By Paul Leyland, Founding Partner, Regulus Partners
* *Disclaimer:Ignorance is not a substitute for bravery. Bravery may result in misadventure as well as success. Virgil cannot be held liable for any failure attributed to feats of bravery
'It seems to be a law of nature, inflexible and inexorable, that those who will not risk cannot win.' John Paul Jones
Last week I had the pleasure of participating in a recording for Timandra Harkness’s slot on risk for Radio Four’s Human Zoo, over a roulette wheel at the Hippodrome.
It was a pleasure on three levels: First, she is a very erudite and entertaining lady who can put across complex ideas in a clear and engaging manner. Second, my efforts to show that chips are likely be quickly lost if bets are ‘high risk / high return’ rather backfired with a couple of lucky wins. Finally, it got me thinking about the sector’s rather odd relationship with risk.
Risk is at the very heart of the gambling sector: It is a key motivator of betting and gaming customers. It is also accentuated from an industry perspective (versus ‘normal’ business) due to the often troublesome presence of regulation. For customers and businesses alike, things can go wrong when people lose their understanding of risk, or perhaps gain an appetite for it above their means or abilities to engage with it.
Given its products, customers and operating environment, the gambling sector should be one of the most switched on sectors to risk. However, it is often curiously blind to it. The sector has proved spectacularly bad at predicting or managing regulatory risk in many cases: Only recently bingo’s tax victory came after years on the wrong side of change. From a product perspective, the default setting is typically to keep gross margin high rather than engage with value and recycling which is especially seen in betting but also in gaming.
The betting sector has boomed over the last fifteen years, but it is instructive to consider this started from government-backed regulatory reform with the move from turnover tax to GPT, and then led by ‘outside’ innovators (eg, Betfair for the exchange and racing value, Bet365 for in-play). The established operators, who have theoretically been managing risk as a business model throughout their long histories, tended to be on the wrong side of these big changes and have often suffered, or caught up late accordingly.
A similar trend has historically been seen in gaming machines and pools.
Managing risk should be about logically weighing up probabilities and then taking a course of action to suit your needs.
For some businesses and customers this might mean a dull but sustainable low return environment: to be noticed the bets would have to be big as per GTECH – IGT. For other businesses and customers, the hope of doing something that has higher returns but contains much higher risk might be more desired or appropriate like the example of IGT buying Entraction. A key problem is that risk is often asymmetric and latent.
Curiously given the lessons of risk, some customers and most operators don’t even ‘plan to lose’ even in a high risk environment, instead they fall for their own hype. When IGT bought Entraction for US115m, in a space it had the capacity to fully understand, a year after the acquisition it was closed down; conversely it bought social gaming site Double Down for US$500m – a bigger price in a space far from the ‘regulated real-money’ core which has (so far) gone from strength to strength. Often executives are taken in by upside potential and choose not to properly understand the downside, especially if the target is in an ‘exciting’ space distant from the acquirer’s core expertise (by geography, channel, or product or, in the worst cases, a combination). This isn’t usually managing risk, often it is simply being seduced by it.
Further, this seems most prevalent in the ‘high growth’ remote sector: as my colleague Scott Longley explored in his blog “Show US your knockers”, “hyperbole and online gambling are inextricably linked.”
What happened in the US dotcom market is a good case study. Prior to UIGEA (which interpreted a poorly worded ‘prohibition’ on online gambling to allow its enforcement), US-facing operators told everybody there was a very low risk of negative legislative change; for year after year nothing happened. The money rolled in and they looked as if they were right; suddenly in October 2006, they weren’t right anymore. Perhaps because it was a Bush White House which passed the restrictive legislation, the sector ‘got away’ with blaming a small cohort of reactionary politicians: how could they have predicted that? It wasn’t their fault…
But all the warning signs were there: for example, the fate of Neteller’s founders (a major US-facing ‘wallet’ and payment processor), who were arrested and pleaded guilty to conspiracy in 2007 would have happened even without UIGEA - creating a much harder situation to explain to hitherto gullible investors.
Similar ‘bromide’ dialogue about regulatory risk was deployed around online operators exposed to protectionist states within the EU (especially Germany), the loss of certain gaming machines in the UK bingo and casino sectors in 2007 (Section 16/21 machines), and numerous other examples which have led to entirely predictable profit warnings and business dislocation. The problem is not necessarily that the sector misrepresents risk to its stakeholders, it often misrepresents risk to itself, even when possessed of ‘all the data’: a subject reflected on by my colleague Dan Waugh in his blog “Crouching Tiger, Hidden Black Swan”.
A sustainable corporate strategy, as well as effective dialogue with lawmakers and regulators, must be based upon a clear, articulated and honest assessment of risk. Without it, the sector is likely to stumble it to yet more regulatory pitfalls while focused on ‘growth’ or looking for others to blame.