is immense, with an estimated total addressable market of $400 billion. The sports ecosystem sits at the center of a series of compelling secular trends, including live events, digitization, data analytics, and international growth, with strong tailwinds that have even accelerated post-COVID. Furthermore, sports have historically been uncorrelated with other asset classes, as a result of high recurring revenues (70%–80%+) and an endless supply of live content, which provides premium intellectual property rights. The MLB and the NFL have each signed lucrative renewals with their television partners recently, which are projected to increase investor interest in sports franchises due to the scarcity of these assets. In addition, there is constant innovation and evolution in the business of sports, with the advent of digital technology and growing financial sophistication in the space. Moreover, strong customer loyalties shield franchises from demand risk and revenue volatility. There is no other programme aside from sports that delivers a guaranteed audience of a specific demographic at a fixed time.
Customer loyalties within sports span generations and are increasingly becoming global, which gives teams strong pricing power. The word fan is synonymous with the word fanatic, which is a very unique type of customer due to the emotional equity that is generated from the experience of watching sports. Dedicated fans scream in unison over the hatred or love for different teams, paint their faces, and sometimes even riot over what they believe to be bad calls. This type of devotion cannot be experienced anywhere else. Additionally, sports franchises each operate in one of the best markets in North America and have legal monopolies with geographic exclusivity through their ancillary businesses and fan base, which provide extensive opportunities to build a comprehensive platform.
Transaction & Fund Structure
Many traditional fund structures and architectures have limitations when underwriting sports investments. Private equity firms typically acquire businesses through leveraged buyouts and use significant amounts of debt to structure their deals, but this is not favorable for sports franchises due to increased default risk. As a result, leagues have set regulations restricting the use of leverage, which means deals (minority or majority stake) have to be fully funded by equity. Investors are also prohibited from using a franchise’s assets as collateral in back- levering situations. Although there is little to no leverage involved in sports investments, return profiles are still attractive with average internal rates of return (IRR) of 15%–20% over a 10+ year holding period, which is comparable to core private equity investments from giants like Blackstone and KKR. Private equity firms also face restrictions in the influence they can have as owners. In contrast to their typical role as control owners, leagues want firms to be passive, long-term investors who provide resources to teams whenever possible, which is difficult for traditional fund architectures to follow. Many leagues like the NBA only allow sub 30%, non- controlling interests in franchise purchases and require private equity firms to have at least 10 years left on their fund life in order to be considered for league approval. Additionally, private equity investments in sports franchises are expected to have longer holding periods or utilize an evergreen model structure, which is an open-ended fund structure that has no termination date. Capital for many future private equity sports deals is expected to be raised via evergreen funds because they don't put as much pressure on teams to hit investors’ return-on-investment targets. Arctos Sports Partners are an example of the ideal investors, as they are committed to non-controlling interests with sub 20% stakes in teams.
Due Diligence
Although there are unique intricacies that need to be considered when analyzing sports platforms, the due diligence process as a whole is very similar to that of traditional private equity investments. A discussion with Robyn S. Slutzky, a Partner and the Head of Capital Solutions at Arctos, provided additional insight on the due diligence process and the key criteria the firm evaluates. Based on the conversation, sports investors aim to identify the best assets and management teams with incredible visions for growth and build a portfolio of exposure across leagues, metropolitan markets and ownership groups to diversify idiosyncratic risk and deliver enhanced returns to investors.
When conducting due diligence, Arctos aims to find “growth assets with compelling financial and operating performance and an opportunity to provide liquidity and growth capital in a historically inefficient market.” Key characteristics Arctos considers are sophisticated ownership groups with long- term vision, strong management teams with proven business-building execution, attractive markets with demographic tailwinds, strong brand and fan loyalty, a deep local buyer base and/or concentration of wealth, ancillary assets such as real estate, and additional revenue growth opportunities.
For Arctos, the due diligence process starts once the firm has identified a potential partner or counterparty and have had some reasonable discussion regarding their terms. The scope of diligence falls into three key categories; the league, the franchise, and the platform assets the franchise owns. Depending on the league, 40%–80% of a team’s economics are generated at the league level, which makes it crucial for Arctos to take a holistic approach to diligence. Regardless of the team, they already know about 40%–80% of its value since the firm has previously completed league-level diligence. One distinct difference in their diligence framework is their statistical and probabilistic approach to analysis, which results in wide variations and outcomes for each variable, especially with longer time horizons. Through this analysis, they are able assess the reasonability of their desired growth and plans post-acquisition.
The firm’s overall process is very similar to any direct investment underwrite, with Arctos spending a lot of time speaking with the ownership group, management, and third-party consultants. The firm meets with managers and control owners of the team, so they can focus on aligning their investment goals with the franchise’s interests. Throughout the process, Arctos meets with their comprehensive roster of senior advisors, who each have decades of deep operational experience and leadership around the areas that impact revenue and value creation, such as sponsorship, ticketing, media rights, real estate, and legalized gambling. They also evaluate the likelihood of a control transaction happening in the next 5 to 20 years. The due diligence process is quite straightforward once the firm has access to a prospective investment’s information, people and key decision-makers. However, gaining access to those resources and being granted league approval to invest is very difficult, which creates a strong moat around this investment strategy.
