Hardly a day goes by when you don’t read about some producer, or quasi-producer, downloading $250 million from a Wall Street “hedge fund,” to make movies. First, it was studios, using off-balance-sheet financing. Then, individual producers realized they could do the same thing. And now, everybody from Tom Cruise to the pornosseurs of the San Fernando Valley, are in on the action.
“Studios,” whatever they are, long ceased functioning as an integral component to actually making the movie. For some time, their role primarily has been financing, and marketing. Financing a movie is a capital-intensive activity. The return is speculative, because the film might not fare well in the marketplace, particularly the last “unsecured” increment of financing, where there is no clear recoupment corridor.
It also may be untimely. The distinguishing characteristic of film investment is it’s non IRR-driven. IRR stands for “internal rate of return,” and it measures not only the percentage of return on investment, but also its periodicity, that is, with what regularity it occurs. An example of a high-IRR investment is a lease, where the tenant makes monthly payments, of the same amount.
Whereas with film, on the other hand, you spend a whole lot of money pretty much up front … and then wait. You wait for the film to be released, during which time interest is accruing, or at least notional interest (i.e., what you could be doing with the money, if you hadn’t invested it in the movie). Then, even after you release it, there are different windows for theatrical exhibition, video distribution, television broadcast, and foreign revenues may be delayed for a variety of reasons, some of which actually don’t pertain to ornery sub-licensees.
I don’t think it’s an overstatement to say most of American business primarily is IRR driven. Which is one of the reasons why, from an historical perspective, film investment has been less than completely attractive to Wall Street; at the very least, it’s carried with it, a healthy dose of skepticism. Wall Street’s historical experience with investment vehicles like the Silver Screen Partnerships (a mid-1980s Disney off-balance-sheet financing vehicle) has been less than stellar. Once TEFRA was enacted, eliminating the ability to write up an asset to 10x its actual value and then deduct it immediately, the bloom was off the proverbial rose.
Which is why the new trend for “hedge fund” investment in filmed entertainment properties must seem like a breath of fresh air to the studios. “With newfound wealth pouring into the independent film sector courtesy of hedge funds and private investors, securing financial backing for projects has never been easier,” Galloway, S., “Roundtable – Film Financing,” Hollywood Reporter (Oct. 31, 2006).
Tom Pollock, former head of Universal Studios, recently characterized Wall Street as a “destination for investment” as large corporations began to look for partners to help finance big-budget movies. “The reason is that the corporate HQ people (at News Corp. or General Electric or Viacom) are saying we need your movies to drive our other divisions but we don’t want to give you the capital to do it,” Pollock said, Kemp, S., “Data, biz models bringing Wall St. to H’wood’s door,” Hollywood Reporter (Nov. 4, 2006).
Laura Fazio, media sector chief at investment bank Dresdner Kleinwort, told the audience at a recent forum the transparency of data from big-hitting producers and the studios alike was a huge bonus. “It gives investors comfort in the analysis of any investment going forward,” Fazio said, Kemp, S., “Data, biz models bringing Wall St. to H’wood’s door,” op. cit.
Transparency of available data? In your dreams! The filmed entertainment business is one of the most opaque devised by the ingenuity of mortal man. Sure, it’s easy to get domestic box office gross. In fact, it’s hard to avoid it, even if you want to – hardly a paper in the country doesn’t carry it, come Monday morning, which wasn’t the case, say, 10 years ago. But what about DVD sales, sales to TV, and foreign? What about the “real” budget? What about the amount of P&A? What about “net proceeds” derived by the studio, after all costs are paid? I strongly suggest Ms. Fazio take a course in film economics 101, and quickly, too.
Marketing presents different, but equally complex, issues. All of the major studios have announced cut-backs in their forthcoming release schedules. This is due to a variety of factors, including economic constraints, too many superfluous films, and a desire to allocate limited resources more efficiently towards so-called “tent-pole” projects.
The key theme in these initiatives seems to be: economies of scale. That is, running a major studio distribution system involves a high level of overhead. In a very real sense, it’s just as expensive for the studio to service a lower-budget “independent” movie, as it is one with the potential for $100 million domestic theatrical box office. Costs don’t amortize efficiently when sales are low.
