Terra Incognita - Novel ideas about investing in the beautiful game

Some of Europe's most prestigious clubs have experienced rapid disruption over recent months with examples such as FC Chelsea, AC Milan, AFC Bournemouth or soon enough Manchester United and Liverpool. Popular arguments for the increase of Private Equity activity in the space - often led by US buyout groups - are uncorrelated returns, diversification and buy-and-build strategies. Others might claim sports has simply become the newest object of prestige for billionaires full of hybris and limitless financial prowess.

In the following paragraphs, I would like to reflect some healthy criticism in this trend and introduce a novel, better idea of investing into the sport: Investing in the "real" assets behind, the arenas selling out every weekend

The market backdrop caused by Covid - never let a good crisis go to waste

Skepticism and pessimism aren’t synonymous.?Skepticism calls for pessimism when optimism is excessive.?But it also calls for optimism when pessimism is excessive - Howard Marks

As legendary investor Howard Marks beautifully stated it in one of his memos titled "Taking The Temperature", it is not hard to point towards one of the hottest trends in alternative investing these days: Taking ownership of European football clubs.

Whether you want to side with the infamous buyout groups or not, there has clearly been an uptick in deal activity in the space since, or better said because of Covid-19. During the 2022-2022 years supply, i.e. clubs willing to open the doors to outside money, increased out of sheer survival instincts. Covid has decimated the finances of many clubs and uncovered the consequences of decades of poor financial discipline. As a consequence, the lack of gameday revenues, ever-increasing wage bills and backlog in media investment have created opportunities for bona fide capital allocators to rebuild the fortunes of these once prestigious, now moribund clubs.

The PE playbook - Uncle Sam is coming for you

Every revolution begins with a single act of defiance - Mahatma Gandhi

Football teams are viewed by (American) investors as underperforming media corporations where digital content creation, internationalization and on-site fan spending is trailing the US's top sports leagues by a mile. Everyone who has ever visited a game of the NBA or NFL easily understands - league passes, pre- and post-game shows, digital collectibles or limited merchandise editions are just a few examples to name where the US simply better understands the 101 of monetization.

Thus far, investors have been proven right: Club valuations have recorded outsized and consistent gains in valuation, major European competitions keep increasing their viewership and revenues associated with this secular growth, such as media deals that are frequently repriced to new record highs, do not show any sign for concern. Hence, no wonder why sophisticated buyout groups like CVC or KKR are seeing great long-term potential in this niche and are chasing the silverware of the European football leagues - media rights.

The issue that is getting ignored - financial opacity

I can calculate the movement of the stars, but not the madness of the crowds - Sir Isaac Newton

So far so good it seems, clubs need money and benevolent investors are happily writing the check. The issue with the current modus operandi lies in the fact that club management, often retired players or managers who gained influential roles thanks to nepotism, ignore one of the core principles of finance: The pecking order theory suggested by Donaldson in 1961.

The pecking order states that companies prioritize their sources of financing according to the cost of financing, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued.

So why are all these clubs selling the most valuable part of their business, the only one that grants them long-term upside optionality? I would argue that what is celebrated as a breakthrough deal, Inter Miami's coup to secure the services of Lionel Messi by granting him an equity stake in the club, is rather the end of financial independence of footbal clubs than anything else in my views.

As I have now put myself as the persona non grata anyways, there is no harm in adding to the critcism. It is hard to justify how owners can credibly generate equity appreciation over the long run in a business where 99% of clubs do not generate any profit as wage costs and transfer sums are rising disproportionally to revenues, a market where winners command the lion's share of revenue and owners dilute their holdings by granting their players or even fans equity by selling digital tokens.

As I iterated above, clubs are essentially the underperforming media assets, players the high-performing media assets. Thanks to personal brands built via social media, power has shifted from the hands of clubs to players, whose savvy managers exactly know how to play the game. These days it is common to see agents negotiate for their players participation rights in merchandise sales or sponsorhip deals, which pinnacled in the failed transfer of superstar Kylian Mbappe to Real Madrid, who rejected a €180 million signing-on fee and a salary of €40 million as he was unwilling to grant the club access to 50% of his media rights.

