Beautiful Game, Ugly Investment

Travelling back from Sunday’s draw between Liverpool & Arsenal (it was never a sending off), I noted Liverpool Football Club had again made the business pages for all of the wrong reasons (see here).

The current battle between RBS, the principal creditor to LFC, and its owners Tom Hicks and George Gillett continues to highlight the dangers of utilising leverage to buyout companies in certain industries.

LFC was bought by the American pair for £219 million in 2007, including debt. Back in April of this year, and unable to re-finance the current £237 million of bank debt, Hicks & Gillett effectively defaulted and ceded management control to an independent Martin Broughton, as a condition of that re-financing. According to the Sunday press, a six month re-financing comes due on October 6th, along with a £60m penalty, at which point it is alleged RBS would take control of the club. No doubt potential suitors are well aware of the impending date and are biding their time, hoping to buy the club for the value of its debt alone. The most likely outcome, absent an earlier credible bid, is that RBS will again roll the loan in October, before finally selling the club later this year/early 2011.

So what has gone so spectacularly wrong off the pitch? Clearly the recession of 2008 proved a huge challenge to industry, although football, with a strong global support base actually weathered the storm comparatively well. Liverpool’s problems lie in the unsuitable debt load and subsequent demands placed on the club post the 2007 acquisition.

As potential debt investors in LBOs (see here) (typically through high yield bonds that are issued to help fund the transaction) we favour those industries and companies with stable and recurring cash flows. We also look for hard assets that we can fall back on if things were to go wrong (higher recoveries), as well as an ability to recognise synergies and operational improvements – leading to improving cash flow and profitability.

Sadly for the fans of clubs with spiralling debts, football fails to tick the boxes. The fixed nature of players’ contracts, an ever increasing wage/revenue ratio, and the ongoing pressure to compete with ‘trophy’ signings make the cash flow generation required to service interest costs a real challenge. Deloitte’s Annual Review of Football Finance 2010 (see here)  makes interesting reading. Over each of the last three years the wage bills of Premier League clubs have grown in double digit percentage terms. ‘With wages growth outpacing revenue growth in 2008/2009, the Premier League’s wages/revenue ratio increased to 67% – a record high.’ The report goes on  ‘[in] a classic example of competitive game theory, clubs are continually driven to maximise wages rather than profitability.’ Despite increasing income streams ‘the vast majority of those revenues will quickly flow into the hands of players and their agents.’ Clearly operational achievements will be massively hampered in any industry operating under said conditions.

Football clubs also tend to be asset-light businesses, with those assets that they do own proving difficult to value. What is Anfield worth if football isn’t being played there for example? How much is Wayne Rooney worth should he break a leg?

Beyond that, how willing or able would a lender be to enforce their rights in an event of default? Indeed, this no doubt partly explains RBS’s previous willingness to afford Liverpool’s owners extra time to find a buyer. Huge reputational issues aside, a punitive administration regime requiring a ten point deduction by the FA makes it a less than palatable option. Finally there is the issue of the super creditors rule, which places players, managers, the FA and other football clubs as preferential creditors in administration. The recent case of Portsmouth demonstrated that under these rules wealthy footballers are made whole ahead of HMRC. (see here)

The current underperformance of the high yield bonds issued by Manchester United in January 2010 (currently trading at 96% of face value to yield 9.6%) despite (sadly) strong performance both on and off the pitch, suggests other investors share our concerns. Whilst certain companies within industries such as cable and healthcare & packaging have proven themselves successful LBO candidates, most football clubs remain a far from attractive proposition for most debt investors.