BioWare & Pandemic: The Fatted Calves?

With BioWare’s Mass Effect a few weeks from release, the recent purchase of BioWare and Pandemic by Electronic Arts seems brazenly timed. The reactions from all corners defy classification, and in their most common form equally defy serious analysis and unbiased discussion. Electronic Arts, burdened by a tumultuous and controversial history, has become an entity which many people criticize and condemn by default, its dealings automatically perceived as some extension of corporate evil defined by nefarious misdeeds and malicious motives. Vilifying Electronic Arts is virtually a pastime for most bloggers and forum posters, and so common as to be nearly cliché. How the BioWare/Pandemic deal might affect future products and franchises is a debate of pessimistic one-upmanship, and the consensus is this will be a bad thing for gamers. However, these conclusions often lack any compelling evidence beyond “if EA is involved, it must be bad.”

What has not been discussed is how this deal came to pass, who benefits and why EA dumped more than three-quarters of a billion dollars on a premier developer.

This deal’s story pretty much begins and ends with John Riccitiello and a three-and-a-half year game of executive musical chairs. From late 1997 until 2004, Riccitiello was President and Chief Operating Officer of Electronic Arts, when, in 2004, he suddenly left to co-found the private equity firm Elevation Partners, along with former Apple CFO Fred Anderson and U2 front-man Bono. It was an unusual partnership, but one imbued with a healthy stash of funds from which to invest in prominent media and tech companies, and among the company’s first significant investment was BioWare and Pandemic.

In the deal, BioWare and Pandemic were merged under a company called VG Holdings, which would manage the business operations of the companies while relinquishing creative control to the two developers. The widely publicized idea was that this new approach to game development would fund creative and proven developers, supplying the resources they needed to commit to a creative vision, while putting them into strong positions to negotiate favorable contracts. Eventually, VG Holdings might even be strong enough to go public, though many Wall Street insiders at the time suggested that such an opportunity was highly unlikely.

In the wake of the deal, John Riccitiello took over as CEO of the new VG Holdings while remaining a Managing Director at Elevation Partners, a company that now owned franchises such as Star Wars: Battlefront, Star Wars: Knights of the Old Republic, Mercenaries, Baldur’s Gate and Mass Effect. In an article with the New York Times, Riccitiello said his responsibility at VG Holdings was to let the developers “focus more on creating games and less on dealing with the mundane business operations.”

Meanwhile, at Electronic Arts, Larry Probst, who had served as EA CEO since 1991, was already making plans for succession. In an interview with Newsweek, Probst said succession is a long-term process, and that even when Riccitiello left his President and COO position in 2004, the discussions were already beginning in preparation for when the timing might was right.

At this point, there are a lot of questions to be asked, which probably don’t have public answers. Since a private equity firm like Elevation usually recoups its investment via an IPO or the sale of a company, and Wall Street is clearly uncomfortable with public offerings from independent developers, particularly those with high creative standards and long development cycles, why invest in VG Holdings if the plan wasn’t to sell the company from the start? How soon did Riccitiello know succession was being considered at EA? If BioWare and Pandemic went into this deal with the desire to receive funding to remain independent, was the lure of an eventual IPO the carrot on a stick that lured down the path to eventual buyout? And, perhaps most importantly, when taking the reins as CEO of VG Holdings, with the promise of merely handling the mundane business operations, did Riccitiello know he was on the short list for taking over the reins at Electronic Arts? In short, were BioWare and Pandemic always intended to be fattened and sold on the market, and did the executives who handed the reigns over to Elevation and Riccitiello know?

There’s a lot of room here for conspiracy theory, but it depends on the executives at BioWare and Pandemic being duped and that Riccitiello left EA with plans from the start to land the “big one.” It is equally conceivable to suggest that BioWare and Pandemic were simply interested in securing creative freedom and were convinced that by taking the investment from Elevation Partners and putting Riccitiello, clearly a savvy and respected executive, in charge of their business operations they could achieve that Holy Grail. Also conceivable is that things just fell into place for Riccitiello, that on being recalled to EA as its CEO with Probst as Chairman of the Board, he was in a unique position of authority and influence to land two of the strongest names in game development for the publisher. The problem is both of these theories also require the assumption that everyone in the deal assumed Elevation would make its money back on an eventual public offering from VG Holdings, which was widely seen in financial sectors as unlikely.

Regardless of the motivations and intentions that might have led to the deal, the endgame played out with Riccitiello returning as CEO of Electronic Arts in February of this year, relinquishing his roles as Managing Director of Elevation Partners and CEO of VG Holdings. In his wake, Greg Richardson, himself a former Electronic Arts general manager, was named to the new CEO position at VG Holdings. The $860 million dollar deal would be the biggest in Electronic Arts’ history.

Riccitiello did recuse himself from the buyout vote, though he highly endorsed it, and in a filing with the Securities and Exchange Commission, Electronic Arts quickly disclosed that their new CEO stood to individually make $4.9 million on the deal. The deal itself was cash rich, with $620 million in cash going to the stockholders of VG Holdings. While the specifics of that part of the deal will remain private, the bulk of that cash likely goes back to Elevation Partners. $155 million of time-restricted equity will be paid out to the management of BioWare and Pandemic, an effort to compensate and retain key talent.

I asked a financial analyst about the deal, and he was immediately surprised that it was so cash rich for a company with such strong stock versus its cash earning potential, citing the company’s unusually high P/E Ratio (price per share over earnings per share). Companies with a P/E above 25 – the U.S. average is between 14 and 16 – usually have stock prices well above and out of step with their corporate earnings and are either thought to have a high potential for future growth or are considered vulnerable to a speculative bubble. EA’s P/E Ratio is 720. When companies with that kind of stock valuation make big deals, they tend to keep their cash in reserve and simply issue new stock without any real fears of devaluation.

EA, instead, gave out more than $600 million dollars in cash to make the deal work.

Why? Perhaps Electronic Arts is looking to shore up their new IP development, which includes 13 new IPs since 2002 with Army of Two, Spore and Crysis yet to come, with the strength of VG Holdings’ franchises. Certainly Activision, which managed to top EA’s earnings in Q1 2007, is making significant money from existing franchises, particularly movie tie-ins such as Spiderman 3, Shrek The Third, Bee Movie and Transformers, taking a page out of what had been EA’s playbook. A few analysts have even suggested that EA may be looking to consolidate strong first-party foundation for an eventual attempt to break into the console hardware market. And, certainly something must be said about the feather in the cap of reeling in such a prestige pair of developers.

But in the wake of the deal, we have a lot of uncertain threads to be tied up. We have a pair of developers who went to extraordinary lengths to secure their autonomy, only to end up owned by the largest publisher in the industry. We have the CEO who just happened to land in all the right executive positions to organize the incestuous deal and go from investor to head of the company that bought out his own investment. We have a financial environment that resists as strongly as ever the idea of publicly traded developers unsupported by large publishers, and we have a private equity firm established to help support those developers which has all but abandoned the concept. In the end, the breaking away and eventual reeling back in of Pandemic and BioWare may be as much about reconsolidating the authority of big name publishers as any franchise.

Sean Sands is a freelance writer, one of the co-founder of Gamerswithjobs.com and runs a small graphic design business with his wife near Minneapolis. When not writing about gaming, he can often be found playing video games and pretending to call it work.