Looking at it from a different lens, there are also risks to Private Equity's strategy such as European Clubs being in relative constant danger of financial misery if relegations happen or a lack of investing opportunities that end up in bidding wars.

To put things from pure narrative into numbers: Football Benchmark reports that only ~20 clubs across all Europe would present a sizeable investment opportunity if we take the threshold of >€500m Enterprise Value as minimum size hurdle. Looking at profitability levelsacross European football, only 10 teams recorded a profit of ￡1 million or more during the period from 2019 to 2021. With over 1,000 professional clubs in Europe, this means that less than 1% were significantly profitable! Symbolic of the condition that football clubs are simply not economically-viable business models, it was celebrated as "colossal triumph" by the local press when Bayern Munich, regarded as healthiest club in all of Europe, posted record revenues at €665m in 2022 while net profit reached a mere €12.7m (= 2%), up from €2m from the prior year. It is certainly hard to steelman that European football clubs are great business models by looking at these figures.

Last but not least, some leagues still stick to their protective rules, such as Germany with its "50+1" doctrine that makes outright ownership essentially impossible or popular clubs like Schalke 04 that are still legally run as "e.V." which comes close to the definition of a non-profit.

Some might argue that Covid has presented itself as a black swan that riddled clubs' finances as gameday revenues, usually 20-30% of the total revenue base, went to 0 and going ahead from now, things should improve.

While I certainly can get comfortable with the Black Swan argument, I still have my 8th grade accounting teacher from high school in my ear that used to preach "long-term assets should be long-term funded". Looking at how football is financing its long-term assets, the players stepping onto the pitch every weekend, a bleak picture emerges: Top leagues like France post a wage/revenue ratio of up to 98%.

Concluding that giving away equity is not the best long-term idea and will presumably cause sellers remorse once clubs have stabilized their balance sheets following the Covid fallout, how about issuing debt?

In 2021, when rates were still at close to 0%, German club SV Werder Bremen GmbH & Co KG aA failed to fill the orderbook for a mere €20m bond at a bounteous rate of 6.5%. As time will tell if this will be a precursor to similar fates for other clubs, more cases are evolving: As of this writing, Inter Milan has reportedly seen its debt to Oaktree Capital increase to just under €330 million, up from a €275m loan granted in 2021 at around 12% interest - presumably structured as PIK given accounts showed revenue of €440 million and a loss of €140 million for the 2021/22 financial year.

The solution - Infrastructure-like returns in sports arenas as natural monopolies

Monopoly is a terrible thing, till you have it. - Rupert Murdoch

As we outlined all the financial issues clubs are facing in the Covid aftermath and the limitations Private Equity might soon face in bidding for outright ownership of clubs that give away increasing share of equity upside to players, I like to quote one of my mentors Philipp Feldmann who beautfully coined the phrase "You can't see any better with your head in the sand".

So to finally switch gears, this chapter introduces a novel idea of investing for European football clubs: Sale-lease-back agreements for their football stadiums.

Football arenas across the continent provide a win-win scenario for all parties - clubs to free up desperately needed capital to deleverage their balance sheets and use proceeds to further drive forward internationalization and content creation as well as investors to find a new, scalable way of investing.

1.Capex spend is a multi-fold of revenue for clubs and by divesting its real assets, clubs create using that capital in more value-accretive manner

FC Barcelona has recently paused a €1.5 billion fundraising for its stadium revamp (~1.5x annual revenues), while its archrival over in Madrid is progressing on a €1 billion renovation of the Bernabeu (3x revenues) and over on the island, Tottenham Hotspur Football Club cemented its huge ambitions to be London's new dominant force with a €1 billion construction (~2.5x revenues) in 2019.

