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Equity
Pooling and Media Ownership Prepared for the conference on Economic Impacts of The FCC’s Minority Tax Certificate and Private Investment Models for Minority Media Ownership, Columbia Institute for Tele-Information, Columbia Business School, July 27-28, 1998, Columbia University, New York. I am grateful to Olimpia Gjino and Radi Mitov for research assistance. Equity Pooling and Media Ownership Peter Chinloy Abstract: We outline a method of pooling equity for acquiring a portfolio of media properties. Each participant receives a security containing an investment return and a management right. The management right goes only to one successful bidder offering a cash payment to other investors as an access price. By offering repeat bidding on several properties, different members of a pool achieve ownership while diversifying their risk. Alternatively, an investor not wishing management receives a higher compensating return. The procedure is particularly suited to media properties dependent on local advertising such as radio, 'free' community newspaper and television outlets. These properties are more vulnerable to downturns in local markets. The pooling procedure allows local risks to be diversified away into the larger economy. Keywords: media ownership, equity pooling, market diversification. Equity Pooling and Media Ownership 1. Introduction Technological advances in media hive blunted some of these arguments. The free disposal cost and an inability to charge consumers may create niche markets that advertisers are willing to support, such as in free newspapers and cable television. Both media have targeted minority audiences. While network television has focused on median consumers, cable television has adopted a more aggressive, narrowcasting format and its growth of advertising revenue exceeds that for radio and network television. These developments do not necessarily diversify the ownership base for media properties. This paper offers a proposal for pooling equity for purchase of media properties. It is based on widespread practices for savings pooling used in inner-city and immigrant communities, but with certain wrinkles that facilitate securitization, diversification, and increased access. The basis of the contract.- is the rotating savings and credit account, used to pool savings to achieve capital accumulation. These accounts provide funds for a down payment on a house or to buy a small business. Investors combine their funds into a common pot. Each investor bids for the lot, the winner being the low bidder. For media properties the bidding is for a package of a financial pool and a management right. A group of investors contributes to a pool of funds, and is concentrated into teams. Each team has the right to bid for both the pool and the management. The low bidder receives both the pot and a management right, in exchange for offering a larger lump sum to the unsuccessful bidders. The management right can be resold, allowing a separation of ownership. The base package provides a preferable alliance of equity ownership and management. Only one investor group receives the management right, which is bid for by surrendering a part of the investment return. to the other investors. Investors who do not manage receive compensation from those do. The successful management group has a minimum equity stake in the business to avoid conflicts between ownership and management. The equity pool bids consecutively on several properties, allowing diversification and access to management of several groups. Alternatively, the same management group can acquire several properties. The proposal has two principal advantages over tax credits and other policies targeted at specific media properties. First, the pooling allows investors to diversify across several properties and markets, reducing the risk of default and loss of equity. Second, markets are introduced for bidding on management and programming. Those wishing to have a management role or to 'elect the content pay for it by compensating other equity holders. Incentives to dissipate resources are reduced by requiring a management entity to have a sizeable stake in the venture. Section 2 of the paper discusses the background for media outlet ownership. Section 3 has an analytical structure of media firms, where revenue comes from national and local advertising. The local station on. property expenses are paying for the national network feed and local costs. Media priorities that depend on local advertising are particularly vulnerable to shocks in their domestic markets. Particular media properties that are vulnerable in this way are radio stations and free throwaway newspapers, to which this proposal is targeted. The proposal is less relevant in media with a more national focus, such as cable television and Internet service providers. These latter can be seen more as content deliverers. Diversification across markets has a greater benefit in such cases, or at least it is more risky to promote programs that involve acquisitions of single properties. Section 4 discusses financial data and analyzes of media ownership. Diversification across media properties has benefits tied to the proportion of revenue coming locally. Section 5 discusses issues and caveats in implementation. 2. Media Ownership
