Football Player Derivatives Are the Best Derivatives
A lot of financial innovation walks a fine line between "great idea" and "sneaky scam," but pro-athlete-trading-market-thing Fantex has added a third dimension of creepiness that makes it especially interesting.
The deal, which Jonathan Mahler wrote about here the other day, is that Fantex buys, say, a 20 percent interest in an athlete's future sports-related earnings, for, say, $10 million up-front, and then sells shares in those earnings to investors to raise the $10 million (and a 5 percent fee for Fantex of course).
The squick factor is obvious -- you're buying a person! indentured servitude! etc. -- and while I generally don't get too worked up about that sort of thing (you're only buying 20 percent of his income stream, you can't force him to work, etc.), here I'm a little creeped out. Fantex's prospectus for its first offering, 20 percent of Houston Texans running back Arian Foster, has a Q&A that includes the question "Who is Arian Foster?," and the answers do not get at the heart and soul of Arian Foster. Well, the heart, yes:
Arian Foster is reported to have experienced an irregular heartbeat on numerous occasions since he was 12 years old, and in one instance he was reported to have left a regular season NFL game early due to this condition.
That's from the second of two paragraphs of the answer.* The first paragraph is about his football stats, the second is about his injury risks. I prefer not to imagine Fantex summing up my life in two paragraphs about my, like, blog pageviews and childhood physical infirmities.**
But Foster is a grown man and he seems to be getting pretty good value here. Fantex is strangely honest about how it came up with the $10 million figure for Foster's future earnings -- see pages 82-86 and 109-112 of the prospectus -- and the answer seems to involve a lot of hope. Sixty percent of that $10 million present value -- and 75 percent of undiscounted estimated cash flows -- comes from what Fantex calls "Category C" income, meaning "potential brand income related to anticipated future contracts, such as future endorsements, playing contracts and/or additional brand generating income from coaching, broadcasting or the like." His current NFL contract will pay a maximum of $25.5 million between now and 2016, of which Fantex and its investors will get at most $5.1 million. Foster made $482,000 in "other included contracts" in 2012, meaning that if he continues at that pace Fantex will get $100,000 a year from endorsements.
That adds up to way, way, way less than $10 million, even before you discount for time value and risk (most of that NFL contract isn't guaranteed), meaning that they're banking on his odds of getting a new and similarly lucrative NFL contract at age 30, and on the likelihood that he will "enter into and maintain endorsement contracts (or earn other brand generating income) that compensate him in amounts that are significantly in excess of compensation that he has had historically from these source." Maybe, who am I to say, they're delighted that he "recently landed [a] role as a professional running back in a new Kevin Costner film, Draft Day," go see it, 20 percent of Foster's film paycheck will go to Fantex.***
Still: He's getting pretty full value for signing over 20 percent of his uncertain future football income. Figure that income lasts for seven more years, discount at 10 percent, and his breakeven is around $72 million. If he makes less than $72 million over the next seven years -- and he made $11.2 million in 2012, but that included signing bonus; he should make $5.75 million in 2013 -- this is a good deal for him. If he makes more than that, it's not. But, y'know, at that point he's made $72 million, who is he to complain.
So for Foster -- or for 49ers tight end Vernon Davis, who signed up with Fantex yesterday -- the trade is a fairly obvious hedge to a risky career whose potential downsides include, y'know, horrible injury.**** That's good! The thing where lots of young people work and sacrifice for a chance at professional-sports stardom, most fail and get nothing, and a few succeed and make hundreds of millions of dollars, is maybe not an optimal thing. Foster and Davis are already successes, but if this works you can imagine younger players with lots of potential doing similar deals as a way to monetize their potential and smooth out their possible future states. Exercise for the reader: Price a Tim Tebow contract as of 2010.
For investors, it's -- well, there are two possibilities. The investors could be sophisticated providers of capital who are modeling this out, estimating cash flows based on comps, using actuarial data to discount the risk of injury, etc. etc. etc. Or they could be, y'know, retail sports gamblers.
The answer seems to be "retail sports gamblers" -- the prospectus says so***** -- though I suppose that doesn't entirely preclude sophistication. Also the fact that this is a somewhat uncertain product being offered to retail investors doesn't guarantee that it's a scam, or that Fantex is taking all of the surplus here. They're taking a lot -- a 5 percent fee for themselves, plus you can only trade the thing through their expensive brokerage system -- but I was somewhat surprised to learn that the offering is for the fixed price that Fantex paid for Foster's income. If the "market" prices this contract at $12 million, Fantex seems content to price it at the $10 million they paid (plus their 5 percent fee). They're making money on fees, not mispricing.
