Sustained Inflation Could Undermine Pro Franchise Valuations
U.S. inflation reached a 31-year high in October. The Labor Department reported the consumer price index rose 6.2% year-over-year, the fifth straight month the inflation rate had cleared the 5% benchmark.
Market interest rates typically rise when the expectation of sustained inflation exists. Economists remain at odds as to when the current inflationary period will peak. RSM chief economist Joe Brusuelas, for one, expects the long-term rate “will probably go from 1.5% to 2.5% next year.” But if one subscribes to the view that the near-30-year grind down on interest rates has helped to propel sports team valuations, then it’s logical to assume a material increase in interest rates over a sustained period would negatively affect franchise valuations, or at least the rate at which they increase.
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JWS’ Take: There is no real historical comparison to understand how rising interest rates might affect team valuations. At no time in the last three decades was the expectation of sustained inflation part of the investment discussion. Then again, 30 years ago, it was challenging to unload a pro sports franchise—in part, because they generated little in the way of free cash flow.
However, over time, investments with little FCF and earnings have shown to be more sensitive to inflation and rising interest rates than those generating meaningful cash returns. Sports teams are generally viewed as high-multiple businesses (i.e. they produce little in the way of cash returns relative to their initial purchase price, and they grow into the valuation over time). So, the expectation of a sustained increase in rates should in theory have a negative effect.
Growth investments that return little capital—like sports teams—typically suffer when interest rates go up, because the risk-free alternatives for investor cash improve (think: 10-year bonds). Other assets also come down in value in a highly inflationary environment (or at least stop rising as quickly) and thus become more attractive.
That, however, does not necessarily mean franchise valuations are certain to decline, should expectations of rising interest rates become widely accepted. In fact, the sentiment might not even be enough to prevent valuations from continuing to climb. But it reasons that expectations of sustained inflation would at least slow the growth rate. Just look at what happened in the stock market when the inflation story first began creeping in. Risk-heavy growth equities (including the sports betting stocks) saw their share prices slide, while the price of gold and commodities like oil rose.
It is possible the expectation of a prolonged inflationary period could also shrink the prospective buyer pool (which may negatively influence future sale prices). Remember, most pro sports owners are borrowing money as part of the transaction, and they are certainly cognizant of how much that debt is going to cost. If interest rates double, so will their carrying costs. Under that scenario, the team ownership opportunity may become less attractive.
Over the last two decades, a number of successful hedge fund and private equity managers have bought pro sports teams. But PE and venture capital are vastly different businesses in a world with higher—and rising—interest rates. A fund that returns 10% per year in an inflationary environment of 2% has a real rate of return of 8%; that fund’s same 10% annual return in an environment with interest rates at 5% or 6% is not nearly as attractive. If one assumes investors will be less willing to pay for lower returns, it very well could reduce the number of people able and willing to pay billions of dollars for a pro franchise.
Brusuelas sees how a sustained increase in rates could potentially stymie valuations and lower the number of new team buyers. But he also says those who already own a franchise—and are debt-laden—“will make out like a bandit [during an inflationary period],” he said. “Inflation erodes the real value of what [they are] going to pay back.” Presumably, a lower cost basis would enable highly leveraged clubs to become more aggressive in their spending.
There are certainly reasons to doubt that sustained inflation will negatively influence valuations. For starters, franchise values have always gone up—even for the worst-run organizations. Many are convinced there is little that can stop that trend.
It’s also possible the American big four sports leagues have reached a point where team valuations have gotten so large, and prospective team owners have to be so wealthy, that they are simply less sensitive to alternative investment opportunities. Then again, most billionaires didn’t become billionaires by ignoring interest rates.
If a club owner is able to command a premium for his/her team right now, and the expectation is that interest rates are going to go up (which would mean their investment opportunities will improve), then it is logical to wonder if a slew of team sales may be on the horizon. But that seems unlikely. Clubs typically trade when either someone dies or the owner gets tired of running the organization. Team owners don’t usually exit to invest elsewhere. Of course, no current owner really knows what having a team during an extended inflationary period is like, either.
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