The Implications of Investing in NFL Superstars

Shares of San Francisco 49ers pro-bowl tight end Vernon Davis and his future earning potential are now available for public ownership through Fantex Brokerage Services ("http://espn.go.com/nfl/story/_/id/10816433/shares-vernon-davis-san-francisco-49ers-go-sale-next-week">See ESPN’s April 2014 article on the IPO).

Fantex essentially offers investors tracking stocks in the income earned by athletes and entertainers. The company plans to add to their asset roster in the near future (Bills quarterback EJ Manuel and Texans running back Arian Foster are scheduled to be next). Considering the true scale of income potential in the celebrity universe and that of pro athletes, this is an inherently interesting subject for investors like us. Dissatisfied with the current depth of reporting on the subject, however, we at SumZero sought to learn more.

The question we ask: Is this a viable asset class for institutional investors to pursue? What about for individual investors? What are the core considerations that all investors need to be aware of before considering an investment?

SumZero asked long-time member Terry Lally (Founder/PM of Spotlight Funds, a Los Angeles-based long/short equity fund) to investigate the issue and submit questions to Fantex’s CEO Buck French. Over the course of several weeks, Mr. Lally researched the subject, exchanged emails with Fantex management, and held a lengthy due diligence conference call with the company’s team. Highlights of his findings and analysis are summarized below. In Mr. Lally’s summary, we expect you will discover a list of the types of questions an investor needs to ask before even considering an investment into this new offering.

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Background

Fantex’s first tracking stock Fantex Vernon Davis opened for trading on Monday April 28th. We expect the security to primarily appeal to fans and individual investors given the sports connection, small float (only 421,000 shares), and limited liquidity (trade by appointment with less than 100 shares trading on many days).

To use a sports betting analogy, the IPO for Vernon Davis sets an Over/Under line for investors. Investors who believe cash flows will exceed those assumed in Fantex’s DCF, or those that are willing to accept discount rates below those assumed, will take the “Over”. Meanwhile, the major “Under” risks for investors to consider are factors like: age/productivity decline impacting new contract value, injury, salary cap cuts, brand damage through bad behavior, endorsement income shortfalls, and less than assumed post-career earnings. All of these factors are major components when considering the present value of these tracking stocks.

From an asset characteristic standpoint, Fantex’s first three scheduled contracts are all considerably different from one another. Vernon Davis is a veteran All Pro tight end. Arian Foster was an undrafted RB who became a Fantasy Football star but is returning from a season ending injury. EJ Manuel is a young, 2nd year quarterback playing in a small but loyal market (Jim Kelly who is unfortunately battling cancer had a few national endorsements with the Bills success). Each asset is likely to offer investors a different experience based on these diverse set of underlying circumstances.

The three primary sources of cash flow for Mr. Vernon Davis are 1)NFL earnings 2)Endorsement Income and 3)Post Career Earnings. The NFL playing contracts are the most material cash flows given size, timing and correlation with other income categories. After an All Pro year, the 2 years remaining on his existing contract functions like a relatively-short term bond, but the majority of value to be generated hinges on signing a new contract for the 2016 season and other economic opportunities that lie beyond.

[Content Below Referenced from Conversations with Fantex Management]

Terry Lally, Spotlight Funds:
As a fan and investor, valuing the brands of athletes and celebrities is a fun exercise. Fantex is taking a unique approach to providing upfront liquidity to athletes and a way to participate in the athlete’s earnings power for investors/fans. Given the size, structure and expected liquidity, the Fantex offering seems to be positioned for the retail investor and fan rather than institutional investors. Is that a fair characterization?

Buck French, Fantex:
Fantex was created to allow individual investors to participate in the income streams of their favorite athletes and entertainers and for these remarkable people, in turn, to have thousands of shareholders that will amplify their brands. Having said that, there has been significant interest in our first offering – Fantex Vernon Davis – from institutional investors: one is not precluding the other. Many find the security very interesting because, based on the estimates, an investor can get their money back in a reasonably short period of time and still have the call option on the upside. This is precisely what makes this an attractive non-correlated equity.