Furthermore, theatrical exhibition, video distribution, as well as television broadcast, themselves all have become consolidated. There only are three or four “major” cinema chains; the top five DVD customers account for some 85% of sales (Wal-Mart alone accounts for approx. 30%). The simple fact of the matter is, big users prefer to deal with big vendors. They don’t have the time, interest or inclination to transact with a plethora of smaller firms, even those selling potentially high-revenue properties.
But there’s a problem. Actually, there are two problems, one pertaining to supply; the other to demand. The supply problem is, in short order, there will be “too many” movies. I don’t mean from a creative standpoint, or in an aesthetic sense. It repeatedly has been demonstrated demand for “good” movies is highly elastic. Rather: I speak of movies meeting the prerequisites any simple-minded financier would insist upon, such as committed, name-recognized cast; a modicum of distribution commitments; some tax-advantaged financing in place; etc. In the movie industry, it is not, or should not, be true, that “if you build it, they will come” – it always has been necessary to have some elements in place, before even the most potentially-critically-acclaimable property becomes an appropriate candidate for actually becoming a movie.
As a result, all of the money now seemingly available will start chasing fewer and fewer projects. Not only will this bid up the cost of qualified projects, but also it will cause managers of investment funds to take risks on increasingly dubious ones – again, not from a creative, or an aesthetic standpoint, but simply when it comes to marshalling collateral elements. A couple of failures in this vein, and the hedge fund money will dry up in a flash. My advice to the studios: grab as much of this money as you can, as quickly as possible.
I’m not the first to make this observation. A recent article in the Hollywood Reporter observed: “Consider, for example, the effect that having an overstuffed pipeline of movies has on the industry’s overall health. Last weekend saw four wide openings that went into about 9,200 theaters. The same weekend also saw a loss of nearly 7,000 theaters for holdover films. One of the key problems distributors face nowadays is holding theaters if a movie doesn’t immediately connect with its audience. In the past, when there was less product opening wide every weekend, films could manage to hold on for a few weeks and try to benefit from good word of mouth or even take a second shot at luring audiences with a revised marketing campaign. Now by the time a film hits its third weekend, it’s starting to hemorrhage theaters if it’s not performing really well,” Grove, M., “Too much money poses hidden problems,” Hollywood Reporter (Oct. 20, 2006).
In the above-cited “Roundtable – Film Financing,” Tom Ortenberg, President of Lions Gate, one of the leading independent mini-studio distributors, answered the moderator’s question, as follows: “THR: How great are the risks for investors? Ortenberg: We’ve seen some pictures recently where you can lose everything. It’s not unlike playing the stock market.” He continued: “From our perspective, there has been a lot more talk about hedge funds than hedge funds themselves. What’s really been coming out of this is how key distribution is. I say that as a distributor, but it has been incredible, the number of people coming to us, looking for some level of guaranteed distribution so they can run to the hedge funds and get financing. And there are only so many places to go in the independent film world.”
Cassien Elwes, an agent at William Morris specializing in independent films, agreed: “The tricky part of that is, with the distributors, there (are) not enough slots for the amount of money that is arriving. So, the distributors are getting bombarded particularly MGM, who have put themselves out there as strictly a distribution entity that is available for the right price to be rented. You just see how many films are being thrown at MGM. If there was another distributor like MGM, there would be another 25 or 30 movies (distributed each year).”
Avi Lerner, an independent film producer, closed the forum by saying: “In two years’ time, no hedge fund will exist in this country. They are all going to lose money because they don’t understand the business.”
