Wednesday, November 13, 2013

Athlete-Backed Securities and Credit Risk

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

The financial media has been abuzz about Fantex, a brokerage firm that is offering investments linked to the earnings of professional athletes.  Their first offering was linked to 20% of the future earnings of Houston Texans running back Arian Foster, and the second was for a 10% interest in the future earnings of San Francisco 49ers tight end Vernon Davis.*  At first, the plan was met with some skepticism (and some ridicule), which was only magnified when last Sunday both Foster and Davis sustained injuries, including a season-ending back injury to Foster.  The IPO of the Foster-linked shares have since been postponed.

Now, we don't know a lot about sports (we're more the nerdy type).  But we do know a bit about esoteric, highly risky securities, so we thought we'd take a peak under the hood of this one.

According to the prospectus for the Foster series, the value of such an investment is determined by the potential future earnings Arian Foster might earn on, or off, the field.  Foster is giving up 20% of his future earnings in exchange for an upfront payment of about $10 million.  If the initial public offering of the shares generates sufficient interest, the shares would trade on an exchange operated by Fantex.  The transaction costs associated with buying and selling the shares on the Fantex exchange "are expected to be up to 1% of the total amount of the purchase or sale."

Few, if any, people will be able to accurately predict the future earnings potential of a professional athlete.  NYU professor and valuation expert Aswath Damodaran gave it a shot, pegging the Foster shares at only 61% of the offering price.  But as he notes, that involved a number of assumptions.  One of those assumptions was that Foster would play until he is 36 years old -- another nine years -- and another was that there would be a 5% chance of a career-ending injury each year.

In finance, the analogy is to credit risk, or the risk that an entity will default on its obligations.  Credit risk is notoriously difficult to measure (at least without liquid credit default swap spread data), and numerous models exist for single-issue credit risk as well as portfolio credit risk.  The Foster shares are essentially undiversified, which maximized their injury risk.

Indeed, running backs have the highest injury rate of all NFL positions.  Jason Lisk has a great series of posts about injury risk to running backs, which varies by workload (number of carries) and even the closeness of games.  Arian Foster certainly got a lot of work in the past two seasons, and his injury risk might have been particularly high.  As any fantasy football player likely appreciates, injury risk is very significant in the NFL and a team's success is in no small way determined by its portfolio 'credit' (or injury) risk.**

Thus Fantax's (perhaps brief) experiment with athlete-backed securities has highlighted one of the most important lessons in investing:  diversification.  Individual entities, whether they be the debt of Fortune 500 companies or shares of a pro athlete's future earnings, have idiosyncratic risk that is difficult to predict.  Often the best bet is to invest in a very broad portfolio of many different types of securities, such that the risk of any one default is relatively small.

Since this was not really possible with the Foster or Davis shares, it's unclear whether such securities would be suitable for any retail investor.  Time will tell if any other similar products ever...wait for it...make it to the big leagues.
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Interestingly, investors in the Foster or Davis series are actually investing in the Fantex business model.  Importantly, Fantex has structured the offerings such that the shares can be converted into "Shares of [Fantex] Platform Common Stock" at any time under the direction of Fantex's board of directors -- not the investor.   Although the value of the Foster series may be linked to the performance of Arian Foster, in the end "[w]hat you are investing in is Fantex the brokerage."

** You could get some injury diversification by buying shares in a whole team rather than just a player.  Unfortunately, there is only one pro sports team that is publicly traded:  the Green Bay Packers.

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