Inheriting Debt from Prior Owners is Not an Excuse

 

On January 19th,

the San Diego Union-Tribune published an article titled, “Look at Padres’ books shows debt reduction has team in position to spend.” Beat writer Kevin Acee offered a limited glimpse into summarized financial information provided by team ownership and management. Before reading my response, read the article yourself. This post addresses only a specific assumption of the owner’s argument, so if you want a thorough review and rebuttal of the article line-by-line (you do want that, by the way), check out Gwyntelligence’s own David Marver of Change the Padres in his solo podcast recorded a couple nights ago. Also, keep an eye out for Marver’s appearance on the Effectively Wild podcast, which should be published in a day or two and where he discussed Acee’s article and the Padres spending habits with national media.

Yet, as you saw from the title of this article, I have a pointed and specific criticism of both the Padres ownership’s arguments and the characterization of such arguments by Acee. The crux of the excuse for why the Padres have not, and will not in the near future, spend more money on player payroll is the existence of debt “inherited” from prior ownership groups. From the article:

[Fowler] referred to the terms and interest rate on the $130 million debts/bonds balance for Petco Park and the parkade construction. Moores, mired in other financial bogs outside baseball, had been compelled in 2004 to agree to backing from bondholders that included a retirement fund and insurance companies at a blended rate of 8.5 percent, about double the prime rate at the time.

We’re supposed to believe that because the current owners of the team had to take on this debt with a relatively high interest rate, the owners have had no choice but to pay it down at the cost of a sub-average player payroll. In this post, I hope to make a convincing argument on why this kind of excuse is ridiculous, using my experience as a finance student and my (limited) exposure into private equity and investment banking financial analysis. A quick disclaimer: the actual processes of valuing these kinds of companies are much more complex than what I’ll dive into, and typically take thousands of man-hours from consultants, lawyers, and investment bankers. The simplified analysis I present here is just that—simplified, but accurate enough for our purposes.

5 Fowlers

 

I think it’s best to first understand how large companies, such as the multi-billion dollar Padres, are valued in transactions:

Putting a simple valuation large public companies is very straightforward: take the current share price trading on the stock market, multiply by the number of shares outstanding, and then adjust for factors such as net debt (net debt = all outstanding debt minus cash and cash equivalents). This calculation gives us the companies’ enterprise value, a metric commonly used to interpret the actual cost of buying the business in its entirety. Enterprise value is able to act a shorthand for the actual cost of buying the business because of the adjustments (like net debt) you make to the market capitalization.

However, the Padres are not publicly traded, so there are a couple other methods to reach an initial valuation. Comparable transactions are the most useful for sports franchises—simply look at what other MLB teams have been recently sold for, then make adjustments to that valuation for differences (for example, the Yankees would adjust their valuation above the Marlins’ because they have a bigger market, more consistent and larger revenues, etc…) Also considered are Discounted Cash Flow (DCF) analyses, a more rigorous and precise valuation based upon the sum of the present value of all cash flows the company is projected to generate ad infinitum. Both (and more) valuation methods are considered by the investment bank when developing pricing guidance. But it does not matter for our purposes, because all valuations get adjusted for net debt, minority interest, stock options, and more, to come up with the enterprise value.

If the core of my argument didn’t jump out to you in the previous paragraphs, I’ll be more explicit: when calculating the price to pay for buying a large company such as the Padres, net debt is subtracted. This makes a lot of sense when you think about it—when you buy a company, you’re effectively buying the future cash flows of the company, so any negative cash flows or liabilities currently held by the company needs to be subtracted from the positive cash flows you’re purchasing.

When calculating the price to pay for buying a large company such as the Padres, net debt is subtracted.

This also lets us understand what happens to the money from one-off expenses or revenues, such as the sale of MLBAM or the Fox Sports SD deal under Moorad: they typically are not included in the cash flow projections, since they are not recurring. Also, it is normal for prior owners to keep the cash from such one-offs before the sale, if not all of the cash generated (even from recurring sources) before the sale. We don’t know exactly what happened when the Padres were sold to the current ownership group, but the important takeaway is that it does not matter. If Fowler got to keep the cash from the FSSD, then the value of the net debt (total debt minus cash) adjustment (typically a subtraction, since most companies hold more debt than cash on hand) is smaller by the amount of cash he keeps. If he doesn’t get the cash, then the net debt adjustment would be greater, which means that the price Fowler and Co. paid was less.

The price they paid for the team was reduced by the amount of debt they would have to inherit.

What does this mean for the Padres ownership? It means that the price they paid for the team was reduced by the amount of debt they would have to inherit. I’ve seen people make the argument that “Fowler MUST have known about this debt when he bought the team!”—which is correct, but does not come close enough to the truth. In reality, the debt Fowler is complaining about now—the debt which has supposedly hamstrung the team’s ability to spend more on players—was subtracted from the “true” price of the Padres when purchased.

