An NBA franchise is a field of dreams for hedging investments
Seattle Mayor Mike McGinn and County Executive Dow Constantine are working behind closed doors to draft a memorandum of understanding (MOU) with San Francisco hedge-fund manager Christopher Hansen, who wants to bring NBA basketball back to Seattle. Under the MOU, the city and county would provide up to $200 million of public financing for a new professional basketball and hockey arena in Seattle's SoDo district.
City sources suggest that the MOU will be released soon. Then will come intense scrutiny by the City Council and others. The vetting had better be intense, because in these negotiations the private side is thick with lawyers, clever deals, and arcane, hidden factors.
A good place for initial skepticism is the repeated claim that this project will be "self-financing." That is absurd on the face of it. There are real choices to make in using $200 million of public financing. That much money is never free. There are up-front costs, opportunity costs, and major mitigation costs that will require more public money to be spent. Pretending otherwise is pure spin.
Another reason for alarm is the absence of a truly independent entity to do the due diligence, such as an Arena Due Diligence Commission. Such an independent entity should not be packed with politicians who stand to benefit politically, nor with private parties who stand to benefit economically (landowners, team owners, bondholders, hedge-funders, investors, construction unions, boosters, nearby real estate developers, etc.).
The Arena Review Panel that early on concluded the idea to be worth exploring sketched a roadmap, detailing 17 rock-solid due diligence items (Section 4) still to be tackled. That panel's work was more "preview" than "review." A new panel should do the heavy lifting that is real due diligence.
But even where the reviewing entity is independent, in these stadia deals there is often a mismatch around the negotiating table, with the public playing defense. The true benefits to backers are greater than most people realize. The opportunity costs and the risks to governments are frequently clouded by fan-fueled boosterism. Vital questions that merit attention can be lost in the din: What is the best use of public financing? Is subsidizing private businesses really the most important thing we can do with these resources right now? Are we maximizing benefit to the public?
The strongest card that the city and county hold is their approval of the deal. The danger is that officials, pressured by the sports interests and their own political interests, will play that card way too early in the game, yielding negotiating strength before full public consideration of every deal detail. That may have already happened, with McGinn and Constantine rooting hard for the idea way before the full costs are known.
Critical in this arena proposal is the fact that Hansen, the backer, is in the hedge fund business, managing the money of high-net-worth individuals with a sharp eye on tax laws, offsetting losses, and hedging. Hedge funds find ways to make money while also paying far less tax on that money. This is a fairly rare skill that clients pay handsomely for. Combining ownership of a professional sports team (whether or not it makes money) with a publicly financed stadium deal offers a field of dreams for hedging opportunities.
On the face of it, investing in an NBA franchise seems risky and an almost sure way to lose money. But not really. These deals provide arena and team investors all kinds of ways actually to make money and capture value on some smart hedges that are unavailable to public financiers and almost invisible to the public eye.
Here are at least six ways for such a "foolish" investment to pay off for investors.
First, the owner group stands to make money on the dirt they already purchased. The MOU will likely specify that the City/County will purchase the land at an appraised price. But who specifies the appraisal? Will it be an arbitrative process (average of multiple appraisals from appraisers chosen by all the parties) or an arbitrary one (the seller's appraiser)? Even so, the purchased land, thanks to the speculative real estate interest it will have generated, is sure to make money, all the more so as years go by.
Second, the owners stand to make money on the acquisition and sale of the teams. Regardless of team performance or operating results, team prices go up, often by a lot, when they are sold over time. That's because team ownership offers powerful tax advantages, and also because there is a shortage of teams to be purchased, thanks to an artificially constrained supply.
Third, the Roster Depreciation Allowance (PowerPoint) allows team owners to claim a significant financial benefit by pass-through depreciation of player salaries (as an asset, just like a herd of cattle), while also claiming their salaries as expenses. It's tricky, obscure, and it requires sophisticated accountants and lawyers who can easily be a few chess moves ahead of the team on the other side of the table. These allowances are worth millions if someone has a lot of other income to offset.
There's also a joker in this deck: once the depreciation allowances are used up, there is greater incentive to sell a team. And after the host of benefits accrued along the way, financial penalties for leaving town are usually a small price to pay unless the agreements made concerning early exits have been made ironclad and very expensive.
Fourth, the operation of the team or the operation of the stadium may each provide a strategic profit or a loss, whichever the owners prefer. Between the many ownership entities, arcana such as seat licensing, beverage-pouring rights, and other allocable revenue, income statements and balance sheets can be driven in the direction needed. It will all be in the very fine print.
Fifth, in the case of the Seattle arena, if the backers propose to manage the construction of the stadium, they will earn some markup on that. How much needs to be perfectly clear. The same may apply to KeyArena if the Hansen group takes on the downsizing of it and its new management. Parking concessions are another lucrative stream of revenue to be clarified.
Sixth and last on my list are the government bonds that provide the local $200 million in financing. If the City and County issue public financing (bonds) for the arena, key questions are whether they are tax exempt, and what interest rate will be paid. For bonds to be tax-exempt, they need to pass a two-part "Private Activity Test. (PAT)" One part of passing the test would be for the bonds to be general obligation bonds backed by "full faith and credit" of the governments. That puts the government potentially on the hook if things go wrong. The alternative is revenue bonds, which are backed only by specific revenue streams pledged against them. Revenue bonds are riskier and costlier, because they are perceived to have less security.
Another part of the PAT test requires keeping the private activity revenue stream below 10 percent of the value of the bonds. If the MOU comes out with strangely low arena rents penciled in, that could be a clue that someone is angling for tax-free status for the bonds. That's complicated but hugely valuable, because if you also want to acquire a few hundred million dollars of tax-free bonds in a municipal project, the tax-free income on those bonds amounts to millions of dollars a year. (Bond policy wonks can dive deep here.)
According to King County budget director Dwight Dively, "much of this is not yet resolved, so these are tentative thoughts. It is likely that most of the debt will be taxable because it involves private activity." Dively continued, "It might be possible to issue these as revenue bonds without a 'full faith and credit' pledge, but the interest rate would be significantly higher. At this point, I assume the arena debt, if issued, would be GO (general obligation) bonds with the full faith and credit pledge."
And what does the public get out of this? The fiscal upside is far more modest, though it can be rewarding to a few politically powerful sectors: short term construction jobs, and later on, part-time, low-skill, low-wage concession jobs or waiting tables at nearby sports bars. Boosters will claim that government stadium subsidies produce or sustain huge numbers of jobs, through tourism and add-on effects. Potentially, but many of these jobs are just displaced from elsewhere in the region (as for example when someone grabs a burger near the arena rather than one closer to home in Bothell).
There will be major costs to the public as well. Making arena and other sports traffic and nearby rail and Port of Seattle operations able to coexist in an area of industrial activity is going to take tremendous resources for new transportation infrastructure. That will have to be funded by public agencies, possibly buried in a special levy for multiple road projects. As to the point that, after 30 years, the governments will end up owning both the land and the stadium. Is that a benefit or a white elephant? Think KeyArena 2.0: old, tired, empty, and expensive.
Above all, information asymmetry is a huge risk in negotiations. Time for a very hard look at all the aspects of this deal, by independent inspectors. If we understand all the upsides for arena investors, beyond professed civic pride, then the negotiating playing field will be leveled.