In the late 1990s – early 2000s, most independent films were produced using a “structured financing”-type structure. Various collateral items were comprised including foreign pre-sales; syndicated tax benefits; and domestic theatrical, television and video rights. These were used as collateral for a bank loan to finance production. Portfolios of these loans were amassed and syndicated like any other collateralized debt obligation (CDO). Banks like JP Morgan-Chase would take on the lowest-risk tranches (first-out); mezzanine funds like those put together by Goldman Sachs would take on middle-risk tranches; and “equity” investment would take on highest-risk tranches (last out). JP Morgan-Chase in turn would re-syndicate its position to a consortium of other institutional investors. Institutional investors were intrigued because of the prospect a portfolio of film investments might offer high returns and provide diversification against other types of fixed-asset investments such as mortgages, equipment leases, credit card indebtedness and the like.
The portfolios were cross-collateralized and were supposed to behave much like a mutual fund. Meaning, successful movies (those that exceeded their collateral value) were expected to make up for unsuccessful ones (those that failed to earn back their collateral value). There was no risk of production default for individual movies because all of them had completion bonds. The main variable was market risk, i.e. that they might not actually sell for the full anticipated value of the collateral package. This risk frequently was mitigated with various hedging strategies such as residual value insurance (RVI), which guaranteed the portfolio at least would recoup. Although I am unaware of any specific instance where it was used with film CDOs, there also may have been a limited market for credit default swaps. Please note the RVI policy I mention is not like the former “gap” insurance, which was the source of much contention (cf. the lawsuit between France’s AXA Insurance and Chase Manhattan Bank). Gap insurance was supposed to indemnify the lender if there was a deficiency between the amount derived from sales of rights and the amount of the loan. RVI insurance on the other hand guarantees a minimum value for the entire portfolio.
There was no secondary market for participations, or to the extent there was, it was extremely limited. Not surprisingly these portfolios performed just like any other CDO; as interest rates went up, the value of the portfolio went down, and vice versa. The value of participations in these portfolios became highly vulnerable as a result of the 2008-present credit crisis. The value of the riskiest or most speculative tiers (equity and mezzanine) was wiped out completely. The value of the tiers thought to be less risky (those held by institutional lenders) was eroded substantially. As a result it became possible to acquire interests in these tiers inexpensively, perhaps for as low as 10 cents on the dollar. The main problem is that the market lacks liquidity; the most likely candidates to purchase these participations are the very institutional investors who are trying to sell them. If they have to be marked to market on the institutional investor’s books, they show a large loss.
I put together one of these deals for Franchise Pictures. Franchise later was sued by the German firm Intertainment AG for keeping two sets of books, a fact I obviously didn’t know about at the time. In connection with the investment banking firm Patton Pacific, I tried (but was unable) to complete another one a couple of years ago, just as the credit market was starting to get crispy around the edges, due to fluctuations in the interest rate environment.
It still is possible to put together a different version of these syndication arrangements today, with several important modifications. First, the debt portion is much smaller, say, 50-60% of the value of the package, rather than 60-75%. Even then, the lender may require other corporate assets such as stock, corporate guarantees, and possibly even convertible debt or warrants, as security. Established entertainment lenders are reluctant to do anything unless they are over-collateralized. Second, the interest rate assumptions are different (typically, much higher) in order to compensate for increased perceived risk. Third, mezzanine-type financing has disappeared, as a result of which most of the balance of the portfolio is first-risk equity. There are no more German Neuer Market deals to “wrap” the entire transaction and supply any difference between the amount of loan and presale commitments, and the film’s total negative cost. If a portfolio of film assets is properly constituted, this equity component may not be as risky as it appears; only the top 10%-5% (last out) really should be at risk, with the balance picking up where the mezzanine component typically (previously) had left off.
Two illustrations of this are Alcon Entertainment, wholly financed by Fred Smith of Federal Express, which has had mixed success; and Crusader Films, owned by Anschutz Entertainment. Anschutz has pumped millions of dollars in to Crusader, only to end up with a bloated corporate staff and dozens of failed movies.
