A release off Bloomberg News ran today (November 13th) in the Los Angeles Times, the Hollywood Reporter, and other industry media: “Relativity Sues Citi over financing.” It detailed the travails of Ryan Kavanaugh and his company Relativity Media. Relativity has been phenomenally successful in financing movies by packaging film slates and brokering them to Wall Street investment firms as collateralized debt obligations. In principle this worked like any other asset-backed security such as mortgages, equipment leases or credit card debt. The investor is not acquiring a specific movie but rather a risk-return characteristic associated with a tier of a portfolio. Through innovation, contacts and tenacity, Kavanaugh has been successful in transporting this model to film industry financing on a large scale, developing relationships with several of the major studios.
It always was subject to several problems. Kavanaugh developed what purported to be a “model” to predict the box-office performance of individual films and portfolios of films. There are no such models and there never will be. He marketed slate financing as a way of “hedging” risk. No hedges were involved. The investor simply was holding a “long” position in a film, subject to market risk. Slate financing was supposed to be less risky overall because the performance of individual films was buffered or protected by the other films comprising the portfolio, much like a mutual fund. This overlooks the possibility that every single film in the portfolio will underperform, as apparently was the case with several of Relativity’s offerings.
Most seriously, the present crisis in the credit markets has totally eroded the financing assumptions on which all asset-backed securities are based. The riskiest tiers – those that get paid last – earn the highest rate of interest, and vice versa. Their viability depends on purchasers of media rights fulfilling their contractual obligations. Foreign buyers, however, increasingly are defaulting or extending payment terms. Domestic release plans have gone awry as studios cut back on the number of releases they are willing to support. DVD sales are down. TV buyers are paying less as competing media alternatives encroach on traditional viewing patterns. All of this has put a squeeze on the lower-performing tiers. There is no secondary market to speak of for these investments, or if there is, it is extremely limited. I would be surprised if the riskiest tiers now are worth pennies on the dollar. Even more ominously, default risk has encroached into less-risky tiers. Investors who thought they were acquiring less-risky tiers (in consideration for lower interest payments) now find themselves on the front line of risk. In many cases I doubt that all but the most senior tiers will survive, and even they might be seriously impaired.
Litigation is the inevitable concomitant to this trend as financiers try to back out of their financing commitments (as evidently is the case with the Citi suit). Who wants to sink money into a losing proposition, particularly in competition with other potentially less-risky investments? It seems unlikely the Fed will want to bail them out. The auto, airline and steel industries probably are worthier candidates for rescue than movies. Banks such as Citi or its counterpart J. P. Morgan Chase typically take the least-riskiest part of the portfolio. If Citi is reneging on the least-riskiest tranche, what becomes of the riskier pieces? The so-called sub-prime mortgage crisis began with only the riskiest loans, but it quickly engulfed the entire industry. Relativity’s model worked great in affluent times when there was plenty of money around and fat-cat hedge fund managers could experiment with Hollywood investments as a way to diversify their portfolios. It seems unlikely it will continue to flourish, and the Citi lawsuit most likely just is the tip of the iceberg.
Good luck to all parties as they lawyer up and start to explore the configurations and nuances of this interesting problem.