Terry Lally, Spotlight Funds:
Your first, three brand management contracts are in football. Why start with football with its shorter careers, non-guaranteed contracts, and lower endorsement potential than a sport like baseball (longer careers, guaranteed contracts) or golf or Nascar with their significant endorsement earnings? If cash flows were more predictable and longer tailed, it would be more like the structured settlements industry which arbitrages discount rates and takes advantage of current low interest rates.

Buck French, Fantex:
While we fully intend bring athletes from other sports to the platform, investing in the brand of an NFL player offers unique elements on its own compared to other sports – particularly the opportunity for a post-career in broadcasting, the opportunities for which are much higher in football than any other sport. There are a number of misconceptions about how professional athletes are compensated. For example, substantial money in NFL contracts is, in fact, guaranteed. It is also a misconception that all professional golfers have significantly longer career length than pro-bowl football players, for example. The average career length for an NFL player drafted in the first round is 9.4 years; the average for someone selected to at least 1 pro-bowl is 11.4 years. Career length in any sport is about what data you are looking at and analyzing.

Terry Lally, Spotlight Funds:
Why does an athlete sign a brand management contract with Fantex? They are earning very strong incomes. Does it signal the need for cash flow to fund their lifestyle? Is it a hedge on the Under (getting cut, injury)?

Buck French, Fantex:
The individuals on our platform are doing it neither for the money or as a hedge. Of course, athletes want to be fairly compensated. However, their primary goal is to help manage and amplify their brands – both during and after their playing careers – by creating thousands of brand advocates who are also participating shareholders.

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Cash Flow/Valuation Assumptions

In valuing brand assets like those that Fantex is offering, there are bond-like elements (existing contracts, endorsements) and call options (new contracts, new endorsements, and post playing career earnings potential). Most of the value assumed in this initial offering is from the player’s NFL contracts with the key assumptions being longevity and contract terms.

In modeling the contract values, it’s worth noting that there have been many recent high profile salary cap cuts (Michael Vick, DeMarcus Ware, Mark Sanchez, Darrelle Revis, etc.). This highlights that big contract signing #’s may not actually be received by the athlete and exposes the athlete/Fantex to mark to market risk/opportunity of new contract. Many teams “ask” players to restructure contracts to be more cap friendly.

[Content Below Referenced from Conversations with Fantex Management]

Terry Lally, Spotlight Funds:
There are four cash flow categories within the Vernon Davis offering with distinct risk profiles: 1)Existing NFL contract through 2015 2)Future NFL contracts starting in 2016 3)Endorsements and 4)Post career earnings.

80% of Fantex’s Vernon Davis DCF is based on NFL player contracts. 49% is based on the key assumption of signing a new $33.5m contract ($8.37m, 4 years) at elite tight end position compensation starting with the 2016 NFL season after his current contract expires after the 2015 season. You primarily use the 2007 Tony Gonzalez and 2010 Antonio Gates contracts as comparables in developing these figures. How have tight end position salaries changed since then?

Buck French, Fantex:
To estimate Vernon’s next contract, we actually did regression analysis on all tight end who were drafted and retired between 1990-2010, to determine his career length. This yielded a dataset of 212 tight ends. To estimate his future contract to complete his career, we then looked at all active and retired NFL tight ends, who averaged at least 600 receiving yards per season, were elected to at least one Pro Bowl, played greater than 8 NFL Season; and signed a contract after 30 years old after 2005. There were only two players who signed multi-year deals who shared those same attributes with Vernon Davis. In other words, these two were derived as comparables from the data, not cherry picked.

What we're basically looking as investors in our model is we're estimating it as a $33.4-million contract that, from a valuation standpoint, we're buying for $19.4 million today because that contract is getting applied a 13-plus percent discount rate. When I look at that discount rate applied to that estimated cash flow based on comps, a CCC junk bond yielding about 8.5% with a 27.5% default rate, I think buying that at a 13.2% discount rate is --I think that's a good compensator for risk.

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Endorsement Assumptions

The current value of Vernon Davis’s endorsement contracts in 2014 and beyond only represent $413,000. The Fantex forecast assumes his endorsement income significantly increases to $8.3m over the course of his remaining career.

Since only elite athletes like Michael Jordan, Arnold Palmer, Jack Nicklaus or Joe Montana earn significant endorsement income after their careers, this assumes a significant increase in endorsement income during his remaining playing years. The 20X increase in endorsement contracts seems aggressive for an athlete who already had strong brand building support from brand innovator Under Armour.

