The California Public Employees’ Retirement System, the largest pension fund in the country, recently sold $6 billion worth of private equity assets at a 10% discount to end-of-Q3 valuations—a warning sign to some market observers that institutions could be scaling back allocations to private equity over the next few years.
“If you are looking for a black swan it’s in private equity,” Macro Intelligence 2 Partners co-founder Julian Brigden tweeted about the sale. Former UBS and Credit Suisse director Grant Williams (currently an advisor for Vulpes Investment Management) agreed, calling the sale a “huge red flag” on a recent edition of the Are You Not Entertained podcast.
If the warning sign is accurate, decreased funds in private equity are going to pose a “significant problem for sport,” Williams said. “The dramatic rise in the valuations of sports franchises over the last decade has been largely built upon off-market valuations, recurring PE raises at loftier prices and the promise of abundant liquidity. With all of those in reverse, prices will fall, investment dollars will become far less abundant, and the cost structure of franchises that have tolerated losing money as the overall value of the franchise itself has supposedly risen will suddenly matter a great deal.”
But not everyone is convinced a downturn in the PE market will have a negative effect on club valuations—at least not in the U.S.
“General economic conditions will impact sports but not the private equity markets,” Bruin Capital founder and CEO George Pyne said in an interview. “The penetration of private equity investment is not significant enough to have a meaningful impact. The success of the sports ecosystem will depend on its own business fundamentals.”
JWS’ Take: PE has played an active role in sports over the last half decade. Sports leagues trying to recover from pandemic-related losses or looking to leverage readily available outside capital to unlock latent value or growth (or both) have embraced it. Fund managers saw the astronomical rises in team valuations and media rights contracts, and want to participate in the returns.
Pension funds tend to allocate much of their capital to diversified mega firms without much sports exposure, so the CalPERS sale is unlikely to directly affect PE investment in the sector. However, it could spark some indirect consequences.
Why? The price CalPERS sold at supports the notion that PE funds generally have incurred big losses. “The question is not have they lost money, but when will they own up to it,” Harry Melandri (advisor, Macro Intelligence 2 Partners) said.
Brigden and Williams are not viewing CalPERS’ divestiture in a vacuum. The Fed spent $4.75 trillion expanding its balance sheet, and Brigden believes that money is “directly linked to asset appreciation.”
To be clear, he is suggesting PE itself will be disrupted, not that the asset class will prove to be a systematic risk for the broader financial system. Other finance professionals we spoke to agreed.
Still, the $3 trillion in committed private equity funds benefits from public equity comparisons, Melandri noted, and “[if] the buying support isn’t there for the public markets, [valuations] may overshoot the underlying values.” Decreased public markets valuations “brings all multiples down and private asset prices with them.”
PE firms lag about two quarters behind in evaluating their holdings. But once they do acknowledge that their portfolios have come down in value, it will influence portfolio company valuations. That outcome could ripple across parts of the sports industry. Melandri gave a hypothetical example of a continental European soccer club purchased at a high price, which sets “a higher comp” for an English Premier League team. If the continental team’s price “is subsequently seen as too high, then the [EPL] valuation will come down in sympathy.”
Stability in valuations is one of the main reasons investors have poured into PE over the last decade. “There is no mark to market,” Williams said, since there is no public market, so fund managers seldom have to explain to their trustees why they lost money. And that flatters Sharpe ratios, which compare an investment’s returns to its risk.
For the last 20 years, “The more private equity you could get on your book, the better your Sharpe ratio would be,” Melandri said.
The current PE party looks to be nearing an end, though. “As [the Federal Reserve] raises rates, public equity comparisons come down,” Melandri said, harming the funds’ existing book value. While PE does not mark to a public market, “everybody knows their public equity equivalent is down 30%.”
New money coming into the space is much more expensive and less available, and “valuations, by definition, have to come down,” Brigden said.
Those funds that pushed the edge of the envelope are at risk. “The music has stopped,” Melandri said.
Declining asset values are not just problematic for the endowment funds and pension funds overextended in private equity. Companies burning through cash are also going to have a big issue in trying to raise funds. PE giants like Sequoia Capital have advised their portfolio companies to conserve cash in “founder’s letters.” Sequoia issued a famous one in 2008 titled “RIP Good times.” In mid-May, they described the current situation as a “crucible moment.”
Sports properties, though, particularly in North America’s big four sports leagues, have a saving grace: recent increases in media rights across the board. One sports finance professional who asked to remain anonymous noted that the companies seeing steep declines in the public markets are burning cash in the pursuit of future profitability. By contrast, at least 75% of big four sports teams are profitable on an operating basis.
History has also shown club values, especially for marquee teams, are largely uncorrelated to the market. In fact, during the great recession, franchise values went up. Investors were well aware of the market’s direction when the Denver Broncos recently sold for $4.6 billion, the largest price in the history of team sales.
Some European sports properties are likely to see valuation decreases, but not necessarily because of a disruption in PE, according to the anonymous finance professional. He seemed more concerned about the economic and political instability this cycle has caused for rights owners abroad. “Inflation devastates economies that do not have the kind of wealth the U.S. does,” he said.
It may only take one property requiring additional liquidity to trigger valuation corrections. “The way that it should manifest itself in the space is someone will come up with a deal they hope to get done and put some ridiculous legacy valuation on it,” Brigden said. When the deal does not close, and observers realize the inflated price was the reason, a “mad reset” could follow.
None of this means many—if any—sports funds will shutter or default on commitments. “The firms investing in sports are high quality firms with strong balance sheets,” Pyne said. And while some sports assets will have depressed valuations, they aren’t down 85% YoY as some Fintech or crypto companies are.
However, the haircuts, and the broader environment brought on by the Fed, will reduce the amount of future capital some firms will attract. Financial conditions will be tighter across the board, leaving less private equity capital for sports federations, teams and related businesses, especially in fast growing sectors like data, tech and betting. “However, it would not cease such investment, it would just slow things down for a period of time,” Pyne said.
Good companies will have interested investors—albeit not necessarily at the number they want. “Private equity will just be pickier about the price it pays for everything,” Melandri said. Klarna recently raised funding at $6.7 billion valuation, down 85% from the previous round.
But marginal companies, clubs or leagues will be impacted by reduced private equity war chests. In a best-case scenario, they will find money at far lower valuations. The unlucky ones will not find funding and will wash out. That is not necessarily a bad thing. The system is supposed to weed out weak management teams and products. For PE investors, the reset should result in better returns down the line.