The Bank of Manny – Deferred Compensation and Debt Limits

"The truth is always a compound of two half- truths, and you never reach it, because there is always something more to say" - Tom Stoppard

The Manny, Boras, McCourt circus continues. This morning, McCourt is talking about lowering the offer and sources close to Boras (some think it is Boras himself) is saying that lowering the offer would offend Manny and could kill the deal.

Reaction to the deal covers the gamut. On Sirius/XM Baseball Beat yesterday, the talk turned populist – how could Manny turn down $45 million, regardless of terms when people are losing their jobs and their homes?

On MLB trade rumors the jury is split. Blueblooded wrote: “This is getting dangerous - Frank's not going in for the kill, he's sneaking out the back door. For a while I thought he was completely motivated by pride and hatred of Boras. Now, I'm starting to buy into the idea that he's just cheap.” On the other hand, celtics464 writes, “The Dodgers don’t need Manny. let him walk. he has disgraced the team the management and the fans. how any of them would want him back still amazes me.”

The issue still seems to revolve around deferred payment versus cash right there on the barrel head. So, my thought for today is – deferred payments: Who benefits. Who gets hurt?

The implication of a deferred payment is a promise to pay a certain amount at some time in the future. It is, in effect, an IOU. Sometimes, but not in this case, there is a promise to pay interest to compensate the lender for accepting the deferral. A bank certificate of deposit is a deferred payment. So is a government bond. You are saying to the bank, “Here is my money. Do whatever you want with it. What I expect is that you will pay me the amount of interest you have promised to pay me and, at the end of the term (one year, two years, whatever) you will give me money back.

Manny, through Scott is saying, “Here are my services. What I expect is that you will pay a certain sum each year for the next four years, although I may only play for you for one more year – maybe two.”

There are three elements to consider when you or Manny agree to a deferred payment. There is credit risk. What if the bank or the team cannot pay? There is opportunity risk. Can I do better if I invest elsewhere? There is inflation risk. What I am investing may be worth less in the future.

Economic theory suggests that reward is a function of risk, so the interest payment is meant to cover those three elements. Businesses often calculate a hurdle rate – a minimum return that is required before they make an investment.

Bank customers do not do that – we read the tables of rates published in our newspapers or we go on line to a rate monitor site and look for a fair return. Of course, bank customers are also made secure by the Federal Deposit Insurance Corporation which, under most circumstances, guarantees that we will be repaid.

Avoiding credit risk is not quite the same for a ballplayer. Major League Baseball is not the FDIC and they do not guarantee that the Dodgers will meet their obligations. There is some protection. MLB has established and enforces debt limit on the teams, based loosely on cash flow (it is really based on EBITDA, but only Jonathan Mariner, the CFO of MLB, really understands the formula). We do know, however, that the definition of debt includes the present value of long term contracts and deferred compensation.

You can have an interesting discussion with agents about the issue of opportunity cost. In a recent blog, I discussed markets as defined by economists and as defined by Boras. For many free agents there is an active market – teams willing to bid for their services. In Manny’s case the market may consist of 1.5 teams – the Dodgers and, maybe, possibly, the Giants; or, it may consist of only the Dodgers.

The future value issue (the inflation risk) is vital when a company calculates a hurdle rate; it is less significant in a deferred compensation contract because it does not matter. Manny may retire in two years, go to play in Japan, sign with another team, or even sign to continue playing for the Dodgers, however, he will still get paid the residual on this contract.

So what is going on?

Frank McCourt is negotiating to improve his cash flow. By deferring payments, he conserves cash. By offering a no interest deferral, he is reducing his future obligation and staying that much below the MLB debt ceiling. In effect his not only banking on Manny, the left fielder, he is tapping the Bank of Manny. Last time I looked, the Bank of Manny was not on the FDIC watch list so for McCourt it looks like a good deal.