So, in the course of inheriting around $200m in debt from the prior ownership, the new ownership group paid around $200m less in purchasing the Padres than they would have if they did not inherit the debt. We’ve heard from the MLB commissioner’s office that Fowler’s group was “very well capitalized” in their purchase: if that is the case, then paying off this debt should not be an issue, since it directly decreased the cost they paid in buying the Padres. On the other hand, the ownership group could be poorly capitalized, in which case their actions since taking over the team (using its cash flows to pay off its own debt) are identical to the actions taken by prior Padres owners who were not wealthy enough to own and run an MLB team. This ownership group may be more of the same.

The new ownership group decided to strip the team of its cash for almost a decade in order to complete the purchase of the team, a decision which had a direct, negative impact on the quality of the roster fielded.

But it gets better: using the company’s cash flows to pay down its own debt is literally the strategy private equity firms use to generate crazy Internal Rates of Return (IRRs) for their investors. IRRs are a nuanced version of ROI used by private equity firms. You can think of it as the average yearly return needed to end up with the final ROI at the end of the investment period. The math can get a little confusing, but simplified, it’s easy to understand logically: if you borrow a bunch of money at an interest rate lower than the ROI you can generate with the cash (like buying a company), you will end up with more profit at the end of the day than if you used all of your own cash up-front to finance the purchase. Using the cash flows the asset (in this case, the Padres) generates to pay off the debt you used to buy the asset is a tried and true financial strategy designed to maximize the return on investment. It is undoubtedly a smart move in order to give the owners the best return on their money. It’s not entirely correct to say that is what the Padres did, but it doesn’t matter, because it is what they are effectively doing with their debt and cash flows now.

But that is the smart financial strategy—and choosing this strategy comes with inherent tradeoffs. The obvious one is that doing this sucks up all the cash flow the company makes, and incentivizes the owner to generate as much cash in as short of a time period as possible. Of course, investment in the company usually halts too, because that investment is just cash that could be used to pay down the debt quicker. This is why large private equity firms (the “corporate raiders” of the late 20th century) are often villainized when they take over a company: some firms are ruthless in their pursuit of generating as much cash in as short of a time period as possible in order to maximize their returns. They do that by laying off a significant portion of their employees, ripping the company’s assets into pieces and selling them for spare parts, and sucking every last penny out of their consumers. This is not what the Padres have done (I think – we definitely do not know how the purchase was financed and if there is more debt on the company/owners from that purchase which they would want to pay down ASAP), yet their actions are the same as if they had. If this debt really is the roadblock to greater payroll spending,  then the new owners effectively leveraged the company to buy itself because they lacked the funds—the exact criticism of past Padres ownerships.

Taking cash flows away really sucks when the company is a sports franchise, and the investment the cash would otherwise go into is the payroll of players. We also see the team attempting to milk its customers for every last bit of cash by refusing to lower ticket, meal, parking, and other prices while they don’t spend for a good roster. It’s the exact crap Padres fans have had to deal with in the past, and we shouldn’t have to deal with it again.

Fowler cares more about paying off debt (read: enriching himself as fast and effectively as possible) than winning. 

To summarize why this debt is anything but an excuse for the ownership:

  1. The amount of debt they inherited from the prior ownership was subtracted from the price they paid for the team
  2. Each dollar used to pay down a dollar of debt raises the value of the ownership’s equity (stake) in the team by that dollar. Doing this has only one, singular outcome:  it enriches the owners further.
  3. Using team cash flows to pay down debt as fast as possible actually enriches the owners beyond the dollar amount of debt reduced—the private equity strategy. And the owners are, indeed, doing this as fast as possible—look no further than the words Acee used to describe Fowler: A man “whose desire to win is tempered only by his love of debt reduction”. Honestly, I can’t believe Acee was stupid enough to write that sentence, because he just admitted that Fowler cares more about paying off debt (read: enriching himself as fast and effectively as possible) than winning. 
  4. The only reason the debt is a roadblock to spending on payroll is because the ownership group did not pay for the entirety of the team when the transaction went through. They got a discount from inheriting the debt, and the final payment on that debt will constitute the final payment for the team as a whole. The new ownership group decided to strip the team of its cash for almost a decade in order to complete the purchase, a decision which had a direct, negative impact on the quality of the roster fielded.

There are more conclusions, more criticisms of Padres ownership, and more dunking of Kevin Acee which can be, and should be, made. This was a critique in one small yet integral dimension of the argument presented to fans over the past couple of days.

TL;DR: Don’t give the team a penny more until they stop enriching themselves and trotting out crappy, underpaid rosters.

 

 

 

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s