Another recent example is the new David Ellison company, financed with $350 million from Oracle CEO Larry Ellison. It was reported that $200 million of this total was bank financing (a consortium organized by JP Morgan Chase) and $150 million was equity. While I don’t know for sure, it’s far more plausible the structure is a revolving, fully-collateralized line of credit. None of the money is released until a project meets certain designated financial criteria. Then, it is paid directly to the producer or even individual vendors, again on a line of credit basis. As or after the film is made, all net proceeds from its commercial exploitation are deposited directly with JP Morgan Chase, which keeps the entire amount. Only when they are fully out of the line, with reserves for future potential liabilities, is anything paid to the equity component. The $350 million figure largely is illusory.
Enhancing Ellison’s risk is his relationship with Paramount. However covertly, and regardless of good intentions, the likelihood is Paramount will attempt to use Ellison as a kind of dumping ground for projects it doesn’t want to fully-finance on its own, simply because they’re too risky. Ellison in turn likely will be unable to persuade Paramount to participate in financing any of its own films. Paramount will make some kind of a minimal effort to accommodate Ellison’s films into its own distribution schedule. Since all Paramount will earn on those films is a distribution margin, it’s unlikely they’ll receive the marketing priority and attention that a full-fledged, wholly-owned proprietary Paramount movie would, under similar circumstances. Big studios such as Paramount only release 20 or so movies per year, maybe less, which leaves little room for the third-party independent film.
The market is responding dramatically to these dynamics. First, demand for mid-priced independent films ($5 million – $40 million) virtually has disappeared. Theatrical exhibition has consolidated. Because of their own financing commitments, large theatrical exhibitors need relationships with established studios in order to guarantee consistent product flow. A film must have considerable marketing support, often equal to half of its negative cost. This results in fewer opportunities for independent films, which are delivered sporadically with (typically) insufficient marketing support. They are perceived as being one-shot or limited-shot players. They take up landing slots that could be devoted to better-promoted studio movies. This also makes them vulnerable to foreign market defaults. Many foreign buyers simply walk away from their financing commitments with impunity if they believe the film doesn’t have the market potential it once was thought to have. Second, with the rise of the Internet, the value of the DVD market – typically a major collateral item for the independent film – has plummeted. One needs look no further than the travails of Blockbuster as evidence for this trend. Third, while tax shelter benefits still are a viable source of collateral (and may lay off a significant percentage of the film’s negative cost), increasingly they are restricted. Many jurisdictions, for example, impose a ceiling on the amount of tax-advantaged benefits they will confer in a year. As with theatrical exhibition, large studios increasingly claim these credits in preference to smaller independent films. Fourth, the value of Internet distribution is unknown, even as it erodes DVD and other margins. Most likely it will be less than is thought, and will be deferred until some distant point in the future, creating significant revenue distortions.
The result is bifurcation. On the one hand, there are $100 million, big-budget movies with established stars (increasingly, in 3D). On the other, there are $1 million or so independent films. There is little room in the middle, where one casting miscue, marketing error, insufficient audience penetration or poor word of mouth can mean disaster. I exaggerate the differential between $1 million and $100 million in order to make a didactic point; in practice the slope is somewhat slipperier and, depending on the project and the vicissitudes of the marketplace, may be as low as $5 million or as high as $50 million. Companies such as Lions Gate – now the subject of a take-over attempt by Carl Icahn – have incurred large losses attempting to navigate precisely this intermediate zone. The value of companies like Village Roadshow has plummeted. So-called “independent film companies” owned by major studios – as Warner Bros. owns New Line Cinema, for example – have been shut down completely.
Even some of the structure-financed portfolios comprising dozens of movies are not immune to this effect. The “mutual fund” concept depends on the principle of covariance, that is, on balance, the sum of all better-performing movies will outweigh the sum of all lesser-performing movies. In practice, it often has happened that each and every movie in the portfolio has underperformed, resulting in substantial losses. Although it does not break out its finances, I suspect companies like Relativity Media, run by Ryan Kavanaugh, have incurred significant losses on their portfolio financing arrangements with firms like Universal Pictures. This might be one of the reasons why Relativity is trying to diversify into television and film production. These domains carry risks of their own, which a firm like Relativity might not be prepared to navigate. Relativity’s recent acquisition of Overture Films – previously owned by Liberty Media and John Malone – is a good example. Overture only made a dozen or so films and likely has a substantial negative book value. It never did achieve any kind of “synergy” with Liberty’s other television distribution assets. What Relativity can do with a firm like this is difficult to imagine.