Two things are impressive about this: First, the minimum threshold of at least €1 billion for a modern day stadium as well as second, the multifold of capital needed compared to annual revenues. Assuming a stadium revamp of this magnitude to happen all 10 years going forward as innovation cycles shorten similar to other real estate, cars or industrial products semiconductors, the 250% Capex/revenue ratio comes to 25% p.a. by spreading it out over 10 years.

One of the highest comparables from other industries in this regard are semiconductors with ~30% Capex/revenue ratio, while Tesla's Capex ratio in 2022 was 9% and Apple's closer to 3%.

Concluding, investment capital tied to arenas embodies huge burden for clubs and creates an angle for dealmaking combined with a minimum threshold of €1 billion before Capex, eliminating much competition from other bidders. We might be onto something ...

2. Football stadiums have become massive entertainment venues that create diverse revenue streams

Fellow Londoners would agree with me that over the last years many large-scale entertainment events or events of international importance have shifted away from Wembley arena towards the Spurs stadium or London Stadium built for the Olympics in 2012.

Testimony might be that the National Football League (NFL) now plays all its London games up North in Tottenham. A 10-year deal, running to 2028, guarantees at least two matches at Spurs every season and superseded Wembley, where 23 of the 28 London fixtures had been played.

West Ham United FC has been a beneficiary of this trend as well. The East London team’s 99-year lease to be the main users of the 60,000-seater Olympic stadium?for just ~€3m?– a shade over the average top-flight player’s salary – plus a one-off payment of ￡15m has been described as “winning the lottery” by ex-Arsenal manager Arsene Wenger. Since snapping up acccess to this high-end stadium for a bargain and freeing the capital to invest into other much needed areas, the club went from irrelevance to finishing Top 5 in the Premier League and reaching the semi-finals of Europa League.

3. Football stadiums represent near monopolies for investors

Real Estate funds could acquire arenas from clubs and have them commit to long-term leases in the ballpark of 20+ years. This structure creates basically a infrastructure-like risk-return profile similar to utilities.

All these assets are basically monopolies within their cities or regions as contrary to the US, where franchises tend to sometimes move their city, football clubs remain loyal to their origins from founding to eternity. Handing ownership from clubs or even cities to private owners could further solve political issues as for example seen with the public debate about the West Ham deal: Public backlash was immense as British taxpayers were said to have been handed a ￡35m bill for a planned revamp of West Ham United football club’s stadium in East London.

Taking it a step further, claiming 20-30% of a club's revenues generated from gamedays makes for a healthy cashflow-based revenue structure that the new institutional owners can use to put leverage on the asset. As an investor grows its portfolio of sports arena assets, cross-collateralization further opens opportunities to de-risk the investment and improve financing cost. For instance imagine owning a quarter of the Bundesliga's arenas, what - other than Covid 2.0 - could possibly happen to disrupt that revenue stream in a meaningful way? Given the average gameday looks fairly similar all across Europe, experience gained in gameday logistics with one club, could easily be applied to similar assets across the portfolio, i.e. think of combined purchasing power for food & beverage catering, streamlining of parking revenue management systems or introducing completely novel revenue streams like selling the data gained from sports fans to third parties.

That Europe is far behind in this regard is obvious for most investors across the pond. Comparing Madison Square Garden to the average La Liga stadium in terms of how well a club manages to extract revenues from its fans is similar to comparing Manchester City to AFC Bournemouth ...

4. Most clubs under-utilize their arenas, making for a reliable value-creation plan for institutional investors

Tottenham Hotspur's deal of securing NFL games for at least 10 years, Drake selling out O2 (Telefónica UK) arena three nights in a row (yes, the one Guy Hands famously tried to acquire for Terra Firma once) or Bayern Munich's Allianz Arena which is arguably regarded as the most sought-after business meeting location in all of Bavaria are obvious points to look for tangible examples how diverse revenue streams for sports arenas can be. The range of sports, music, business or comedy events will not just de-risk the business.

