It's not often that business and pleasure collide for me, so in honor of Dirk's piece on whether or not the National Hockey League as a whole is losing money being cited twice by Yahoo!'s Puck Daddy blog -- first by Ryan Lambert and then by Greg Wyshynski -- I thought I'd share a few thoughts about a recent Bloomberg Businessweek piece that asks, "Could private equity solve pro hockey's problems?"
This discussion brings hockey together with our current presidential politics, as the private equity model of turning around failing businesses has emerged as a central point of contention between the two major party candidates this election cycle. Regardless of which horse you're riding in the presidential race, follow after the jump for reactions and thoughts....
First, a brief primer on the private equity model:
- A private equity firm like Bain Capital, the brainchild of Republican challenger and former Massachusetts governor Mitt Romney, identifies a business that, despite demand for what it produces and positive cash flows, finds itself in some financial trouble.
- After analyzing the books, making some valuations, and estimating future viability, the private equity firm acquires the target company with a mix of equity and debt. They put down some of their own cash on the deal, and they buy the rest with money they borrow from an investment bank like Goldman Sachs. They use the target company's assets and future projected cash flows as collateral for the loan they take out; thus, the target company becomes responsible for the debt. This is called a leveraged buyout, or LBO. I'm not enough an expert (if an expert at all) to say for sure, but people ostensibly in the know say the ratio of debt to private capital in these deals is usually pretty high.
- The LBO is sometimes conducted as a straight transaction with the ownership of the target company selling to the private equity firm voluntarily, and other times done as a "hostile takeover," in which the private equity firm offers large (debt-funded) bonuses to middle and even top managers as an incentive to pressure ownership into selling -- so still voluntarily, but certainly under some influence. The latter method is why filmmaker Oliver Stone wrote and directed Wall Street.
- As new owner/managers, the private equity firm partners then act as efficiency consultants to the struggling company, helping to shed underperforming assets, physical plant, and labor. The equity partners charge what's called a management fee, on top of whatever dividends they earn as owner/managers, for providing the guidance on restructuring. If done properly, the target company becomes profitable in the long run, and the private equity managers are able to divest themselves of holdings in the target company at a profit before moving on to their next acquisition.
Whether or not private equity managers have an incentive to actually turn a company around -- as opposed to taking the literal and proverbial money and running -- depends on the ratio of management fees to private capital staked on the acquisition of the private company. If the firm only invests a small amount of private capital in a struggling business, but gets even or better money in return on that investment, then it doesn't really matter whether or not the target company ever succeeds (unless you take into account a private equity firm's reputation as a turnaround specialist; with a bad reputation, Acme Equity Corp. could have a pretty short life, as nobody would want to do business with Acme no matter how badly they might be struggling financially).
Roughly 7% of businesses restructured under a private equity model wind up in bankruptcy, which to me is a pretty remarkable number; this means that 93% of companies acquired by private equity actually wind up profitable in some way. Even those equity firm-owned companies that go through bankruptcies emerge from the process much faster than companies with similar debt loads. In any case, this 7% average bankruptcy rate estimate is much lower than the bankruptcy rate of companies serviced or restructured under some other financial model. This probably has to do with the fact that experienced financial planners and managers negotiate the terms of the target company's new debt with the investment bank, rather than someone at the target company attempting to negotiate the terms themselves:
Private equity-owned companies may have a lower general default rate because of the better debt terms that sophisticated private equity firms can negotiate. For example, Moody's has found that an outsize number of companies owned by private equity firms avoided default during the financial crisis because they had so-called covenant-lite debt, which had fewer terms that could be violated.
Your thoughts and feelings about the relative morality of the private equity model as a way for finance executives to make a living probably will have some bearing on how you vote this November (if you vote at all). But how do we answer Bloomberg Businessweek's question, "Can private equity solve pro hockey's problems?"
Author Nick Summers hedges in a couple places, though he emphasizes that the NHL would be a perfect fit for the private equity turnaround model:
When private equity firms go shopping for a takeover, they look for certain qualities. Weak management. Underachieving revenue. Opportunities to expand by taking on debt. Problems that are driving down value, but could be solved by a fresh set of outside managers.
Sound like any professional sports you know?