[Content Below Referenced from Conversations with Fantex Management]

Terry Lally, Spotlight Funds:
The $8.3m endorsement income assumption has less contractual support and requires an increase in Vernon Davis’ brand appeal and endorsements. What brands and endorsements do you see Vernon having an opportunity for?

Buck French, Fantex:
Endorsements are correlated to performance, position, and sport. The reason you see more quarterbacks is they touch the ball the most, so they get the highest profile. You then get the offensive skilled positions next, the running backs, wide receivers, tight ends. I'm talking NFL now. That's where the vast majority is. There are exceptions to that with examples like Richard Sherman and others.

Again, it goes to performance, position, and sport. And so it's all over the map. The vast majority of players make a 100 grand or less a year, then there's a bunch of guys that are left to make in the $250,000 to a $1 million range. And then there's the guys that have the footprints, the million Twitter followers, they have an audience. Those guys can make $1 million to $2 million. And then the quarterbacks can make anywhere from $3 and up.

Vernon takes a different approach. He is not looking for just the cash comp. His approach is -- which we support and actually advise athletes to do -- he goes for the equity side.” At Jamba Juice and Ike's Sandwich Shop, he's taking franchises instead of comp for his endorsements - he's reoriented his business over the last couple of years, his brand -- to look for those opportunities versus getting paid 300, 400, 500 grand for endorsements and appearances. He'd rather own for his post career. He's not looking for, "Give me $500,000,” and go do an Under Armour. He's looking to do things that create equity or revenue sharing opportunities versus the one offs. The reality is when you're making $5 million, $6 million, $7 million, $8 million a year on the field, then an extra $0.5 million really isn't going to change your life.

But if you get a couple of percentage points, so you get a franchise or something else that has perpetuity potential or longevity with it, then, it's smart to do that versus, -- "I've taken $500,000, half of it goes to Uncle Sam, I’m net 250).” It's not changing your life. But to have something that generates cash flow for you for -- well past your playing career, that's a smart play. And it's unique. When you see guys getting it, that tells you right there they're unique from a brand market perspective Our goal is to create that long tail. We don't get paid commission. We are basically aligned because we're acquiring that future cash flow stream from them. So our incentive is to increase the cash flow stream. So, that gives us the ability and the desire to look longer term for the brand and to start bringing this broader picture of the brand out into the marketplace.

Terry Lally, Spotlight Funds:
In his post NFL career, the primary assumption is that Vernon goes into announcing. Unlike football where you have plenty of data on contracts, there is not much data on how much an announcer makes. How much do announcers make and what is the typical duration of career?

Buck French, Fantex:
Based on our estimates and understanding the industry, there's no playbook out there like there's for the NFL salary. A couple of $100,000 to millions. Look at what Michael Strahan is making between Fox Sports, Michael and Kelley -- and supposedly, they're in talks for him to sign with Good Morning America. But he's an exception, right? So, it's anywhere in-between.

Davis’s projected post-career salary which is a 10-year tail, starts off at one number and tails off over 10 years. We're buying that post-career for $1.4m. Our goal is to turn that into a real career that has a very long, high-income-generating potential.

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Counterparty Risk

Fantex is asking investors and athletes to take a Leap of Faith on a new security and firm. The contracts are contingent on raising the financings. With the security structure, the investor is taking Fantex counterparty risk since the tracking stock ultimately becomes convertible into Fantex platform stock solely at the discretion of Fantex’s Board. The recent Mt. Gox bankruptcy highlighted counterparty risk. There are limited financial disclosures for Fantex except reference to the history of startup losses, dependence on parent to fund losses and 5% management fee to the parent.

Secondary market trading is exclusively through FBS ATS (Fantex alternative trading system). Investors need to have an account with Fantex. With the trading restrictions and security structure, this appears to be a buy and hold security like the Green Bay Packers or Boston Celtics rather than an actively traded security with liquid markets. Fantex is not required to act as market maker.