A second issue is that the media disseminate the culture of the society. If the outlets are owned by corporate or other entities targeting the same advertisers, there is a tendency to appeal to the median consumer, even though that market segment represents a small slice of the overall population. Television markets focus on women aged 18-49 in their advertising pitch, even though this group is a minority of the overall population and audience. The target excludes the elderly, minorities, and males aged 18-49. The first two groups have low propensities to consume and the last group tends not to watch network television. To achieve high ratings has traditionally meant targeting median consumers. The targeting of the median consumer and its corresponding neglect of minorities is no longer a successful strategy, as cable tel(.vision has shown. Advertising revenue on cable television has grown more rapidly than in radio and network television during the 1990s. Network television now attracts only half of viewers watching the medium, excluding those who have gravitated to the Internet. Figure 1 shows advertising revenues on the three types of media outlets. During the 1990s, cable television advertising revenue has grown at a rate of 12% annually, more than double the growth rate of network television. To the extent that cable emphasizes narrowcasting and a targeted audience, the strategy of appealing to median consumers is no longer necessarily optimal. The problem with cable television is the fixed cost for entry access onto local cable company lineups. This fixed cost is another barrier to entry for undercapitalized minority entrepreneurs. Economies of scale in production, high fixed costs and low variable costs, and the inability to charge at the margin have continued to favor concentrated ownership in the media. The response by the federal government has been to promote diverse ownership by tax expenditures. Favorable tax treatment is granted to minority buyers or to the sellers to these buyers. In 1978, Congress passed the Minority Tax Certificate program that gave preferential treatment in the sale of media companies to minority ownership. Minorities included African-Am en cans, Hispanic-Americans, Asian and Pacific Island Americans, Native Americans and women. In these groups bought an interest in a media company, the seller received preferential tax treatment on the capital gains. The program was controversial, since some relatively affluent owners benefitted, and it was repealed in 1995. The program has remained under review. William Kennard, the chairman of the Federal Communications Commission, has expressed interest in reintroducing some program to expand minority ownership. There may be a different perspective from having minority ownership. The content of the programming might be altered. There is an educational externality for members of the majority group, and educational diffusion for the minorities themselves. The media represent the culture, and it is advantageous to have that diffused across the economy. The market expands by having different types of ownership. The criticism has been that the minority ownership is concentered in the hands of a few owners who do not exhibit a broad-based perspective. Other fun(ling sources have been introduced, such as the Broadcap Fund that includes minority media ownership. Even when minority or other capital-constrained owners are able to buy a media entity, that holding is concentrated and vulnerable to risks in the local market. These unsystematic risks are diversifiable by holding a larger portfolio of several media properties, although most public programs have been directed toward a single property purchase. This single property focus increases the risk of default or of the minority owners serving as a front for more established capital. Large-scale media companies are able to diversify risk by holding portfolios of stations across the country. Ownership rults allow media companies to own up to twelve television stations, allowing CBS, Disney (NBC), General Electric (NBC), Time-Warner, Fox and other broadcasters to be largely immune from local risk. The Minority Tax Certificate program concentrated on ownership of one local outlet in one market. The conditions in tha; market increase the bankruptcy risk of all investors. There is evidence of low correlations in returns on properties across cities within the Umted States at the same time, notably in the housing market (Goetzmann (1993) and Chinloy and Cho (1997)). In the latter study, the five largest markets in the United States, New York, Los Angeles, Chicago, San Francisco and Philadelphia were examined. The corrdation coefficients in -eturns to holding a single-family house in these five markets range between -0.25 and 0.1. These are low correlation coefficients, since individual stocks in the U.S. market frequently have correlations of 0.7 to 0.9. The implication is that a substantial amount of risk across markets can be removed by being in both markets instead of a single one. Large-scale media companies are already aware of this situation, and are diversified across markets. These correlations are lower than between stocks and other financial assets. If returns to radio stations in Buffalo and Chicago behaved identically, their correlation coefficient is one and it makes no difference to hold stakes in both of them. For practical purposes, such as the transaction costs of tt.e inevitable Kis on income tax returns, monitoring and fixed costs, it pays to hold cL single asset. If those correlation coefficients are less than one or even negative, then it pays to hold a diversified portfolio at one point in time. Targeted programs focusing on acquring a single property carry risks without commensurate return. Given the low correLations across markets, it is desirable to have a program that allows investors to hold a ponsfoho of media properties. Details on the impacts of a concentration on local adveiti(ing and the effects of diversification on media properties are in the Appendix. 3. Equity Pooling
