Video games have been around since the 1950s and have advanced from Pong on the Atari to the modern-day, cross-platform cultural phenomenon of Fortnite (if you have kids, they’ll know what this is). With this evolution, video games have progressed from a leisurely pastime into a vibrant, competitive ecosystem. In this series of posts, we will help break down the ins and outs of the complicated framework of the industry to give a better understanding of investing in esports and the massive opportunity it presents. In this introductory piece, we will cover:

• Market opportunity
• Understanding the industry players, including publishing studios, teams, the tech stack and event organizers
• Leagues
• Investable universe
• Risks

TL;DR – Viewership for popular video game titles already exceeds Super Bowl viewership. Popular game franchises are owned by developers, while no one owns the intellectual property of individual sports. There are several direct and indirect investment opportunities in the space right now. To capitalize, it’s important to see the forest for the trees and understand the interlocking parts of the industry.

Investing in esports: the market opportunity

Esports is the professionalization of competitive gaming, played in front of massive audiences with passionate fans. While gaming is a very large industry, esports is still in its infancy. The esports and video game markets combined are expected to generate $149-billion in global revenue this year. That’s more than what the traditional sports market will rake in, which is projected to be around $140-billion.

Quick facts on the esports market:

• More people watched the finals of the League of Legends World Championship than the Super Bowl in 2018 (approximately 200-million viewers versus 98-million)
• The average professional League of Legends player makes roughly $330,000 in annual earnings
• Top players can make up to $7-million per year in overall esports earnings, including Twitch revenue and sponsorships
• Many owners of traditional sports franchises also own esports teams, including Robert Kraft (New England Patriots), the Aquilini group (Vancouver Canucks) and Jeff Wilpon (New York Mets)
• Franchised leagues in esports are formally aggregating media rights, sponsorships, advertising and player contracts in the same way traditional sports have
• Twitch, the main online channel to watch gaming, has twice the number of subscribers as ESPN
• There are five million daily active viewers for live gaming who spend an average of 106 minutes watching per day
• Twitch is second only to Netflix in minutes watched per average user per month
• Huge revenue upside: the average esports fan spends $5 per year while an NFL fan spends $60

Understanding the industry players in esports

Publishers

The main publishers are Electronic Arts (EA), Take-Two Interactive, Activision, Ubisoft and Tencent. These companies use their large R&D budgets to hire software engineers who develop and maintain games. Large publishers also leverage their balance sheets to acquire independent studios, providing access to talent and ownership of their intellectual property. Publishers push out content through sales, marketing and distribution networks in order to drive revenue.

Somewhat similar to movie production, gaming is a “hit” business. A single game can take six years and upwards of half a billion dollars to develop. Historically, games have had a one-time cost of about $60 per game. The revenue model for many games is now shifting to a “freemium” model, where titles are free to download and revenue growth is driven by in-game microtransactions.

Under the freemium model, revenues have become more recurring to some extent. Players tend to continue to spend money through microtransactions to upgrade their characters or refresh their battle passes (think of them as buying additional content in bulk). The freemium ecosystem is highly competitive, but it’s currently where all the value is accruing by balancing development and cost with sales.

While the business model of individual games is evolving, publishers themselves are established. For example, EA was founded in 1982 and has a public market value north of $25-billion. Ubisoft was created four years later and also has a public market value in the billions of dollars.

Teams

Esports teams are organizations of professional gamers that are usually scouted and signed to contracts for one or two years. Team members include players, coaches, general managers, talent scouts, operations managers, public relations professionals and even housing staff, personal trainers and chefs.

Teams monetize through prize pools, media rights, advertisements, sponsorships and merchandise. They also accrue value in their brands. When it comes to the teams in the esports ecosystem, it’s a winners-take-most environment.

Team Liquid is one of the most recognized teams in the esports universe. Founded in 2000, the team has won over $26-million in prize pool money and was most recently valued at more than a quarter-billion dollars. Alienware, Monster Energy, SAP and Honda are among Team Liquid’s current sponsor partners. Other top-tier teams include Gen.G, Fnatic, Splyce, Team SoloMid (TSM), FaZe Clan, OpTic Gaming, G2 Esports and Cloud9.

Tech stack

While the esports world obviously wouldn’t exist without games, it also relies on other pieces of software to push distribution and interactivity. The set of these different software components is what’s known in the tech sector as a “tech stack.” A variety of applications have been created to distribute and facilitate the expansion of the esports ecosystem.

Games need distribution networks and, in this area, Twitch is king. Twitch is a website that allows users to follow their favourite gamers and watch live gaming tournaments. Twitch viewers can pay gamers directly $5/month for access to premium content. They can also tip real money to cheer and encourage spectacular plays.

One of the things that separates Twitch from traditional sports viewing is the real-time interaction. As viewers type in the live chat panel, the pro gamers will communicate back in video, live over the stream. The more viewers tip, the higher the likelihood the star player will identify them in the livestream with a shout-out.

