A merger borne of weakness

By W.Z.

FANTASY sports have become so pervasive in America that it is often increasingly unclear whether fans care which real-life team wins. The games, in which players speculate on athletics by building teams of virtual players whose performances track those of their real-world counterparts, have blossomed from the informal “rotisserie” leagues of the early 1980s into a massive entertainment industry, with 57m participants and some $1.5bn in revenues per year. Watch a National Football League game today with a group of friends, and you will inevitably be inundated with jokes about how your fantasy team has just tanked thanks to a poor throw from a quarterback—even if it was your beloved hometown club that intercepted the pass and returned it for a touchdown. On the surface, the announcement on November 18th that DraftKings and FanDuel, the two largest players in daily fantasy sports (DFS)—the fastest-growing segment of the market—would join forces in a “merger of equals” would appear to be a case of the industry’s nouveau riche getting much, much richer.

In reality, the deal was probably borne more out of weakness than strength. Fantasy sports owe their popularity partly to the games’ addictive nature, partly to the social element of competing against one’s friends—and partly to favourable regulation. Thanks to the Professional and Amateur Sports Protection Act (PASPA) of 1992, which prevented states that had not already legalised sports betting from doing so, wagering on the outcome of athletic contests is mostly illegal outside Nevada and is strictly forbidden online. The law has been sustained by a political marriage of convenience between the strangest of bedfellows: social puritans and lobbyists for the Nevada casinos that enjoy a protected market. Fantasy sports, however, enjoy a carve-out from this ban, making them one of the only ways to wager legally on anything sports-related outside of a Nevada casino sportsbook.

As any economist could have predicted, no sooner was the fantasy-sports exemption established than clever firms promptly began trying to classify their betting products as fantasy sports. The main innovation was DFS. For all their appeal, traditional fantasy sports always had one Achilles’ heel: because players build their teams at the start of a season, most participants lose interest just a few weeks in, once it becomes clear that they cannot contend for a title. DFS alleviates this problem by allowing players to choose a new roster every day or week, thus sustaining their attention—and renewing their wagers—over the course of an entire season.

Over the past few years, DFS has exploded in popularity. FanDuel and DraftKings are currently estimated to have a combined 5m users. Both companies have at times been valued at over $1bn, and together, they make up over 90% of the market. They’ve attracted investments both from traditional buyers like the private-equity giant KKR and from professional sports leagues, including Major League Baseball and the National Hockey League. Until late last year, their exponential growth seemed limitless.

But the industry’s honeymoon period proved to be short-lived. Although DraftKings and FanDuel always knew that they were operating in a legal grey area, they adopted the same ask-forgiveness-not-permission approach to regulation that has enabled Uber to become a global behemoth. Last November, they wound up needing generous forgiveness indeed, when Eric Schneiderman, the attorney-general of New York state, ordered FanDuel and DraftKings to halt operations in the Empire State. Challenging the firms’ assertion that they offered legally protected fantasy sports, Mr Schneiderman argued that DFS were games of chance rather than skill, and that they thus constituted illegal gambling. Other state attorney-generals soon followed suit.

FanDuel and DraftKings competed vigorously for players and revenue, and had ploughed their investors’ plentiful financing into an almost obnoxiously aggressive advertising war (see picture). But the New York lawsuit made clear that the greatest threat to their businesses was not each other, but rather unfriendly regulation. Faced with this existential risk, they cut back on their marketing budgets and focused on mollifying their tormentors.

On August 3rd they caught a break, when Andrew Cuomo, the governor of New York, signed a bill authorising DFS and categorising it as a game of skill—which it clearly is, since the best players win the vast majority of the time. Nonetheless, such legal recognition came at a price. Mr Cuomo extracted a hefty tax on the industry, expected to yield $4m a year. And Mr Schneiderman’s office clawed away $12m, settling a case that the two companies had “consistently misled consumers in advertisements” that overstated their odds of winning money against the professional “sharks” who fish for novices in DFS waters.

The business case for the merger is fairly straightforward. The industry’s growth rate—perhaps 20% year-over-year—has disappointed analysts who once believed that the market would reach the tens of millions of users. As a combined company, DraftKings and FanDuel will be able to focus their efforts and budget entirely on advocating for legal recognition and public awareness of DFS, rather than multi-tasking this project alongside a brutal battle for market share. Just eight states have formally declared DFS legal, leaving the industry with an arduous path to broader recognition.

But in their efforts to surmount one regulatory hurdle, DraftKings and FanDuel may soon find themselves faced with another. Together, they will have the DFS market virtually all to themselves. The companies argue that their 5m users are a tiny share of the overall fantasy-sports market of 57m, and that barriers to entry in their industry are relatively low—certainly low enough for the big media firms that dominate the fantasy-sports space, including Yahoo, CBS and ESPN, to muscle their way in. But Marc Edelman, a law professor at Baruch College who is currently consulting for a fantasy-sports company that is in litigation with DraftKings disagrees. He argues that the DFS is its own market, distinct from season-long fantasy sports, and one in which the two dominant players already exhibit oligopolistic pricing power. As platforms that enable players to compete against each other, the DFS firms certainly benefit from network effects, which form a formidable barrier to entry and often attract extra scrutiny from antitrust authorities.

The broadest-ranging consequence of the DFS industry’s lobbying efforts may be to prompt a reappraisal of PASPA itself. Chris Grove, the editor of Legal Sports Report, a sports-gambling publication, argues that the New York DFS law contains a massive loophole. Because it allows players to bet on the performances of individual players, it’s not difficult to imagine scenarios in the future where players will be able to approximate betting on the outcome of real-life professional-sports games by combining bets on select players. That would surely weaken Las Vegas’s hold on the sports-betting industry, and make brick-and-mortar casinos outside Nevada hungrier than ever for a piece of the pie.

Laws that include regulatory carve-outs, such as the fantasy-sports exemption, have a long history of effectively authorising the behaviour they are supposed to prevent. Gambling on sports is not likely to become an exception.

Clarification (November 28th): This story has been amended to include Mr Edelman's relationship with DraftKings.