These informal pools allow individuals to group together to make a major purchase. Such a system could be applied >0 acquisition of media outlets, which have similar characteristics to houses or local businesses which the pools often acquire. Concentrating an investment on a single mtAia outlet or a single house is risky, especially if the investors derive most of their income from the local market by dint of employment or entrepreneurial activity. In the equity pool, investors are grouped collectively for the purpose of buying into a portfolio of media properties. Each group bids to receive an investment return and a management right on a specific property. Bidders bid for the management right by surrendering their investment return. The low bidder receives the pool of funds and the management right. The difference between the pool amount and the tow bid is a return to the unsuccessful bidders. Each time the pool is formed, all members share in the ownership, but the low bidder is the sole entity holding the management. Alternatively, the pool takes a minority position in the media outlet and contracts the management to another source or to a corporate entity. The successful bidder receives a supershare, an above-average equity position. The investors commit to funding for several rounds, until a series of acquisitions in different markets or with different properties is made. Existing rotating savings and credit accounts operate in immigrant and minority communities to pool equity capital. Each member pledges to pay an amount into a fund, typically a fixed annuity. One member of the group acts as the banker, collecting and receiving the funds from contributors. Each member or investor receives two rights in exchange for the continuing investment: a return and a right to the pool. The right to the pool is determined either by random draw or by bidding. The low bidder receives the pool, permitting a down payment on a house of starting a business. Since the low bid is less than the pool contains, the unsuccessful I bidders receive the differential as additional interest. Suppose there are four pool members each contributing $5,000 per draw for a total of $20,000 and the successful low bid bids $15,000. This low bidder receives the funds from the pool and uses them to start in business or buy a house. The other bidders are co-owners if the asset allows several investors to be on the title. The unsuccessful bidders receive the remaining $5,000 either as initial interest or as additional equity in the investment. If this were a house, the homeowner might be assigned less than 25% ownership in exchange for paying the operating expenses. The house is usually owned 100% by the resident, since mortgage application guidelines require sources of the down payment to be indicated and the financial statements of co-owners. The other pool members are unsecured lenders and equity holders and rely on the informal relations and structures to ensure repayment with a return. Equity pools formally securitize informal arrangements where individuals combine resources to accumulate capital. In immigrant and inner-city communities the practice is widespread, frequently being imported from societies where the immigrants came from. The Jamaican partner, (Ghanaian susu and Korean kye are methods by which households save for a down payment or start a business. Within the Korean community, dry-cleaning and corner-grocery businesses. receive initial financing from ye funding in addition on ongoing support, factoring, credit lines, and technical expertise. Besley, Coate and Loury (1993) in describing these rotating savings and credit associations in the African-American community, view the pools as a pot of money to which each participating household contributes an annuity. The households differ by their desire for the capital in the pool, or by their rate of time preference. Equity pools allow minority business to become established and house purchases to be financed. They operate almost entirely off the radar screen of financial markets for several reasons. The banker is usually reluctant to deposit funds for tax and drug identification reasons, leading to security and theft risks. There is an enforcement problem in requiring members to continue contributions. If members fail to contribute, the pool is incomplete, and the pool cannot purchase or continue. The contracts are not secured. If a member who has bought a house fails to maintain it or defaults on the mortgage, the pool investors lose their investment. But perhaps that is the beauty of the program: it survives as virtually the only formal capital accumulation program in the ghetto. In inner-city and immigrant communities formal financial institutions typically do not exist. There are frequently no banks or lending entities to provide debt finance. There are no investment banks, venture opportunity funds, even as these self-same entities located a few miles away scour the world for investment opportunities. There is evidence of a change. Michael Porter (1997) has argued that the inner city is a new frontier for investment opportunities. Forrial banking firms are purchasing other entities that lend to low- and moderate-income households, such as First Union purchasing the Money Store. 4. Media Equity