In this same vein, the Wall Street Journal recently reported: “‘Harsh Times,’ a gritty Los Angeles drama written, directed and produced by ‘Training Day’ screenwriter David Ayer, made $1.8 million in 956 theaters, for the second lowest per-venue average of the weekend’s new releases. (Ridley Scott’s Fox comedy ‘A Good Year’ fared slightly worse.) The poor performance is bad news for Bauer Martinez Entertainment, a new film company that acquired ‘Harsh Times’ for $4 million at the Toronto International Film Festival. Formed in 1999, Bauer Martinez has a track record of meager releases of its own (‘Modigliani,’ ‘The Groomsmen’), but has also partnered with the newly reconfigured Metro-Goldwyn-Mayer Inc. to distribute bigger films. But when the fledgling outfit failed to foot millions of dollars in promised marketing expenses for ‘Harsh Times,’ the film’s release stumbled. MGM stepped in to assume the costs, but only because they’ll be able to take a greater share from future Bauer Martinez releases. If MGM has found a viable business as a distributor-for-hire, so far, the model has created as many heartaches (‘Flyboys’) as hits (‘Clerks’) for producers,” emphasis added, Kaufman, A., “Harsh Times falls on Hard Times,” Wall St. Journal (Nov. 12, 2006).
Mr. Kaufman’s note articulately poses the demand problem: there isn’t now, and there won’t be in the future, enough distribution outlets to collateralize adequately the surplusage of potentially bankable films. As Mr. Kaufman makes painfully clear, any independent producer who thinks he can “rent” a major studio’s distribution system, is in for a rude surprise.
From the studio’s standpoint, renting out a scarce economic resource, such as distribution, must result in purely “incremental” income. This means zero costs, and found money they wouldn’t otherwise be making. In other words, they won’t, nor should they, lift a finger to help “market” the film, that is, promote or publicize it.
Another factor is, studio management always will be under pressure to favor its own, proprietary projects. Not only do they present the potential for greater margin – that is, earning more than just a distribution fee – but their proponents within the company are zealous advocates on their behalf. Thus, to the extent limited resources are available, such as variable marketing spend, they inevitably will be commandeered for redirection to these internal projects. There is no such thing as “renting” a major studio’s distribution system, with the expectation it is “label blind,” or totally impartial, when it comes to establishing and implementing marketing priorities.
One of the ways this works is what I call “implicit cross-collateralization.” In other words, your project well may end up being the “snack” or “dessert,” “thrown in” for little cost, in order to induce the exhibitor (distributor, broadcaster) to buy a larger, more expensive, frequently proprietary, property. Transactions like this occur all the time, and there really is no way to audit, or track them, effectively, simply because there’s too much discretion, and human judgment, involved.
There is a complex hierarchy of implicit trade-offs between the major studios, and the major exhibitors (distributors, broadcasters). The basic way to characterize it is, “are you in a debit or a credit position in the favor bank.” The “favor bank” is that subtle, sinewy, intertwined series of relationships, in many cases dating back years, which facilitates the ongoing occurrence of business and commerce, in any industry. For example, if one property is a “stiff,” they’ll make it up to you with something else. If you didn’t get everything you wanted here, we’ll give it to you, there. Only a big studio can play this game, because only a big studio will have a sufficient number of contestants in each Friday’s demolition derby.
I don’t mean to cast a pejorative tone over this, either; it’s an accepted fact of American business, in almost every area of endeavor, from selling washing machines to cars to breakfast cereal. It’s no mystery why the stuff with the best margins is right at the height when the kid can grab it and put it into the cart; it’s no mystery why some products are end-capped (i.e., at the end of aisles), and others aren’t. It’s the grand stream of commerce, in all of its multifaceted and variegated glory. The big question for the property seeking third-party distribution is, if they want to be the football in that particular game.
So, how do I know the trend towards hedge fund investment has peaked? A recent article in the Wall Street Journal opined: “Private equity is taking Wall Street by storm. Now it’s getting easier for individual investors to get a piece of the action. Private-equity investing is a risky and expensive game traditionally played by institutional investors and the super rich willing to commit as much as $25 million. Now, a number of new investment opportunities are opening up that cater to the merely wealthy and even small investors,” Laise, E., “Private Equity Targets Littler Guy,” Wall St. Journal (Nov. 8, 2006).
And about the time the gates start opening up for the “little guy,” all that’s left on the table are dry bones that have been picked over by a whole armada of previous vultures. So if I were one of the “little guys,” considering this type of investment, I’d head for the exit, just as fast as my legs could carry me!