“SHARE THE UPSIDE” BREEDING PROGRAM FINANCES BY ROBERT L. LOSEY

One of the inevitable effects of a wrenching adjustment in the Thoroughbred breeding business has been increased innovation.   One intriguing innovation has been the “Share The Upside” plan originated by B. Wayne Hughes at Spendthrift Farm.  Ken Wilkins, stallion manager at Spendthrift, points out that banks’ reluctance to lend to purchasers of stallion shares has contributed to the development of “Share the Upside” (STU) programs.  A related impetus is the decrease (by approximately one-third from 2007 to 2011) in the number of mares bred that has caused many stallion managers to scramble to try to fill stallion books.

The essence of a typical deal has a breeder buying a lifetime breeding right to a new stallion by paying a modest non-refundable up-front fee plus breeding fees for (usually) two years.  After these fees are paid the breeder owns an annual breeding right that, at most, requires paying only modest breeding shed fees in the future.

Not surprisingly, the breeder in a STU program faces trade-offs.  In the absence of the STU program it is likely that an enterprising breeder could have gotten to the STU stallion for a lower initial breeding fee.  The implicit deal then is that the STU breeder pays higher up-front fees that “buy” future breeding rights at no (or low) costs.

The following is a financial example that is neither a best- nor a worst-case scenario for the STU breeder.  Understanding this deal helps provide a basis for determining whether or not the STU program makes sense for the parties involved.

The Deal

Assume that it’s February and to close the deal a STU breeder must pay $1,000 now plus $10,000 payable on a live foal basis for the first two foals produced from mares that she breeds to the STU stallion.

In the absence of the STU deal, the breeder could have purchased seasons in this or a comparable new stallion on the following terms (assumed to be market value) for the next five years.  Note that, as is not unusual, the market value of the stud fee is assumed to drop by more than half over the first five years.      

Year         Stud Fee

0                      $0

1                      $7,500 Live Foal

2                      $6,500 LF

3                      $5,000 LF

4                      $4,000 LF

5                      $3,500 LF

If the breeder had mares that she was going to breed to this or a similar stallion anyway over the next five years, then the year 1 and year 2 expenses listed above would have been incurred regardless of whether or not the breeder participated in the STU program.  Thus the incremental cost of the STU program will be the nonrefundable fee and any incremental charges that exceed the market value of the stud fees for the first two live foals produced.   But, if the STU breeder has live foals by the STU stallion in each of the first two years, the fees paid also buy year 3 through 5 (and future) breedings.

First consider the case in which the breeder gets a live foal in years 1, 3, 4, and 5 (thus no foal in year 2).  Let’s further (pessimistically) assume that the stallion becomes worthless after the fifth year.  The expected net cash flows for stallion services of the STU breeder appear below in the third column.

Year  STU Outflows  Expenses Saved  Net Cash Flows

0          -$1,000                  0                          -$1,000            

1        -$10,000            $7,500*                    -$2,500

2                0                       0                                 0

3        -$10,000            $5,000*                    -$5,000

4                0                  $4,000                      +$4,000

5                0                  $3,500                      +$3,500

*Note that in years 1 and 3 it is assumed that the breeder would have paid $7,500 and $5,000 respectively to breed a mare anyway, hence the incremental cost of the STU program in these years is the difference between the contract price and the fair market price of the stallion season. Out-year fees represent net cash inflows insofar as they allow the breeder to breed for free rather than have to pay for a season.

In this scenario the breeder pays an extra $8,500 over the first three years relative to buying seasons at a normal market price, but this buys him seasons that generate savings of $7,500 in years 4-5.  My HP 10b calculates that the net investments totaling $8,500 from now through year 3 that returned a total of $7,500 in years 4 and 5 yielded an effective annualized rate of return on investment of negative 5.12%.  Booking and/or breeding shed fees would decrease the return further.

