In the previous articles, we have already seen that sporting franchises are required to raise a lot of capital at regular intervals. Hence, they are required to regularly raise debt from the marketplace. However, it is important to note that the decision regarding how much debt can be raised by a sporting franchise is not taken independently by a franchise.

In fact, this decision is taken by the management of the sporting league on behalf of the entire league. It is common for sporting leagues across the world to set a debt limit or a debt ceiling.

In this article, we will have a closer look at the concept of debt ceiling and how it impacts the finances of the sporting franchise.

What is a Debt Ceiling?

A debt ceiling is an artificial limit that is imposed by the management of the sporting league in regard to the amount of debt that can be undertaken by individual franchises in the league.

This debt refers to the gross principal amount outstanding. It generally includes all junior as well as senior debt issued by the franchise. However, the accrued interest is not considered to be a part of this calculation.

The franchise agreement signed by the franchises provides such rights to the franchisors. Such debt ceilings are common in many top leagues across the world such as the NBA and the NHL in the United States of America.

Why is a Debt Ceiling Important?

It is important to understand the reason why sporting league management goes out of its way in order to restrict the debt that the sporting franchises can raise. The amount of debt that is allowed has some important implications on the overall financial position of a franchise.

1. Impacts the valuation: It is common for prospective new owners of teams to raise debt in order to acquire a team in the sporting league. Hence, by limiting the amount of debt that can be raised by the possible suitors, the sporting league management tries to control the overall valuation of the sporting franchise. This helps them ensure that the player valuations as well as the overall valuations continue to remain rational.

   The objective of the management of the sporting leagues is to ensure that the valuations of the franchise rise steadily and are based on fundamentals. They want to avoid a situation in which sporting franchises can first be overleveraged by giving them too much debt and later they end up being bankrupt and can be purchased for pennies on the dollar.

2. Skin in the Game: By controlling the amount of debt that can be undertaken by a sporting franchise, the management of the sporting league is also indirectly controlling the debt-equity ratio of the franchises.

   It is common for the management of sporting leagues to ensure that the owners of the franchise have a significant equity interest in the game. If the entire franchise is allowed to be funded via debt, then it is possible that they may not have any skin in the game and the sporting franchise may make reckless high-risk decisions that have little impact on them but have a much larger impact on the franchise as a whole.

Types of Debt Ceiling

There are two or three different types of debt ceilings that are used by sporting leagues across the world.

1. Fixed Value: The debt ceiling imposed by the management of the sporting league can be of a fixed dollar amount. For instance, no sporting franchise participating in the league will be allowed to raise more than one million dollars in debt.

   The problem with this type of ceiling is that the dollar amount of the debt is the same for every team playing in the league. This may not be fair since there can be a huge disparity between payroll as well as other expenses of different teams. Hence, using the same debt limit for all is unfair to the teams with higher expenses.

2. Value-Based: Some leagues annually revise the debt limit based on the valuation of the sporting league in the previous year. This approach solves the problem created by the fixed value approach because it provides a larger debt limit to larger teams.

   However, it is quite difficult to implement. This is because of the fact that finding the valuation is a complex exercise. Even if the sporting league prescribes a standard methodology, it can be difficult to execute the same and find an accurate valuation on a yearly basis.

3. Profitability Based: There is a third approach that relies on the profitability of the sporting franchise in order to select the debt ceiling. This approach allows different teams to have different limits. It also does not necessitate that complex calculations such as valuations need to be done on a yearly basis. Hence, it is preferred by a lot of sporting leagues.

   However, it needs to be understood that the profit number can be manipulated by changing the accounting policies. Hence, it is common for sporting leagues to also define the accounting standards that need to be used while finding out the profitability of the franchise. This helps in standardizing the approach and making it fair for all the parties involved.

The bottom line is that limiting the amount of debt by imposing a debt ceiling is an important part of the overall financial strategy of many sporting leagues around the world.