Investment Strategies
From a financial standpoint, there are three minority stake investment strategies that are utilized to support sports platforms; growth capital, acquisition financing, and liquidity solutions. These investment strategies are the primary focus for limited partners, like Arctos. Growth capital, also referred to as operating capital, provides financial support for these businesses to achieve their growth targets and operating objectives organically. Acquisition financing helps sports businesses with inorganic growth to acquire additional assets and become larger platforms, integrate other franchises to develop economies of scale and capture revenue and cost synergies, and provide capital to control owners, so they can acquire their first platform asset. Historically, potential growth from a pipeline of high return on investment (ROI) opportunities could only be funded through operational cash flow and new equity injections from shareholders. Since there are currently several high growth opportunities in the sports and live entertainment industries, growth capital and transaction financing can help sports platforms realize step function growth.
Value Creation
After a private equity firm makes an investment, they focus on value creation initiatives during the holding period by making operational changes to the business. A unique aspect behind investing in North American sports franchises is that Robert Klein, a Partner at RedBird Capital Partners explained after the firm acquired Fenway Sports Group. "This is not the case of a mismanaged business or an under- managed business. This is the case of something that's already really great." However, rising asset prices and new ownership structures will require a greater emphasis on disciplined financial management and greater operational effectiveness, which are areas where private equity firms can step in to create value.
One of the core components in the investment thesis behind deploying capital into sports franchises and leagues is the investment in a broader sports ecosystem and portfolio of assets in a fragmented industry that could benefit from greater operational efficiencies. Institutional investors use team properties as anchor assets within broader content platforms that incorporate everything from physical real estate to mobile sports betting and gaming, which provides significant potential for growth and value creation. With regard to operations, private equity firms don’t interfere with the management of a team, instead, they focus on the growth of the assets associated with the franchise. For example, if a team wanted to discuss ways to renovate their stadium, acquire local real estate around their arena, or drive sponsorship growth, private equity firms would step in and support ownership groups with those initiatives. Key value creation focus areas for Arctos include: evenue generation, platform building, M&A, deal flow, technology, shared services, sponsorship, analytics, and customer dynamics. Bain & Company indicates, “the basic principle remains that there are two ways to make money in sports: increase the number and intensity of fans [or] monetize this fan engagement through traditional and emerging revenue sources. To thrive in this dynamic environment, investors and owners need to develop a clear understanding of the sources of value within the sports eco- system and how the disruptive pressures are changing value flows.” Media rights are the most important piece within the overall strategy for private equity firms to drive value, as the influx of streaming services and on-demand content has made live entertainment more valuable. For many professional sports leagues, media represents the biggest piece of the revenue pie, contributing 40%–60%, and is a private equity firm’s main driver for returns and revenue growth. Sports remains the single greatest aggregator of live content, and sports rights are an increasingly important and strategic asset within the entertainment ecosystem, which can be seen through notable step-ups in the national media rights deals with the NFL, MLB, and NHL recently. Looking to the future, three things are simultaneously causing the value of sports media rights to increase. First, the relative share of sports viewership has steadily increased, indicating sports and live content more broadly are becoming increasingly important to the still highly lucrative linear bundle. Second, OTT providers are increasingly realizing the need for live sports as a customer acquisition and retention tool. Finally, the rise of digital experiences is changing how engagement and content is monetized and catalyzing new opportunities across sports betting, international expansion, and youth engage- ment to reach a new generation of fans.
Impact of Private Equity Ownership On Sports Teams and Leagues
Private equity ownership will have a positive impact on sports teams and leagues by driving increases in valuations, supporting the growth of franchises, and improving the overall fan experience. First, the influx of private capital into into the space will increase valuations by providing liquidity to limited partners, contributing to greater transaction volume, and improving the financial performance of sports teams and leagues. The exponential growth of franchise valuations has made it increasingly difficult to find individuals wealthy enough to purchase ownership stakes, however allowing institutional investment increases liquidity and significantly expands the pool of potential buyers for minority shares. This increase in demand will fuel additional competition and cause a surge in transaction volume, which further increases valuations. In addition, access to sophisticated ownership groups through private equity will give teams and leagues access to an abundance of financial and business resources that can help them increase operational efficiency. As a result, they will generate stronger revenue growth and profitability going forward, which will also contribute to higher valuations.