There are other structural problems though none of them worry me too much -- they're mostly no worse than you'd see in other tracking stocks. No, you're not literally buying 20 percent of Arian Foster. That's probably for the best.******
David Merkel wrote a good post the other day that begins: "Derivatives exist to subvert regulations, at least the regulations that don't involve derivatives." This is not an orthodox statement. Textbooks tend to treat derivatives as instruments of risk transfer -- hedging and speculation -- rather than as instruments of regulatory arbitrage.******* Both are true: Derivatives really are used both to hedge and to subvert regulations, and it is an empirical question which is more important. Me, I'm with Merkel. Derivatives exist to subvert regulations.
Mostly! These derivatives on Arian Foster and Vernon Davis are a genuine risk transfer. Also, they seem like a socially beneficial transfer, where each side really is improving its position by doing the trade.
Foster and Davis have huge, incredibly undiversified, incredibly risky exposure to their own future earnings power, which depends largely on things outside their control -- principally, on whether the many strong skilled people trying to break their legs and/or skulls succeed in doing so, and secondarily on whether marketers find them charming enough to use in commercials and Kevin Costner movies. It is the sort of risk that it would be nice for them -- and other similar but less rich people in their position -- to be able to hedge. It makes all the sense in the world for them to give up a little of the upside -- above $72 million! -- in exchange for cushioning the downside.
Meanwhile, sports gamblers like to gamble on sports. They want precisely this risk. They're getting a speculative investment that, look, I mean, you can read Fantex's vague and hopeful qualitative description of how it priced Foster's contract, and you can do your own modeling if you want, I am not the guy who'll tell you whether he'll make $72 million in the next seven years, but presumably if you're thinking about investing you have your own views on that, and you know more about NFL salaries and running-back career longevity than I do from reading this prospectus. Also you are more likely to watch a Kevin Costner football movie.
Also you are probably not gambling your whole net worth on Arian Foster's career, which is more than you can say for Arian Foster.
Even more to the point, the people betting on Foster get utility from the act of betting on Foster. In the aggregate, betting on sports is negative-sum (once you take out bookies' profit); it's still a big business because people like doing it. It's more fun to root for a team that you've bet on, or a player whom you partially own. And while your favorite NFL team only plays once a week, if you buy a Fantex contract you have constant opportunities to root for your guy: You want not only strong on-field performances but also, like, charming press conferences and successful acting careers. It suffuses your whole week with the warm glow of sports gambling. What is not to like?
Financial innovation is held in pretty low regard these days, for obvious reasons, so it's easy to understand why people are suspicious of Fantex. And it's not like Fantex, with its high fees and captive exchange and rickety structure and vague valuations, is really doing much to help its case. But! The social purpose of financial innovation is to find new ways to move risk from those who don't want and can't afford to bear it, to those who do want to and can. That's the idea, though it turns out to be surprisingly rare in practice. Rare enough that it's worth celebrating even imperfect efforts to actually do it.
* The whole thing is sort of a stonker so I'm going to reproduce it here, from page 20 of the prospectus:
Q: Who is Arian Foster?
A: Arian Foster is a running back for the Texans in the NFL. He has been in the NFL since 2009. Arian Foster attended the University of Tennessee, where he was the starting running back for three seasons. Arian Foster went undrafted in the 2009 draft and signed with the Texans as an undrafted free agent. Arian Foster was born on August 24, 1986 and is 27 years old as of October 31, 2013, and he currently lives in Houston, Texas with his wife, daughter and son. During the 2010 NFL season, Arian Foster was the leading rusher in the NFL with 1,616 rushing yards. Arian Foster was named First Team All Pro in 2010 and Second Team All Pro in 2011. Arian Foster has also been selected to three Pro Bowl appearances, in each of the 2010, 2011 and 2012 seasons. In addition, Arian Foster led the NFL in carries in 2012, with 351 (405, including post-season games), and was in the top six in carries in 2011 and 2010 with 278 and 327 carries, respectively.
Arian Foster is reported to have experienced an irregular heartbeat on numerous occasions since he was 12 years old, and in one instance he was reported to have left a regular season NFL game early due to this condition. In addition, Arian Foster played with a torn meniscus, or cartilage in the knee, during the 2010 NFL season, without publicly disclosing the injury until after the season when he underwent surgery to repair the injury. Arian Foster's playing status was questionable for two games during the 2011 NFL season, and he missed three games due to hamstring issues. Arian Foster re-aggravated this injury during an NFL regular season game on October 20, 2013 and left that game during the first quarter. A knee injury during the 2012 pre-season also made his season debut questionable. In addition, Arian Foster recently underwent an MRI on his right calf that was strained during off-season practice in May 2013 and has missed most of training camp due to a lingering back pain. Arian Foster has experienced these and other instances of normal wear and tear as an athlete in the NFL and we expect that Arian Foster will continue to experience such wear and tear. Any worsening of these conditions, or re-injury or new injury, could materially and adversely affect Arian Foster's playing performance and the value of the Arian Foster Brand.