It is arguable that this scenario is pessimistic because it assumes that only two live foals are produced the first three years.  However, the rate of return to the breeder would have been even worse if one of the mares bred in years 4 and 5 did not get in foal.  On the other hand, the rate of return would have been higher if live foals were produced each year, or if the barren year was year 3 instead of year 2.

The return to the STU breeder could be significantly higher if the stallion has value after five years.  But, if past is prologue then approximately 75% of stallions will lose 90% or more of their original values by the end of their fifth year.  Perhaps 10% of the time a stallion maintains its (decreased) year-five stud fee into the future, and perhaps 15% of the time a stallion’s stud fee increases (here assumed to double on average) in the out years relative to year one.  The calculated average annualized rate of return when these three scenarios are weighted by their probabilities is approximately 17% for the example above under the further assumption that a live foal is produced two out of three years from years 6 through 15, whereupon the stallion is pensioned.  (Please e-mail the author if you wish to see the calculations.)

The Stallion Owner’s Viewpoint of the Share the Upside Program – A Win-Win Situation?

Financial economists use the term “zero-sum game” to describe some financial transactions.  Betting on the flip of a coin is a zero-sum game because the winner wins exactly what the loser loses.  In today’s market however, it is likely that the STU deal can be a “positive-sum game” in which both the original stallion owner and the breeder come out ahead.

The original stallion owner potentially comes out ahead for the following reasons:

1) In many cases the STU program is likely to increase the number of mares bred to the STU stallion, thus generating more stud fees, especially in the early years.

2) The attraction of incremental breeders to the stallion is likely to mean that it will be easier for the stallion manager to bolster the STU stallion’s stud fee for the early years.

3) More foals produced during the early years mean more runners on the track that “advertise” the stallion in future years.  This hopefully results in a higher stud fee for the out years.

4) As Ryan Norton at Darby Dan points out, STU breeders have more of an incentive to breed fertile mares and to breed higher-quality mares than do average breeders, thus further enhancing revenues and the potential future “advertising” effect.

5) The extra fees collected in the early years of the STU program allow stallion owners to lower their net investment (and thus their risk) and may allow them to stand more stallions.  More stallions may mean more breeding rights to stallion managers (who often are the owners of stallions these days) and more mares paying fees at farms.   

But there may be a significant cost to the original stallion owner if he maintains a substantial interest in the stallion and the stallion does well.  In future years the owner has given up breeding rights to the stallion.  The question is whether the positives for the original owner enumerated above are likely to outweigh the costs from lost breeding rights.  My cursory analysis suggests that the original stallion owner is likely to come out ahead on average in a reasonably designed STU program relative to merely selling seasons.

Some Caveats

Read the fine print in the contract.  You may face significant restriction on the use of your seasons.  You may have to pay a “shed fee” to breed.   You may be entitled to little or nothing if the stallion is sold.  If any of these conditions apply your return is likely to be less than the 17% rate of return I estimate.

Breeders should breed a fertile mare on the STU program – the sooner the initial fees are paid the sooner free seasons start rolling in.    

The owner of a breeding right has NO SAY in any decisions made regarding the stallion.

Even if the STU investment earns a reasonable rate of return, this may not mean that the related  investments necessary  to support a breeding right (own a mare and sell or race her foals) generate a profit. 

___________________

Robert L. Losey, Ph.D. (rllosey@gmail.com) is a financial consultant who taught finance at American University in Washington, DC and equine finance at the University of Louisville, Ky. Dr. Losey has bred and raced horses since 1972. He has recently invested in a “share the upside” stallion. 

 Copyright © 2012 Horse Racing Business

Comments

  1. Interesting. But look at it from Mr. Hughes’ side. When that same stallion may essentially be worthless after 5 years, he’s already basically sold a sizable portion at initial costs, not depreciated value. So a great move by him, but not a good investment by the breeder.

  2. STU is useful for a stallion that is acceptable in pedigree and race record and conformation, but not great.

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