What is the proper goal for a professional sports team, profits or championships?

Professor David Zaring asks if “the high-end sports team debt burden [is] a feature of private equity?”:

And plenty of other examples exist, as Americans continue to buy up the English Premier League, as concern grows that debt financing in high end soccer (Real Madrid, AC Barcelona are almost as debt ridden, Arsenal isn’t far behind) is reaching unsustainable levels. I’ll note that the most indebted teams are the ones who have been playing in the Champion’s League finals, of late, and the least indebted ones – those would be the non-private equity owned German teams (often owned by their fans, in fact) – are not. But that too, smacks of the risk-or-insolvency strategy that, fair or not, is almost as associated with private equity strategy as is a love of debt.

And one can go further. . . . It’s armchair empiricism at best, but if I were in major league baseball, the one American sport without a salary cap, I would worry about selling another franchise to a private equity firm.

This question runs right to the core of the paradox of big time sports, with a modern financial crisis twist. For traditional businesses, there is (generally) a single primary goal: become and remain profitable, thus ensuring that you survive. Many people assume that all businesses do this well and the only issue is how to fairly distribute their profits, but if you take the longer view you’d be surprised how much turnover there is among the largest companies — many that at one time were among the largest on the planet now no longer exist. A perusal of the companies that historically made up the Dow Jones Industrial Average confirms this. So remaining profitable is a constant struggle.

On the other side, you have the teams’ professed goal: to win games and championships. Of course it’s not clear that these two interests are aligned: sure, more wins tends to result in more ticket sales and sales of merchandise, but putting out such a good product requires expensive players, expensive coaches, and expensive facilities. There’s no guarantee that the “break-even” point from a profit or business standpoint would result in championship level output. It might be to have a winning season but avoid New York Yankees levels of expenses.

This tension is not new, and the two motives have generally been able to coexist. Everyone, at least implicitly, understands that sports teams must at least make some money (just ask the USFL what it is like to have an unprofitable sports franchise), but fans and the sports media tend to turn on owners who are perceived as pursuing profits ahead of wins. The most beloved owners tend to be the ones who establish an image of being willing to spend and even lose money to see their team succeed, even if in practice that is really the case. But things have gotten more interesting in recent years.

There are a number of factors now that have not always been present in major sports. The first factor is the one that underlies them all, which is that, at least in certain sports like professional football, it would be very difficult for a franchise to actually be unprofitable. This is because the league as a whole generates massive revenues, and it redistributes much of that revenue among the various teams, including TV revenues, merchandising, and even some team specific revenues get redistributed to other teams (though that may change). Buttressing this is that, despite the high demand for professional football, the league has an effective monopoly over the sport and limits the numbers of teams.

This sounds like a strange point but think about it: The NFL limits the league to keep the revenues per team artificially high, whereas if you wanted to open up the market for football teams (i.e. if we imagine the NFL didn’t enjoy all the legal exemptions it now does to restrict who can have a team), you’d see a lot of people starting new football teams because each one, even the bad ones, enjoys profits. It’s the old supply and demand argument: if you are making big profits making widgets, eventually — unless there are significant barriers to entry — others will jump in and sell widgets too and get profits too, until the market got saturated. Don’t think others would start teams? I believe they would (though I admit this example is very artificial) as there are many geographic areas of the country without a football team and, further, football, being a sport, would attract many wealthy hobbyists. Think about horse racing: The sport of kings is profitable for very few owners despite the large purses for winning, because, to oversimplify, wealthy people can buy a horse, get it cleared, and begin competing.

The point is that NFL teams effectively make monopoly profits, which allows them more freedom to “go for winning” as opposed to always focusing on profitability. But that’s not always the case with sports leagues, as we’ve seen with European soccer and other leagues, including non-NFL football leagues.

