Wednesday 3 September 2014

The Falcon Has Landed…But Is He Here to Stay?

With the first UEFA Financial Fair Play fines fresh in managers’ and club owners’ memory, the end of the summer transfer window brought a newly emerging trend into the light. Top players are no longer transferred, but are rather borrowed and lent. Chicharito to Real Madrid, Falcao to Manchester United; no name is too big not to be lent out and tried out. But don’t be fooled, it’s just a transfer in disguise, with payment partially deferred, so as to circumvent financial fair play rules. Is it really, though? In this post, I will explain why those gullible enough to believe the emerging loan + purchase-option is a mere deferred-payment plan are bound to find out that it isn’t. Those who understand that it isn’t, may have an opportunity at their feet to start building their dream team for the near future.

The underlying logic of UEFA’s financial fair play is a straightforward one: you ought not spend more than the money that is coming in. By the end of a transfer window, clubs typically have already spent close to their maximum allowance and are thus at risk of punishment if they sign big-ticket players. By rather borrowing a player, a club avoids having to pay a large transfer fee upfront. Instead, a typically much lower – otherwise there would be no point – fee is paid to the owner-club in return for transferring the services of their employee for certain duration, typically one year. In addition, there is a purchase-option included, which the borrowing club can exercise when the loan spell ends.

An at-first-sight similar construction has since long been used in American professional sports, where salary caps cap the amount a team is allowed to spend on players’ wages during a season. When a club wants to land a new star player but is close to its salary cap, a preferred solution is to offer a back-loaded contract, by which wages earned early on, e.g. in the first year, are relatively very low, but will go up substantially in later years.

It is important to appreciate the fundamental distinction between both mechanisms. In the case of the salary cap, payments are simply reshuffled, but essentially secure. In the case of the loan + purchase-option, the option element, critically, is uncertain to be exercised. It is an option, not an obligation. In finance, options come at a premium, exactly because – other than with an obligation – you are locking in the upside potential, but do not bear the downside risk. No free lunch in finance. Is there one in football?

A concrete example, if Man. U. signed Falcao on a four-year deal for, say, €65m, Falcao would get injured this season and never return to his old level, Man. U. would lose its capital invested. With the loan + purchase-option, if Falcao became top scorer in the Premiership this season, Man. U. would gladly exercise the purchase-option. But would it also if Falcao broke his leg and was facing revalidation at the end of the season? Not likely. And no-one can force them to exercise their option. Surely, today Man. U. intends to exercise the option at the end of the season, as it told Monaco – but it can postpone that decision till the end of the season – when there may be a new hot kid on the block.

Source: dailymail.co.uk

Options tend to be extremely valuable – the difficulty often lies in finding a counterparty willing to take on the downside risk while ceding the upside potential. Influential Belgian sports commentator Stef Wijnants was wondering out loud why clubs were agreeing to lend their top players and that this had previously been unthinkable. Indeed, if before a Manchester United would have gone to Monaco and said, ‘listen, we are interested in Falcao, but we would like to try him out for a year and if we like him, we will buy him’, the Monegasques would likely have told them off with the warning not to waste their time. Thanks to financial fair play rules, however, the story can be framed differently and becomes very credible. It is not that the Mancunians do not want to sign Falcao and pay everything – say €65m – upfront, it’s that they are not allowed to! Plus, this is actually true today. Will it still be true next year? The risk is entirely Monaco’s.

Based on the numbers from the sports press, the option premium in the case of Falcao was…0. Spanish sports site sport.es is formal: “Van Gaal’s club will pay €65m to Monaco”, the number that had been circulating earlier, when talks of a – real – transfer were picking up. The small print: Man. U. pays €10m to hire the Colombian for the first year, with a €55m purchase-option. €10m + €55m = €65m: Monaco agreed to the terms as if it's about deferred payment. It kind of is – only without any of the upside potential, and all of the downside risk: If Falcao will be worth €55m or more (to Man. U.) next year, they will exercise the option. If, instead, anything between that and 0, Monaco will get him back.

To what extent these numbers are reliable and this case may be indicative of a more general trend to erroneously conceive of the loan + purchase-option as equivalent to a transfer with partially deferred payment with the same nominal amount is hard to judge. What does seem clear is that, as far as the borrow-side clubs are concerned, financial fair play is, paradoxically, enabling them to pull something off in terms of top transfers that they could not have gotten away with otherwise. Thanks to the “credible threat” of financial fair play, sell-side clubs are apparently found willing to lend their best players in the expectation that they have de facto transferred them. The ones who will continue to be stars, they will actually prove to have. The "lemons", they will see back in a year’s time. Thanks to financial fair play, the smart stand to get richer and the gullible poorer.

Cruijff had known it long before there was talk of financial fair play: “Elk nadeel heb z’n voordeel”. Every disadvantage has its advantage.