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Fancy a Flutter

This newsletter looks at financial sector themes. But nothing exists in isolation. Sometimes I look at sectors that sit in close proximity, like I did last week with expert networks, whose customers are principally financial institutions. This week I’m venturing outside the box again, this time to look at the betting industry.

There is plenty of overlap between betting companies and financial companies. We’ve talked before about the spectrum that spans gambling (which bookmakers serve), speculation (which contracts-for-difference brokers serve) and investing (which stockbrokers serve).¹ Where Robinhood sits on this spectrum is key to understanding its business model.

In addition, there’s a lot of overlap between the characters involved in each of these categories. Many entrepreneurs that cut their teeth in betting are now active investors in financial technology, including Ed Wray and Tim Levene, both ex-Betfair.

Similarly, many successful investors were inspired by betting markets. Stuart Roden, former chairman of the hedge fund where I was a partner, appeared on a podcast recently.

“The reason I got into investing was probably because of my love of gambling … At the age of fifteen, [I] used to spend my – rather ashamedly – summer holidays on the racetrack or in bookmakers. So I liked gambling, I liked risk … From a pretty early age I knew I’d go into some form of risk-taking career.”

But perhaps most usefully, the financial industry provides good analogies for thinking about business models in the betting industry. Peter Jackson, CEO of Flutter Entertainment, the largest online betting firm in the world, may very well agree. His background is as a retail banker, although he’s been accelerating a pivot at Flutter away from a quasi-financial business towards an entertainment business.

With sports betting having been legalised in the US over the past few years, it’s a growing business globally. To understand what’s happening, let’s take a look at the betting industry through its largest player, Flutter Entertainment...

Insurance Model of Betting

Flutter traces its roots to the streets of 1980s Dublin. Betting was big business in Ireland, centred mainly around horses and in betting shops. The large UK-based bookmakers had been expanding into the country, and several local independent firms wanted to fight back. So, in 1988, three local bookies combined their 46 shops into a single firm they called Paddy Power.   

The Paddy Power name drew on the legacy of one of the firms, an eponymous bookmaker founded by Richard Power at the end of the nineteenth century. Richard Power started out running bets from the counter of the drapery store where he worked, before setting up alongside the racetracks of southeast Ireland. His business stayed in the family for three generations until his grandson, David, decided to throw in his lot with his fellow Irishmen. The Paddy name ran through the family and the three bookies decided it conveyed the right amount of Irishness to stand out against the British upstarts. They dressed their shops in green and opened for business.

Straight away, the bookies understood that to compete they needed to shoot for market share.

At its core, their business was not dissimilar to an insurance business. Like an insurance business, a bookmaker agrees to pay out cash contingent on an event in some unknown future. Lloyd’s of London began in a coffee house near the London docks where patrons would wager over events on the seas. One such early bet there was whether Admiral John Byng would be shot for his incompetence in a naval battle with the French. (He was.) Eventually, the patrons focused their bets on the safe passage of ships and their activity evolved into marine insurance. 

Both bookmaking and insurance models require a provider to take one side of the market against customers who take the other side. But bets are typically shorter in duration than insurance policies, and so bookmakers don’t hold customers’ cash for as long. Their profit therefore comes exclusively from how they price their risk (insurers are also able to capture investment profits from the customers’ cash that they hold).

There are two elements to doing this right. The first line of defence is to price risk correctly. No bookmaker is going to last very long offering long odds on Liverpool winning the English Premier League (showing my biases there). However, in some cases, risk is purposefully mispriced in order to win business, particularly by managing the odds on favourites whose prices sit in bookies’ shop windows. Sometimes this can lead to disaster. In March 2003, half of the horse races at the Cheltenham racing festival were won by favourites, forcing Paddy Power to issue a profit warning to the market that its revenue would fall €4 million shy of expectations.

Where there is capacity, risk can be reduced by placing bets with other bookmakers, similar to the way insurance companies use reinsurance. Beyond that, scale is a useful strategy since it allows risk to be spread over a larger volume of business. This is the second line of defence. 

For bookmakers like Paddy Power, in the days before online gambling, scale meant more shops, particularly given lack of customer loyalty to any one shop. In its first six years of operations, Paddy Power grew its footprint to 82 shops across Ireland. It financed its growth by selling freeholds on existing shops, leveraging the expertise of one of its founders who was big in the real estate business. By 1994, the company had established itself as the country’s biggest bookmaker with 18% of the market.

Through the late 1990s, Paddy Power continued to grow in its domestic Ireland. It passed a milestone of more than £100 million in turnover in 1997, an average of £1 million per shop, hitting a market share of 25%, more than 10% above its nearest rival Ladbrokes.