Pools Each investor puts in a given amount on each call to participate, analogous to those made by venture capital funds. The investors are grouped into larger bidding teams, for purposes of bidding on the package including the management right, to avoid fragmentation of ownership and management, investors not wishing any management rights opt out of team membership. A bidding team for the management right must have a minimum equity position, such as 15%.. The bid is made by surrendering some of the cash to other bidders. The successful bidder is given a management fee, capped at 2% of revenues. The pool contributes the equity capital, and other sources of debt and mezzanine equity contribute the rest. The 15% minimum pool size reduces the incentive conflicts from management holding a small portion of the equity. These agency conflicts with shareholders come about when management has a minimal equity stake. The conflicts are reduced by the pooling and minimum equity requirement. A management with a low equity stake has incentives to consume perquisite such as travel and entertainment, hiring friends to work at the property and otherwise dissipating capital. While these moral hazards exist in any business, if the management has a larger stake it dilutes its investment by wasting equity holders' funds. The equity pooling concept reduces the risk of such expense and resource wastage, but does not eliminate it. Unsuccessful bidders receive compensation from successful bidders, another incentive-compatible feature. The management is paying other shareholders for the right to manage the property. The management right could be set for a specific time limit as a further brake on dissipation of resources. The proposal is an enhancement of existing arrangements. First, the funds receive a formal equity stake with title to the property. Title in existing equity pools frequently rests with the owner-occupant, and the other investors have difficulty in proving their ownership. Second, funds are maintained by a third-party trustee and deposited in a financial institution and not held by a member. There are problems with member bankers absconding with investor funds. Third, the program is familiar to most minority and immigrant entrepreneurs, who are frequent. y in such arrangements already. Fourth, the minimum equity requirement and cap on management fees reduces incentives for wastage. Public programs have an incentive to maximize expenses, and no incentive to maximize returns. As a case study, suppose a radio or television station is being valued at 16 times annual cash flow or 8 times gross revenue. Gross revenue is $2 million annually, 75% coming from local advertising. The value of the property is $16 million at the 8 times gross valuation. The annual cash flow, or earnings before interest, income taxes, depreciation and amortization (EBITDA) is $1 million, and the 16 times annual cash flow multiple supports the valuation. Gross revenue
$2,000,000 The property purchase of $16 million is to be financed with 75% debt or million, payable at 8% annual interest. The debt service and interest cost is $960,000, or 8% of $12 million. There is no amortization on the debt. Annual cash flow
(EBITDA) $1,000,000 The property is financed with $2.4 million of mezzanine equity, or 15% of the total. These investors receive a preferred, priority return, such as 6% of their funds if capital is sufficient, plus 40% of any residual. The $40,000 left over is paid to these investors, entitled to 6% of $2.4 million or $144,000, and there is an unpaid return of $104,000. This transaction leaves a minimal cash return initially, with the market multiples placing a price on future growth. The equity pool contributes the retraining $1.6 million of capital. The summary of the three investors' position is: Debt:
75% of capital investment, 8% interest rate The management of the property gives an equity participant an opportunity to disseminate the culture or to provide diversity. Equity holders receive a package of 60% ownership of the property after al others have been paid and a management right. This management right receives a capped proportion of gross revenue from the property, such as 2% of revenue, but allows the manager control of programming and strategy. The combination is a valuable right to income a d content. It achieves the goal of diverse management. A management bid requires a team to have at least 15% ownership percentage of the equity, and to form a formal entity such as a corporation, partnership or trust. The management right has a value to investors wanting direct content and programming control. Investors not interested in the management receive compensation in the form of additional debt. The pool is collateralized at $2 mill on. The mechanism is for investors to make contributions, which can be as low as $2,000 or 0.1% of the initial capital requirement. Each investor is assigned to a team. Subgroups interested in management find equity investors to contribute to their team. As an example, suppose there are four bidding groups, each of which has a 25% ownership stake in the $2 million pool. There are no individual investors wanting to remain outside of a team. After $12 million in debt and $2.4 million in mezzanine equity there is $1.6 million required by the seller. The capital structure is:
Mezzanine Equity: $2.4 million Equity: $1.6 million The low bidder receives the management right. Any residual in the pool belongs to the unsuccessful bidders. A low bid of $.6 million covers te equity and leaves $400,000 in the pool. This amount is a capital reserve, held as a promissory note payable to the unsuccessful bidders, but a liability of the venture acquiring the media property. The balance sheet is:
Assets Liabilities Equity The promissory note has priority over the mezzanine equity in the balance sheet. This situation is not a requirement, although it provides an incentive in initial capital raising. The investment has a debt-kicker that encourages bidding, as a consolation prize for the unsuccessful. If the low bid is less than $1 .6 million, the successful bidder must place additional capital. A bidder at $1.5 million must invest another $100,000. All four pools retain ownership based on their contribution to the original pool, not the bidding process. The only exception is where this additional capital is contributed. Since the capital pool is now $2.1 million, the management group is given a share of 6/21 3/7 of the investor interest. The remaining $500,000 is a promissory note payable to the unsuccessful bidders, so the management investors have bought the right from the other investors at a premium. The other three investor teams own 5/21 of the 60% provided to equity partners. A bid between $1 .6 million and '2 million does not change the balance sheet. The seller only needs $1.6 million. A successful bidder at $1.8 million pays $1.6 million, but $200,000 is a promissory note to the unsuccessful bidders and the other $200,000 is a promissory note to all bidders, including, the successful ones. The first note has priority over the second, to encourage the management group to keep its capital invested. Each of the four groups holds 25% of the equity portion. All investors have access to the management right, but the group that values it most highly is the successful bidder. Investors who want a passive investment do not bid on the management right and are compensated. There is a market for management and control, offered for sale between participating equity bidders. Those most desirous of management control bid lower and compensate the other bidders. There are other modifications. A separate submarket could develop for programming and content. A bidding contest for programming and content can be separated from that for management. 7?here may be specialized management firms available for radio and television stations that can be hired on a contract basis. In a radio station case the bidding allows selection of format and context. The low bidders have control over the format and programming structure, and the implementation is up to outside management. {n this way, the cultural and educational benefits are maintained, there is diverse ownership, but the management of the properties takes advantage of economies of scale. The equity position f® the mezzanine equity capital is open to modification. The investment could elect :0 hold only debt and equity, in which case the four pools have a direct ownership of 25% each. The successful investor group has effectively contributed $500,000 of the equity, or 25% of the total equity capitalization of $2 million. To acquire the property alone, even with the same mezzanine and debt financing would have required $1.6 million and no capital reserves. The successful invest® team is able to hold a diversified portfolio of properties. If the investors had access to the full $2 million, they participate in four rounds of the equity pooling. If there are three other properties available, they bid at each of the drawings, and if successful, hold the management of four media properties. Alternatively, each of the four teams has access to managing one property, but with diversification reducing the default risk and the bidding process providing incentives to allocate management to those willing to compensate others. Figure 2 summarizes the equity pooling and securitization program. Combining cable television, radio rnd network television, about half of total broadcast advertising revenue comes from local sources. The mix of advertising revenue differs by property type. At the fast-growing cable television medium, advertising is predominantly national. Network television relies on national advertising at the aggregate level. The networks pay the local stations to carry the national programming. The stations sell local advertising both during certain assigned slots during network prime time and have revenue control outside of prime time. In exchange, the television stations affiliated with the network must carry the prime time and other network programming and its national advertising. Radio has an above-average mix of local advertising, partly because of the signal limit but also fragmented ownership. This unsystematic risk can be mitigated by diversification across market and stations. An issue of late is an upsurge in the. demand for radio stations. Apart from the boom in all assets, physical and hard, the demand growth comes partly from FCC proposals to ease concentration ownership restrictions on radio stations. Hicks Muse of Dallas has become the largest radio station operator in the country. Walt Disney, CBS, Chancellor, Liberty and the leveraged buy)ut firms Muse and Kohlberg Kravis Roberts have all recognized not only the d versification benefits but the ability to sell to national advertisers with a national network. The corollary is any comparable entity may require a presence in several markets. 5. Concluding
Remarks Financial markets have been securitizing both debt and equity contracts. An equity pool has some elements of securitization. Participants are required to make periodic contributions, not unlike mortgage payments. In exchange, they receive ownership positions entitling them to cash allows and bids for management rights. If the capital inflows from contributors were partly predictable, they could be sold as securities providing lump sums to investors, as zero-coupon bonds. |
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