Furthermore, franchises face several financial constraints from their leagues, such as borrowing limits and cash flow reinvestment requirements, which limits their ability to take advantage of growth opportunities. As a result, the industry has historically had to fund growth organically. Capital providers in the form of private equity firms will support the growth of franchises by sharing operational expertise and financing strategic initiatives. The application of data analytics presents promising opportunities, as sports increasingly rely on direct fan engagement to generate revenue. By investing in these technologies, franchises can use artificial intelligence to track viewing behavior, develop strategies to monetize fan engagement, and use data to improve content and digital experiences for fans. International expansion also provides significant growth potential for sports franchises, with many leagues looking to establish their respective sports as a global game. Growth capital provided by private equity firms will accelerate this expansion and help leagues reach a greater number of fans. Additionally, private equity firms will enable the growth of franchises by building broader premium content platforms. Horizontal consolidation and vertical integration across other sports, media properties, real estate, live entertainment, and hospitality would support this platformization and expand a franchise’s reach and presence. Within these platforms, sports betting will play a key role in enhancing the entire sports value chain by unlocking new sponsorship oppor- tunities and increasing fan engagement, which translates to higher media and customer lifetime values.
Finally, private equity ownership will enhance fan experiences through next generation venues, streaming, and digital channels. Deeper fan engagement is crucial to the value creation strategy for private equity firms because all revenue sources within the sports ecosystem ultimately lead back to fans and marketers. In terms of live experiences, fans can expect a more captivating environment at games with private equity firms helping franchises invest in next generation venues. These new smart venues use Internet of Things (IoT) technologies to “provide fans with a wealth of information on parking availability, bathroom and concession lines, seat upgrades, special offers, and more. Fans get a convenient, personalized experience with shorter lines and directions to navigate faster through crowded stadiums and parking facilities,” explains Intel. At the next level, these state-of-the- art facilities will incorporate contactless technology, augmented reality, interactive seats, and thousands of large screens throughout venues to ensure fans don’t miss a play. The various cameras and sensors in smart stadiums will provide security staff with real-time data and improve communication between hundreds of staff members and external police, thus also improving stadium security. In addition to improving fan experiences at venues, private equity will influence how fans view matches at home. Similar to broadcast entertainment, sports will also be migrating to streaming platforms, which means leagues and teams will need to develop new direct-to-consumer (DTC) distribution models. A hybrid model with both linear and streaming features will most likely emerge, with a variety of convenient and personalized viewing options for fans to watch their favorite teams and leagues. These mediums are likely to become more advanced with access to data on player and team performance, real-time betting opportunities, and other interactive and immersive viewing modes, as franchises look to digital experiences for deeper fan engagement. The introduction of esports and next-generation fantasy sports will provide additional ways for fans to interact with sports leagues and teams.
Conclusion
Private equity firms have historically received backlash for the bankruptcies of several globally recognized companies - such as that of Toys “R” Us, brought on by Bain Capital and KKR. These events eventually translated over to sports through CVC Capital Partners’ acquisition of Formula 1, where the firm focused on relentlessly pursuing profits at the expense of the sport. Over $230 million of interest was payable every year after CVC made the purchase, over 50% of which was financed with debt. The firm employed Bernie Ecclestone to run the sport and his was unfavorable by the majority, with racers speaking out about his poor leadership, which damaged CVC’s reputation. Despite the negative attention, they turned a $952 million investment in 2006 into a more than $6.7 billion return by exit in 2016, marking at least a 7x cash- on-cash return.
Overall, there's good reason for fans to be aggrieved by private equity firms as history has proven, but fans shouldn’t be concerned by the emergence of private equity in North American sports. Leagues share the same skepticism as fans and have implemented regulations that ensure private equity firms will be passive, non- controlling partners over a long horizon without the use of leverage. To ensure firms can financially support the teams they’ve invested in, some leagues also require that funds have $500 or $700 million of capital dedicated to their league. In addition to constraints placed on fund structures, leagues will monitor conflicts of interest with firm leadership who may personally own stakes in teams. From an operational perspective, private equity firms can’t be involved in or discuss any activities that relate to players or coaches. Firms are strictly prohibited from receiving any information regarding these topics and have built proprietary compliance systems, very much like material non-public information (MNPI), to detect and quarantine any sensitive and competitive information about players that they might be exposed to. Many of the private equity firms entering North American sports leagues don’t have any intention to take significant control, but rather to be trusted advisors. Furthermore, the success of a team on the field, court or rink matters less to private equity firms than customer experiences, the assets the franchise owns, and the market they operate in. For example, the Sacramento Kings have had the second-worst record in the NBA over the last decade, however their modern arena and extensive real estate holdings, which include a hotel, retail, and restaurant district around their arena, provide value to Dyal Capital and Arctos, who each purchased minority stakes in the franchise.
If anything, private equity ownership will provide more benefit to the teams, the owners and the leagues through increased valuations, substantial franchise growth, and improved fan experiences. In the end, private equity firms are likely to remain the silent partners of sports teams for the foreseeable future and fans can rest, knowing that they can continue watching their favorite teams and leagues for years to come.