Next, you have the imposition of the salary cap, which is a great deal for owners and a terrible one for players. Of course, that is different than saying it is bad for sports fans, because it might well be good for them (competitive balance and all that). But it’s a terrible deal for players as a whole because it makes competing for salaries a zero sum game: Assuming teams max out the salary cap (as most teams effectively do in football), each additional dollar a player earns is taken from a teammate. On the other hand, for owners it protects them from the hard business versus winning decisions owners in leagues with looser salary caps must make. In Major League Baseball, every team is compared to the Yankees and Red Sox, simply because they tend to outspend everyone else. Sure, when a lesser team wins it’s a great underdog story, and occasionally it gives rise to superior management techniques as with Moneyball, but sports contests are like wars between countries: At the end of the day, the bigger team with more resources is probably going to win.

If you combine the above two points, you have a very owner-friendly system in a league like the NFL: You have guaranteed profits from your restrictions on other entrants into the market and you have alleviated pressure from the fans and media to focus on winning by spending more because of the salary cap.

But let’s get back to Zaring’s point about debt.

One of the major stories, if not the major story, coming out of the financial crisis were the unsustainable debt levels throughout the economy. Private equity investment firms, commonly known as buy-out shops, were known for one technique in particular: The leveraged buy out. The gist of this was that the private equity company would buy an existing business using (a) some of its own money, and (b) a lot of borrowed money. One of the tricks was that the borrowed money was actually borrowed by the company being bought rather than the private equity firm itself. This did a few things: (1), it allowed a private equity company to buy something worth a lot of money using only a little of its own capital, which it could then sell at full value later either to someone else or the public; (2) sometimes it could be structured that the borrowed money would go right to the company being acquired which would then pay its new owners a “special dividend,”; and (3) the company could use the borrowed money to aggressively go out and expand or invest in other growth strategies — if they worked, the private equity investors would win big; if they didn’t, the company would be unable to pay its debts, resulting in a real (but capped) loss for its new investors.

All this was not new to the recent boom (it goes back at least to the 1980s, if not further), but it was a key feature, and as Zaring points out we actually saw such private equity firms and their individual dealmakers becoming owners of sports teams. We haven’t seen it much in the NFL, but they often employed strategy three in the sports context: Borrow a lot of money to invest heavily in big name stars (and sometime also stadium expansion and the like), with the goal of winning championships now, thus taking a high-risk/high-reward approach to winning a title. In other words, these new owners take “championship or bust” quite literally.

This is the final twist on the profits/winning tension. Is it possible to have both, though in different time periods? And if the owners become dealmakers rather than long-term owners, what is to stop them from taking a private equity approach to owning a team, where as soon as they buy it they look for an exit strategy. Buy a team, lever up (i.e. take on more debt), win a title now, then sell the team at a profit, leaving future owners saddled with debt that limits the teams’ ability to spend on quality players in the future?

I don’t have any firm answers here; this is just meant as a thought piece for some trends with business. If anything, it probably counsels in favor of the NFL’s highly artificial, highly restricted nature with just a few teams and owners with little incentive to push the envelope. It’s maybe unfair to other owners and possibly even players (i.e. they could have a broader and deeper market for their services giving more opportunities to more players while also giving them opportunities for higher pay), but there’s no denying that the NFL seems quite stable, and that is probably what the fans most want.

It’s often said that the NFL is rarely creative, but it’s also almost always scarily efficient.

  • Sam

    I think the difference is that the American leagues are structured with the teams as “franchises” rather than independent entities under loose affiliations like the Premiership / Football League in England. This allows the leagues in the U.S. to impose regulations on the minimum financial wherewithal of the prospective owners and the ability of the club to take on debt. Recall that the major reason why Art Modell had to eventually sell the Browns to Steve Bisciotti was because the management company that he owned that controlled Cleveland Municipal Stadium was in financial distress.

    In Spain, Real Madrid and FC Barcelona are also “owned” by the fans (FC stands for “Futbol Club”), but that doesn’t stop them from taking on debt.

  • Excellent work Chris, very intelligent and engaging post. It really gave me something to think about that never occured to me before. Bravo

  • joe83843

    It’s kind of ironic that you mention the NFL limiting the number of teams to remain profitable (but everyone wanting to start a franchise because they can make a profit), because while it wasn’t really profitable for awhile, the AFL was basically started up because the NFL wouldn’t give Lamar Hunt his own expansion team. I doubt history will repeat itself anytime soon, but still kind of funny.

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