Private equity firms like to buy distressed properties, and right now the National Hockey League—fourth of the four pro sports, nonentity on SportsCenter, and days away from its second work stoppage in seven years—is as distressed as it gets. Fans have long fantasized about new league management (booing Commissioner Gary Bettman has become a tradition at the Stanley Cup ceremony), and the idea of private equity swooping in to the rescue is actually not as far-fetched as it sounds.
Summers also recounts the failed 2005 bid by Mitt Romney's former equity firm Bain Capital to acquire the NHL for $3.5 billion during the last lockout. "[A] number of owners," Summers writes, "made it clear they were unwilling to part with their franchises—which, to some, hold far more emotional value than real worth." This refusal to undergo an LBO is symptomatic of what I think to be pervasive and generally insane thinking among pro sports owners, who treat as axiomatic the notion that "you have to spend money to make money." If they're in it for the emotional returns, and many (all?) are independently wealthy because of successful careers in other industries, why do they insist on now redefining hockey-related revenue, among other things, and complain that their margins are too small, or that they aren't meeting their bottom-line projections? Indeed, being profitable requires some risk-taking; but franchise ownership will only be profitable, on balance, to some, and only then in the long run. Teams can't chase bad money with good year in and year out and expect to make money every single time. If that were the case, we would all own pro sports franchises!
(Side note: it should come as no surprise that the Nashville Predators, on the business side, have emerged as a model franchise in recent years. With Tom Cigarran, who got his MBA from NYU's B-school, and Herb Fritch, whose background is in risk valuation, at the helm, the Predators have already, in a manner of speaking, been through a private equity-like transition, and the team is in the black today because Predators Holdings, LLC has taken the bottom line seriously. Pittsburgh underwent a similar transition in recent years, with Mario Lemieux vying for and arranging millions in cash infusions from the gambling industry that wound up financing, among other things, a new arena.)
One of the caveats Summers raises, however, is both relevant to the current CBA negotiations and a very important contribution to the enduring quality of hockey at the NHL level, and that is the manner in which private equity tends to handle labor contracts:
One aspect, though, might pose a challenge to the usual private equity way of doing business. "In an airline industry, I can see a private equity shop going in and taking out or reconfiguring the contracts for the bag handlers," Chaplinsky says. "You can replace them with technology, or with other workers. But if you go in and redo the contract for Sidney Crosby, is he going to play as well? The problem is, although there's a lot of seemingly physical assets around this, in the stadiums and all that, at the heart of this there's one huge intangible asset, which is the players."
It's not always the case that the laborers are also the product in the markets for certain goods, but it is certainly the case in pro sports. You can't simply force out the Sidney Crosbys and Alexander Ovechkins of the game, and expect even last week's AHL first star of the week to draw the same types of crowds. Large market hockey fans are fickle, I'm finding after three years living in the Washington metropolitan area.
All that being said, I think a private equity-run restructuring is worth the NHL's serious (re)consideration, especially given other opportunities for teams and facilities to tighten their belts. Teams that are interested in averting protracted labor disputes with the players union, disputes which threaten brand reputation and the well being of players in complementary markets, like television providers, would probably benefit from the advice of dispassionate third parties focused more on making money than the thrill of sitting in the owner's box or parking in a reserved spot in the bowels of a large arena. One of the more common charges leveled against Gary Bettman's tenure as league commissioner is that his Southern Expansion project was wrong-headed and too aggressive. As the ownership situation in Phoenix remains unresolved, and we look back to the displacement of the Atlanta Thrashers to Winnipeg and near-displacement of our beloved Predators, it's hard to rationalize Bettman's strategic thinking when considering alternatives. After all, like we already examined, the evidence shows that on average only 7% of firms that undergo equity transitions wind up bankrupt; that's the equivalent of 2 NHL teams, and is in no way worse than what we've already seen without sophisticated experts having their go at turning a profit. The devil would be, as they say, in the details, but from where I sit, it's hard to think of rational reasons why the league shouldn't seriously consider this following the conclusion of the current CBA negotiations.
A lot of fans -- especially season ticket holders -- consider themselves partial owners in pro sports franchises. So put on your ownership hats, Preds fans, tell us in the comments how you'd approach this problem. Remember to keep it civil if you bring politics into it!