Amazon bought Twitch in 2014 for $970-million. It’s possible that five years from now, Amazon’s acquisition will be comparable to Facebook’s purchase of Instagram (which was bought for a billion dollars and is now worth $100-billion). Other components of the tech stack are not as developed as Twitch, but they include gambling (Unikrn), messaging (Discord), and analytics (Stream Hatchet).

Event coordinators

The various aspects of the esports industry all come together in the tournaments. Tournament operators pay a licensing fee to publishers to host events. Event coordinators focus on games that are not being used by franchised leagues. This structure mimics a model more similar to golf and tennis than football or basketball. These operators earn revenue from ticket sales, merchandise, concessions, media rights, sponsorship and advertising.

One of the largest operators in the space is Modern Times Group (MTG), a publicly traded company based in Sweden. The 32-year-old company adapted rapidly to the esports industry after acquiring two major tournaments operators (DreamHack for $28-million and a majority stake in Turtle Entertainment).

Types of esports leagues

Leagues have taken three main forms:

1) Publisher-owned leagues and tournaments are controlled by the publisher of the game being played. This helps with protection of the brand and encourages investment. Individual teams enter these tournaments under their team brand names, such as Team Liquid. The popular League of Legends game falls under this category, as tournaments are organized by the publisher and developer, Riot Games.

2) Independent organizers can purchase licenses to host tournaments. Teams can enter under their own brands, but the publishers have no control over how smoothly or poorly the tournament runs. Gaming giant Valve uses this model, licensing out rights to independent organizers to host events featuring its games, including Counter-Strike: Global Offensive.

3) Franchised leagues are run by publishers, but involve ownership groups which band together and pay hefty fees to enter. Pooled media rights and sponsorship revenues are distributed to the team level. Ownership groups are forced to follow the publisher’s rules for branding. Activision operates this model with its popular Overwatch game. Splyce features an Overwatch team, but in accordance with Activision’s branding requirements, the team must play under the moniker Toronto Defiant.

The investable universe for esports

Investment opportunities exist across the entire esports spectrum, but access differs for each segment. Publishers provide the most direct exposure, as many of the companies are established and their shares are available to trade on public markets. However, publishers only represent one portion of the overall esports industry and buying a basket of these companies does not provide enough diversification in a space with such rapid advancement on different fronts.

Investing in the tech stack allows investors to take an “own the pipes” approach. Investing in the major player can only be done indirectly, as Twitch is owned by Amazon. But there are competitors available, including China’s Huya, which is publicly traded, and Douyu, which is preparing for an IPO in the US. Both are financially backed by publisher Tencent. These companies, along with several others, are title-agnostic and can likely facilitate the growth of esports with attractive monetization opportunities.

There are a variety of options for investing in teams, but most of them are currently private. Several teams are expected to go public with listings on the TSX Venture Exchange.

Legacy tech companies can also provide indirect revenue exposure to the space. An example of this would be Microsoft, which owns Xbox, several publishing studios and Mixer, a streaming service that competes with Twitch.

Risks

When evaluating the opportunity, our long-term thesis boils down to eyeballs and interaction. The growth of esports is undeniable. Parents are discovering that Fortnite is a phenomenal hit and their kids are playing it instead of watching TV or playing baseball. However, several factors will be medium-term hurdles.

The shifting business models of game titles, fraudulent and inflated viewership statistics, the struggle to monetize fans, ballooning franchise fees for teams and the power of publishers in the ecosystem all present unique challenges for investors. These are only a few of the risks that need to be addressed in order to establish a structurally sound ecosystem where all parties can mutually benefit. However, given our long-term view, we see these problems being solved as the industry matures.

Some final thoughts on investing in esports

Esports is an emerging industry that is at the intersection of several advancements in technology. 5G infrastructure is reducing latency (network delays) while developments in graphics processors are creating fully immersive and imaginative worlds. These two factors have led to cloud computing capabilities that remove the prohibitive barrier of hardware costs. Anyone can play anywhere as processing power is pushed to the cloud. This is what the upcoming Stadia system from Google is trying to do, attempting to revolutionize how games are played.

In community building, the “third place” is a social surrounding that is separate from home and from work. Howard Shultz set out for Starbucks to be this “third place,” but we believe it now exists online in the gaming environment. There is great opportunity in chaos, as the power dynamics unfold between the publishers and the teams. In our next post on investing in esports, we will highlight the power of publishers within the franchised league systems and walk through hypothetical fixes to balance the power.

Nick Mersch, CFA is an Investment Analyst at Purpose Investments. Along with CIO Greg Taylor, CFA, he manages Purpose Global Innovators Fund, which allocates roughly 20% of its holdings towards the esports theme. He is also a nerd.

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All industry figures quotes and graphics used are sourced to NewZoo.

All monetary figures are quotes in US dollars, unless otherwise noted.

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments believe to be reasonable assumptions, Purpose Investments cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.