** Also, while you can't force him to work, you can ... sort of force him to work. At a job that involves giant armored men trying to harm him. If he retires in the next two years "for any reason other than a 'good reason,'" he has to pay Fantex back $10.5 million (minus whatever they've already made off of him); you'll note that that's $500k more than they paid him. Here (from page 102 of the prospectus) is what constitutes a "good reason":
- he suffers or sustains any injury, illness or medical condition that renders him incapable of performing in professional football; or
- he suffers or sustains a major injury and a qualified medical physician (depending on the nature of the major illness) advises him that as a result he would be putting his physical health at substantial risk (i.e., a risk that is substantially greater than simply by virtue of his participation in professional football) by continuing to engage in professional football.
I say unto you: That last parenthesis is pretty ghoulish.
*** Fun trivia: Fantex participates in his earnings for any film or TV "with respect to which he either performs in the role of a professional or amateur football player, or performs as himself." If he just develops a non-football-related acting career, he keeps all his earnings. Also, as Katie Baker points out in her great story on the Fantex/Foster deal, his music career and children's-book-writing are off limits. But! An example from the contract:
Talent receives a 2015 Chevrolet Corvette Stingray as the Super Bowl XLVIII Most Valuable Player. The cash value of the MSRP of the Corvette would be considered Brand Income because it was earned by Talent for his performance in the Principal Business. However, solely for purposes of calculating the Brand Amount, up to $40,000 (or 4% of all Brand Income, if less than $40,000) of such value would be deductible from Brand Income for such calendar year under the Merchandise Income Deduction for such year.
**** As Mahler points out, there is a theoretical incentive problem here, since "the moment Fantex -- or whomever -- guarantees him income that's unrelated to how many yards he gains on the field, you reduce the financial incentives that contribute to that work ethic." But, y'know, come on. Foster made $11 million last year. That's more than he's getting from Fantex. One thing he could do would be to just take that $11 million and stop playing football. But he didn't. If your model is "Foster had a 100 delta to his career before signing with Fantex, but now he has an 80 delta to his career," your model is probably wrong: Foster's portfolio in life is not just his Fantex deal plus future earnings; it includes past earnings too. But even if that is your model, an 80 delta is a big delta and he has significant reason to keep making money. I should note that the contract restricts Foster from encumbering "more than an additional 15% of his brand income from his NFL player contracts and 30% of his other brand income in any given year," beyond the 20 percent he's sold to Fantex, presumably for these incentive reasons. (See page 102 of the prospectus.)
***** From the risk factors:
We expect that our offering will primarily attract individual investors, and therefore our initial public offering price may not be sustainable if and when trading begins, and the price of our Fantex Series Arian Foster could decline rapidly and significantly.
We intend to set an initial public offering price at $10.00 per share and expect that the market for our offering will primarily be individual investors.
In a typical initial public offering, a majority of the shares sold to the public are purchased by professional investors that have significant experience in determining valuations for companies in connection with initial public offerings. These professional investors typically have access to, or conduct their own independent, research and analysis regarding investments in initial public offerings. Other investors typically have less access to this level of research and analysis, and as a result, may be less sensitive to price in participating in our initial public offering. As a result, our initial public offering price may be different than the price that would be established in a more traditional underwritten offering involving institutional investors.
****** Here and here are representative "BEWARE you are not buying Arian Foster" articles, which are all true enough; Baker makes many of these points too. Yes, Fantex is not required to distribute all the cash it gets -- though it's said it intends to distribute "in excess of 20%" of that cash. Yes, Fantex can collapse the Arian Foster stock into its main player-ownership-platform stock (not stock in Fantex itself), though it's said it doesn't plan to except in unusual circumstances. Yes, Fantex's fiduciary obligations to tracking stockholders are underwhelming. But these things are largely true of real tracking stocks and everyone lives with it. And I doubt their lawyers are advising them that going back on those promises, never paying a dividend, collapsing the stock, and generally hosing investors is a good idea just because they disclosed that they might. That's not, like, a great lawsuit to have.
******* Merkel goes on: "Ideally, derivatives allow those that want to take on a given risk, to have the ability to do so. And the same for laying off risk."