Years later, when it was even bigger, Paddy Power would go on to set up an actual insurance operation. The business – Airton Risk Management – allows sporting organizations and their commercial partners to hedge against their financial liabilities on the outcome of future events. In 2019 more than €100 million was hedged through Airton Risk. One client is a national rugby union, which paid the company €1.93 million to cover possible bonus payouts of €7.7 million if they won the 2019 Rugby World Cup in Japan.

Exchange Model of Betting

The first online bet was made in 1996 by a Finnish punter, Jukka Honkavaara, who won $2 from a $50 bet on Tottenham Hotspur beating Hereford United. Paddy Power wasn’t on the other side of that bet, and it would take a while for it to realise the potential, but over in London, another firm soon grasped the opportunity that online betting unleashed.

In 1999, Andrew Black and Ed Wray co-founded Betfair. Black was a college dropout who had spent time as a professional gambler and had worked on bank trading floors and in government intelligence; Wray was a banker at JPMorgan.

Rather than fashion their business as a one-sided insurance-like model, they used the stock exchange as inspiration to build a two-sided marketplace. 

“With the FTSE there are a lot of brokers who just put their prices up. In New York you ring your broker and say “I want to buy” and he'll go and just stick your bid on the board. Anyone can come and post their bid on the board, which creates a great big matching system. There is almost a beauty to a really efficient industry.” [Source]

Person-to-person betting had been legal in the UK since 1960, but until now there was no vehicle to institutionalise it. With Betfair, customers could trade freely with each other as on an exchange.

Black and Wray weren’t the first with the idea. Flutter.com had already raised over $40 million of venture capital to create a marketplace. But whereas Flutter.com allowed customers to create a market in anything they liked, Betfair restricted its range to a few markets, channeling liquidity to those markets. It also aggregated bets, allowed bets to be partially filled and calculated punters’ overall exposure to an event, giving them a better view on their capital at risk. 

As a result of these features, Betfair grew more quickly than Flutter.com and in 2001, the two agreed to merge. The combined group went on to dominate the betting exchange market, its liquidity sufficient to shake off more than 40 other startup betting exchanges. The company earned revenues by taking a percentage – initially 5% – of customers’ net winnings and between 2003 and 2007, grew its revenue by over 50% per year. 

Betfair’s tech-driven model allowed it to innovate around products. It launched in-play betting, so that punters could bet in real time while the event was going on. Similar technology allowed the company to offer cash-out options, giving nervous punters the opportunity to settle bets before the end of an event for a lower sum than they would receive if the result was final. 

At first, bookmakers hated the new model. They saw Betfair as a place for unlicensed bookmakers to lay off risk, they worried about it being abused by insiders cheating, and they questioned the tax treatment of the company’s revenues in comparison to their own. Over time, though, they learned to live with Betfair, even using it to lay off some of their own risk.

Trading Firm Model of Betting

Another reason for traditional bookmakers’ eventual acceptance of Betfair was that the overall market began to grow more quickly with the advent of online betting. 

In 2004, the global gambling market was worth around $300 billion, but only 5% was online. By now, Paddy Power had begun to see the potential.

As well as creating an easier user interface for customers, and one that fostered higher betting frequency, the online shift also allowed bookmakers to capture a lot more data. Just as electronification in financial markets led to emergence of new power brokers in finance, the same happened in betting. Bookmakers became increasingly like trading firms, handling high volumes of transactions each day, and using algorithms and models borrowed from financial services to manage risk. 

A good way to make money in financial markets is to “look for easy games” where differential skill pays off. In the early 2000s, betting markets represented an easy game. While quantitative methods were being employed extensively in financial markets, they were largely absent from betting markets. Paddy Power hired quants to harness the raw data the company was privy to, many of whom came from the world of finance. According to one of them:

“The customers didn’t know what each other were doing, but we did and that was a fantastic source of information. It was much better than the previous sources of information, which were feeds from racetracks or televised matches, where a trader would literally sit in front of a computer and change the odds as the match went on.” [Source]

Paddy Power established a deep risk management operation at the heart of its operation. Its capabilities grew as more business went online. By 2010, three-quarters of the company’s €143 million global profits came from the online side, powered by 643,000 customers. Sitting at the centre of it all was a risk team, which by 2012 numbered 140 people. 

With access to large volumes of betting data, the risk team developed a predictive model of customer profitability. Paddy Power reckons that by the time a punter has placed 15 bets on horse-racing or turned over €500 in their account, the firm has a strong knowledge of how much it could expect to win off them. In his book, Punters: How Paddy Power Bet Billions and Changed Gambling Forever, Aaron Rogan reveals that of 100,000 randomly selected Paddy Power customers as of 2018, around 40% would generate an 11-13% margin for the firm, with around two thirds of customers in the range 9-14%. Because bookmakers have the right not to take bets from punters who consistently win, the left side of the tail doesn’t stretch very far; not a single one of the 100,000 customers is expected to lose the firm more than 3%. 

