ABAnomics

A syndicated piece has been making the rounds about the financial deal sealed by a fellow named Ozzie Silna 30 years ago. Not surprisingly, the sportswriters have written a good story, but airballed the financials.

Silna owned the Spirits of St. Louis. Never heard of 'em? I hadn't heard of them since I was a kid, but I retained faint memories.

The Spirits were the third location of a franchise in the American Basketball Association (you know ... the red, white and blue ball, Dr. J, afros, the 3 point shot, and the slam dunk).

When the ABA folded, the NBA adopted 4 teams, one went bankrupt, one took a lump sum to go away (Kentucky Colonels owner John Y. Brown), and Silna took a financial perpetuity to dissolve his team.

The sportswriters breathlessly pronounce that Silna and his partners have gotten $168 million dollars out of the deal, as if they have that all laying around waiting to buy hats. They also imply that John Y. Brown - no financial slouch - somehow got a raw deal when he settled for a lump sum of $3 million in 1976.

Of course, what the sportswriters are missing is a clue about discounting and present value, the cornerstones of finance.

At the time, Brown took $3 million, Silna took a perpetuity. A perpetuity is a cash flow that never ends. Further, Silna's perpetuity was a 1/50 share (see below) of annual NBA TV revenues; if they grew, so did his payment. At the time of the deal, this share was worth $300,000 per year.

Valuing perpetuities is one of the first things you learn in finance. Just about everyone prefers to have cash now as opposed to cash later, so the trick is determining by how much to discount the latter. Choosing discount rates is objective up to a point, but also has a big subjective component.

Once you settle on a discount rate, the calculations are easy: the present value of a perpetuity is the annual cash flow divided by the discount rate.

Presumably, Silna and Brown were offered the same deals, telling us the discount rate is 10%. The logic is that neither deal was clearly better at the time (otherwise they would have done the same thing), and that Silna's $300,000 divided by 0.1 is equal to Brown's $3 million.

So, what does this tell us? The first thing to note is that this discount rate is in real terms. If there is expected inflation, we need to tack that on top. Secondly, no one knows how risky any deal is before it is carried out, but increased risk has to be compensated for with an increase in the discount rate. Discount rates are usually 3% or so when there is zero risk, so Brown and Silna settling around a discount rate of 10% suggests that there was some risk. (Of course, if you watched the NBA in the mid-70s, you had to be wondering whether it could continue to be a going concern with its high predictability and limited excitement.) Third, growth rates have to be subtracted out of discount rates, so Brown's 10% discount rate is actually a larger percentage minus the expected growth rate of the economy.

What would a realistic nominal discount rate have been on an investment in the NBA in 1976? With inflation the 3 previous years averaging almost 9%, and real GDP growth reasonably expected to be 3% or so (even in the 70s), a nominal discount rate of 22% is plausible.

It turns out that the cash flows that Silna and partners have received, discounted at 22%, gives a present value in 1976 of $4.4 million. This is a far cry from the 168 million pieces of (uncertainly valued) paper called dollars quoted by the sportswriters.

Still, it seems like Silna got the better deal.

But, a deeper look at the numbers shows that this is almost all dependent on Johnson, Bird and Jordan. There are only two 4-year NBA television contracts that increased by that much over the previous one: the annualized return required to justify the NBA's renegotiation in is 23% in 1987-90, and 31% in 1991-4.

Other than those two negotiations, the NBA television deals have been dogs. There is program called Crystal Ball that can simulate uncertain outcomes like this within Excel. The actual growth rates of the TV contracts are 15% annualized, with a standard deviation of 9%. Even if Silna had known those values with certainty 30 years ago, there would have been an 18% probability of his end turning out worse than Brown's (download the spreadsheet here).

Note: Silna's share is 4/7 of franchise's share, locked in with the 28 teams the NBA had at the time. So he gets 4/7 out of 28+4/7. Divide the one by the other to get 1/50. Apparently, the share of TV revenues that any expansion teams get comes out of the other 98%.