This dynamic also is reflected by several recent independent film business transactions. In July 2010 Disney finally sold its Miramax division for $660 million to Colony Capital, a group headed by Ronald N. Tutor. Unless Disney financed most of the deal, it is difficult not to conclude Tutor dramatically overpaid for these rights. Miramax has no films presently in production and no capacity to make them. All it has is a “film library” of approximately 700 movies. The value of a film library is the present discount value of its anticipated income stream over some defined period of time – say, 10 years. The problem is that most film distribution rights are pledged for lengthy periods of time, frequently for as long as 25 years. While there may be nominal future revenue streams resulting from anticipated future exploitation, most of the value is paid up-front in the form of an advance. These advances long have been spent and no longer are corporate assets. Reciprocally, most films are hedged with producer and talent participations. There’s not a lot of free cash flow after these are paid; frequently, no more than a sliver. Disney argued there was considerable value in sequel/prequel rights. Even granting this premise it will take millions of dollars to make the films based on the sequels/prequels, all of which are subject to market risk.
A more realistic scenario is MGM/UA, which was acquired by Providence Equity Partners in 2004 for $4.9 billion. Based on the kind of operating cash flow analysis I described, its present worth has been reported at approximately $1.6 billion – probably, far less than this amount, once one got into the books.
So where does this leave the prospects for a new independent film company? There are a half dozen or so well-established ways now to finance independent films. No one is going to innovate anything new. This means it is all about execution and professional judgment; relationships with talent; and relationships with agents. Considerable discernment is necessary to vet qualified projects, not only from a financial standpoint, but also from a script and participation standpoint.
For all of the palaver this skill is in remarkably short supply. The movie business run by the large Hollywood studios is a completely different industry than independent film. They really have nothing to do with each other, particularly when it comes to originating and producing repertoire. As an example, the major studio has dozens – probably hundreds – of films in “development.” This means they vaguely attempt to attach talent to them, various directors, various script-rewrites, development executives with expense accounts, etc. The last thing development executives want is for a film they are responsible for actually to get made, because then it probably will fail, and the development executive will get fired. This creates a culture of conformity and decision-by-committee which is endemic to a creative film company. The major studio is not limber, lithe or agile. Rather it is a bureaucracy dependent on economies of scale – a contradiction in terms for any company involved in creative endeavor.
A far better strategy would be to comprise a small administrative unit to run an as an independent business organization. Each film production would be established as a separate limited liability company (LLC), with the film company as its sole member and manager. This truncates all financial liabilities at the LLC level. All “corporate” overhead could be pushed down to the LLC, so the effective cost of running the business is zero. Since the corporate unit is the sole financial member of the LLC, it alone is entitled to tax benefits (such as NOLs that might be incurred in the first year gap between production and receipt of revenues). Under certain circumstances these in turn can be rolled up and passed through to a parent company so as to reduce its overall tax liability. The company literally will pay for itself. While there would be financial supervision of each production, there would be limited creative supervision. One of the biggest overhead items studios have is cadres of executives deciding which walls should be painted mauve instead of fuchsia. The entire reason why one buys into a creative team is because one trusts their creative judgment; if one doesn’t, then one should not make the movie to begin with. Each LLC also would capture and retain maximum syndicated tax benefits, production credits and other incentives. Once an active portfolio of projects has been comprised, then it can be syndicated as an integrated, performing unit to a consortium of institutional investors, such as those lead by JP Morgan Chase.
As proof of concept, this in principle was the strategy I implemented when I was President of Gold Circle Films to finance movies such as “Double Whammy” and “My Big Fat Greek Wedding.” After I left, the company formed its own foreign distribution company and its own domestic distribution company, both of which no longer exist. It started producing movies in the middle market range, with decidedly mixed results; I believe this is the riskiest zone to be in, for the reasons I set forth.