As an institutional investor, I have a number of concerns regarding estimating cash flows (magnitude, duration) as well as structure (not securitized, custody, conversion into platform stock taking Fantex credit risk, transparency into Fantex’s financials, governance Board “extraordinary latitude without your consent” conversion, dividends, attributing assets/liabilities, expenses, can vote to force conversion).

[Content Below Referenced from Conversations with Fantex Management]]

Terry Lally, Spotlight Funds:
For the platform to become profitable, it requires building a portfolio of contracts to get to scale. What level of athlete brand income do you need from the multiple tracking stocks for the platform to reach profitability? Can you provide disclosures on Fantex’s financials?

Buck French, Fantex:
The stock is not convertible for the first 2 years and then, as it states in the prospectus, the major reason for conversion would be due to the brand contract not generating income any longer. Unlike the example you provided, Fantex Inc.’s financial statements are disclosed in the S-1 and are audited by Deloitte.

Buck French, Fantex:
What do you expect the daily trading volume to be? Will it be like closed end funds or the timeshare market where sellers have to take a significant discount for liquidity?

Buck French, Fantex:
Our system is a bid/ask system with liquidity dependent on the marketplace. We fully intend these securities to be actively traded. Given the tremendous amount of general information available on these brands, we believe investors will form trading opinions and trade.

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Credit Risk

The athlete is expected to make payments to Fantex. There has been a history of high profile athletes having financial problems (Mike Tyson, to name one) despite earning significant career income. There has also been a history of athlete’s avoiding disclosure of extra income (IRS audit of Pete Rose’s baseball card signings).

[Content Below Referenced from Conversations with Fantex Management]

Terry Lally, Spotlight Funds:
Why not have legal rights to the key contracts and have income assigned to Fantex vs. taking the athlete’s credit risk? How do you effectively track and protect Fantex’s share of extra income? You have audit rights. Is there any teeth other than suing?

Buck French, Fantex:
Where possible, Fantex will gain assignment of the acquired percentage in contracts, so we may be paid directly from the contracting party. Fantex also has audit rights through to the athlete’s tax returns. As part of our on-going disclosure, we will provide asset-to-debt ratios to our investors to provide an early warning system to potential bankruptcy. Any failure to comply with the contract signed between Fantex & the athlete, would be considered a breach which we would enforce by seeking the appropriate remedy.

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Securitization

Musician royalties have been securitized. With its separate custody, legal rights and cash flow prioritization, securitization removes the counterparty risk and would make the offering more acceptable to institutional investors.

[Content Below Referenced from Conversations with Fantex Management]

Terry Lally, Spotlight Funds:
Why create single athlete tracking stocks rather than a diversified portfolio of contracts? A diversified portfolio would improve predictability by diversifying away some of the “stock specific” risks such as injury or negative PR.

Buck French, Fantex:
We at our core are a brand building company. We are not about providing a pass through for the cashflows of the athlete. We believe that we can acquire the cashflows with a basic return in mind for our investors and importantly enhance the income streams to provide a greater return in the future through our marketing expertise.

Our approach is really no different than the traditional equity markets. People want to choose which stocks they invest in. We fully plan to have “baskets” of athletes available on the platform over time. However, we don’t feel the absence of ETF-like investments makes the current platform any less compelling.

We see building a very diverse portfolio of hundreds of athletes (and eventually entertainers) across any number of sports, playing any number of positions, and at various points in their career. While all within football to date, our signings so far have been a microcosm of that strategy.

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About Terry Lally
Prior to forming Spotlight Funds, a Los Angeles-based long/short equity fund, Mr. Lally was Chief Investment Officer of Spotlight Capital Management. Prior SVP, Principal and Co-Portfolio Manager at Cramer Rosenthal McGlynn. Co-PM of CRM Smallcap Strategy, Co-PM CRM Allcap Strategy. Senior small cap equity analyst at CRM and Prudential Investments. Prior Prudential Investment roles in corporate finance, treasury risk management, and equity trading including $4B strategic divestment of Prudential Home Mortgage Company. Harvard MBA, Notre Dame BBA, magna cum laude. Recognized as one of the top finance students in 1989 as Notre Dame’s selection for the Wall Street Journal Student Achievement Award. Earned CFA in 1993. Member of the CFA Institute and CFA Society of Orange County. President of the Harvard Business School Association of Orange County.
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