Entertainment Model of Betting

From its earliest days, Paddy Power recognised that to sustain growth it needed to broaden the appeal of betting. Even when it hit the #1 spot in Ireland in the mid 1990s, its market was limited to the 12% of Irish people who gambled in bookmakers. 

From a product perspective, this meant doing more to cater for people with little interest in horse racing. And from a distribution perspective, it meant repositioning the shop away from a social club for out-of-work men and bored pensioners. The solution was to frame the business less as a traditional bookmaker and more as an entertainment business.

Paddy Power’s first CEO, Stewart Kenny, pushed this idea relentlessly. At its core, his business model was based around punters losing money. But if that loss could be framed as the cost of entertainment, the business would be a lot more sustainable and attractive to a broader group of customers.

“Most bets lose, don’t they? Or there wouldn’t be bookmakers. So we had to sell that sweaty palms feeling of when the bet is about to be decided, and the social currency of when your bet lands. That was way ahead of the curve.” [Source]

Like in financial services, there are no sticky patents in the betting industry so innovations are quickly copied. Nevertheless, Paddy Power was early to adopt many initiatives that helped to broaden its market:

• It introduced new betting markets, such as the ability to bet on numbers that come up in the national lottery. Key to the success of this market was keeping it simple – the company’s Lucky Numbers market required the punter to choose just three numbers. 

• It offered money-back specials designed to appease customers when they lost a bet. (In actual fact, this was just another way of competing on price. For a long time bookmakers have offered better odds as a way to attract punters on a market; by offering money back to losers rather than enhanced payouts to winners, Paddy Power was simply re-allocating its marketing spend differently.)

• It offered novelty bets, many of which were quite controversial. 

Underpinning these and other initiatives was an aggressive marketing ethos. Each morning, Paddy Power’s marketing team gathered for a morning briefing similar to those held in newsrooms. The goal was for Paddy Power to insert itself into anything its potential customers might be watching. In 2012, the company paid Danish footballer Nicklas Bendtner to wear Paddy Power branded underwear, which he revealed on scoring (to the dismay of the national team’s sponsor, Paddy Power competitor, Ladbrokes). Other similar campaigns didn’t pay off, for example paying Tongan rugby player Epi Taione to change his name – legally – to Paddy Power, and sponsoring Dennis Rodman’s basketball trip to North Korea.

Many of the company’s marketing campaigns were explicitly designed to garner controversy. The company was early in identifying increased engagement levels that can come from division. Even before social media, it promoted division via traditional advertising. 

“One of the rules in the rulebook was that if you piss off a small vocal minority that is not in your customer base, then so be it… We wanted to get the complaints up basically, from people outside our target audiences.” [Source]

This understanding may have come from within the betting market itself. When you place a bet, you are aligning yourself with a particular side or point-of-view—literally putting money where your mouth is. Division is built into the fabric of the betting market, and as social media platforms have demonstrated, it drives user engagement.

Epilogue: Going Global

Ireland was a pretty good launchpad for Paddy Power, as one of the most active sports betting markets in the world. Australia, though, was even bigger. Annual gambling spend in Australia is around $890 per adult, equivalent to around 2.3% of consumption. That compares with $380 per adult in Ireland, or 1.4% of consumption. In 2009, Paddy Power bought majority control of an Australian online betting business, Sportsbet, before buying it all in 2011.

Closer to home, Paddy Power got acquisitive, too. In 2015, it bought Betfair in a £5 billion deal to create the world’s largest online gambling business. Over time, the models of the two firms had converged. A few years earlier, Betfair recruited a senior Paddy Power executive, Breon Corcoran, as its CEO. Straight away, he launched a traditional bookmaking product to operate alongside Betfair’s exchange business. In 2013, the two firms were neck-and-neck in the UK online market, with 9% market share each. The acquisition (Betty Power) forged a firm with immense scale in the market: 1,000 staff working on product development, a £300 million annual marketing budget and an IT budget of £171 million. The newly merged Paddy Power Betfair led the markets in Ireland, Britain and Australia, and close to 90% of its £330 million profits were generated online.

Then, in 2018, the US market opened up. Through a series of acquisitions, Paddy Power – now renamed Flutter Entertainment – gained a strong foothold in the fledgling US market. Goldman Sachs estimates that online sports betting will grow to a $38 billion market in the US. Because of historic regulatory restrictions, the market lags well behind Australia and Ireland, with gambling representing only 0.6% of consumption, leaving room for catch-up. 

Just like financial services, gambling is a highly regulated business. But as we have seen in the financial sector, high levels of regulation lay the foundation for a stable, oligopolistic market with clear barriers to entry. Parlay that into a play on entertainment and it could be a winning bet.

This week’s subscriber-only section includes insight on Sequoia, Third Point and Robinhood. To read it, sign up here.