4. Risks & mitigants - any free lunch here?

The critical reader might point to exit liquidity as main concern for such assets. As funds have to recycle capital to their LPs at the end of a lifetime, healthy liquidity and exit pathways are vital. I would like to argue while this might be on of the main concerns, exit pathways are multifold.

Ideas to liquidate could be shifting the arenas into continuation vehicles, handing them back to cities as public owners or adding the arenas to the offering when a club gets sold again.

Primarily however, assets like the aforementioned Madison Square Garden have shown that there is a feasible IPO playbook for such assets. In 2015, the original MSG company spun off the sports and entertainment division into a separate company. Over time, the entity has grown into owning 5 more iconic, world-class entertainment venues across New York and Chicago while locking in 35 years deals to host home games of the New York Knicks and Rangers.

As a result, MSG creates long-term secured, diversified revenues across basketball, ice hockey, boxing, music and many more while achieving an outstanding 18% operating income margin. Shareholders have rewarded the strategy by bidding up the share to >2x their IPO price.

MSG as prime example shows the pathway for a credible value-creation plan:

i) Acquire the asset and restructure the balance sheet by assuming an optimized debt structure

ii) Secure long-term lease structures

iii) Increase asset utilization by introducing new revenue streams from events in different verticals such as MMA, music, business events

iv) Improve revenue engagement across venues and enable tailored offerings and cross-promotions

Further looking at the risks of this investment strategy, it can be discussed how much disruption risk there is hidden in sports arenas. As digitization has attracted more and more teenagers to spend their time and entertainment spending online, football arenas could likewise be affected. The risk here presents its own mitigant in the same argument if we look at phenomenons like League of Legends where tickets to the LoL world championship final in Los Angeles, sold out the 17,000 capacity venue in less than an hour and later that year, a similarly sized venue in Berlin in just three minutes.

Thinking the approach out further, all digital content like pre-/post-game shows or online streaming offers are directly born from inside the asset! Stating the obvious, how can someone create content about the sport if he has no access behind the gates of the arena where the event takes place from within? Speaking in more commercial terms, this means owners of stadiums have always a certain negtiation power with streaming providers and other entertainment offers by leveraging their gatekeeper position.

5. To win the Champions League once is easier than pulling off 'La Decima'

Coming back to the aspects of making investing in sports arenas a scalable strategy, it can be said that it shares similar fate to the players on the pitch: Winning once is easier than repeating to win a major title.

Whereas buying clubs is very restricted given opposing legal structures and a shortage of supply of profit-making clubs, quite the opposite is the case for the real assets behind:

i) High single ticket sizes up to €1 billion+ means that less deals need to be sourced until the dry powder of a large fund can be fully invested.

ii) While only 1% of European clubs are profitable which is somewhat a necessary requirement to make them eligible as an institutional investment product, I would argue at least 30% of stadiums from Europe's Top-5 leagues would make for a feasible investment given the local importance of each club in every town. This directly correlates with the hit ratio required for investors. While everyone tries to circle a club like FC Chelsea or Bundesliga's media rights when they come to market and outbidding each other, investors can patiently pass on the purchase of a sub-optimal sports arena given their sheer abundance.

iv) Sourcing football arenas is quite straighforward (not to be mistaken with easy). Imagine trying to figure out which growing perfume brand is currently around in the United States before it reaches mainstream attention. You would need to evaluate the scientific efficacy of the fragrance, know where to find it given some sell via wholesale, others via ecommerce and others again via owner-operated stores. Understanding how true market share is distributed and how it might evolve is very hard and success of many brands in the space is often tied to the personal brand of its founder which distorts A&P budgets and margins. Comparing that to finding out where local football arenas are is fairly simple: They are huge, located in every major city and to estimate asset utilization, simply buy a ticket to a game and count all the people chanting the anthem befire kick-off...