Tuesday, 30 August 2016
Last updated 10 hours ago
Feb 27 2011 | 5:49pm ET
If there were an Oscar for Best Film-Financing Deal, the winning transaction might look something like this: original equity investors are returned a multiple of their initial investment within in a prescribed time frame; mezzanine investors get all their interest and principle paid; senior debt is fully serviced—and possibly re-cycled for another favorable round of financing.
But that’s not an award likely to be given out any time soon—in part because even the non-televised portion of the Academy Awards show is already too long; in part because of the many challenges to achieving that sort of success in a Hollywood film-financing deal; and in part because of the extremely confidential nature of these industry deals.
Nevertheless, deals matching the above description have been done during this latest film-financing capital cycle, and they’ve frequently involved hedge fund managers, investment bankers, private equity fund managers and other alternative investment types. In fact, it’s these finance industry players that characterize the latest capital cycle (which dates to roughly 2004) and distinguish it from previous cycles.
But before we continue, a word on previous cycles.
New Wave Financing
Like cinematic movements, film financing seems to come in waves. One hedge fund manager, who has extensive experience in the film-financing field but prefers not to be identified because he’s no longer focused in this space, summed it up this way: “If you go back 30 years, you see the Japanese coming through; 20 years ago, insurance companies; 10 years ago, German film funds who had tax reasons for investing in films; and then this last decade, it’s been hedge funds, largely.”
Each investment wave has its own characteristics. In the early ‘80s, much of the investment was tax driven: investors could purchase films as they were being completed and effectively lease them back to distributors. They could accelerate the depreciation and amortization of the asset just purchased to defer income and other taxes.
Insurance companies, during their Hollywood period (roughly the early ‘90s), offered to insure gap loans on films. Banks would provide gap financing to producers, then insure the loans in case sales targets were missed and producers couldn’t make good. Emboldened by their insurance policies, banks increased the gap loans to as much as 50% of film budgets. Many films failed to reach their sales targets, many insurance companies were called in to repay loans, some litigation ensued and, as a result, insurance-backed gap financing has become more rationalized since the height of the market.
Past cycles have also been characterized by public underwriting. The German government, in response to the increasing domination of the major studios, developed a public market in tax-shelter vehicles—the Neuer Market¬—which, according to another industry insider, raised money from wealthy German investors “who had glossy pamphlets put in front of them.” Large German film funds like Helkon and Kinowelt invested hundreds of millions of dollars in independent production companies like Newmarket and New Line Cinema. The funds sprang up like mushrooms, their trading prices soared, and then in 2001, the Neuer Market melted down, a victim of bankruptcies and insider-trading scandals, and with it went the film production financing funds. The collapse left major studios and large independents looking for new sources of production financing.
And that brings us to this latest film-financing cycle. Between 2004 and 2008, an estimated $15 billion was invested in slates of films. Players like Merrill Lynch, Credit Suisse, Deutsche Bank, Goldman Sachs, Citigroup and JPMorgan all arranged co-financing deals with studios raising money from hedge funds and private equity firms. The players are mostly U.S.-based and mostly on Wall Street. The financial crisis had its effect on this sector, like all others, but after a lull, money is once again flowing back into the film industry.
It should also be mentioned that, through all financing cycles, there’s one group of investors that can always be counted on. These, says the hedge fund manager, are people “using methods of analysis that don’t relate to the statistical success rate of films,” i.e., my daughter is in the film, my son has always wanted to be a film producer, my son wrote the script, my wife wants to be a movie star. Such investors, he says, go into the business for “emotional reasons” and often end up with “an enormous pile of burnt cash.”
Financing Your Film
Producers have a number of ways of financing their films:
First, and most basic, is equity: this is the early-stage financing that turns a script into a film in progress. As with much venture-capital, angel and other seed capital seeking high returns against high risk, most equity investors in the independent environment fail to see returns on their money. On the bright side, most equity investors in the independent environment don’t expect their money back—they’re the ever-dependable investors mentioned above, frequently the family and friends of the filmmaker. When they do see returns, of course, they are sometimes spectacular, as was the case with investors in The Blair Witch Project—made for about $60,000, the film went on to gross $249 million worldwide. But The Blair Witch Projects are the exception, not the rule, says the hedge fund manager, “Most people who invest professionally in film financing don’t do equity investing and even studios have to own a film outright if they’re going to make an equity investment in it.”
Next is senior debt, which accounts for a significant portion of the film’s total financing. Traditional providers of senior debt (banks like JPMorgan Chase) require a security interest in the film and all revenue streams associated with it in priority to equity. So, before a film is completed, a producer might sell the distribution rights (including theatrical, home video/DVD, pay TV, free TV and other rights) for various countries. The producer can then use the value of these contracts as collateral against a production loan from a bank.
Another form of financing, which became an important part of the funding for independent films around 2002, is ‘soft dollars’ or tax credits for shooting your film in a certain state or country. One fund manager recounted his own experience with a tax credit deal for “a fairly mediocre” film (if you haven’t seen it, “you might find a better use for 90 minutes of your time,” he says) in Connecticut.
In that state, a portion of the film’s budget qualifies for a tax credit provided the filmmakers meet certain criteria in terms of filming and spending in the state. The film in question—let’s call it Generic Action—had a budget of about $60 million with a tax-credit qualifying portion of about $20 million. To get the credit, however, the director couldn’t simply promise to spend in the state—he actually had to do it, then claim the credit later.
The director, naturally, thought a better deal might be to swap the right to the tax credit for ready cash he could use to finish the film. To sweeten the deal, he’d offer to sell the credit at a discount (say, $16 million).
For this sort of deal to work, credits must be transferable—no financier will be interested if the rights can’t be assigned directly to him. The Connecticut tax break could only be used by a corporate tax payer with a tax obligation to the state, so a financier purchasing the tax credit needs to use it himself or sell it to a Connecticut corporate taxpayer who can use it. The Pennsylvania tax credit, on the other hand, “is marvelous because it gives you an actual rebate, so when the film is done, you submit the expenditure documentation and they cut a check,” says the hedge fund manager.
Since 2005, according to Business Week, states have granted $3.5 billion in incentives to makers of films, TV shows and commercials, but many of these programs are currently under assault, as states struggle to balance budgets.
Still another component of film financing is print and advertising financing—prints need to be made for theatrical distribution, but the main part of the tab is advertising. The typical P&A budget today, says the hedge fund manager, is equal to the film budget, if not higher. He gives the example, from his own experience, of a $16 million film with a $20 million P&A budget. The financiers offered to provide $8 million senior debt at 20%, which, he says, is a very common interest rate range for P&A financing. “What’s distinct about P&A,” he says, “[is] it has no security. The rights in the film itself are not the security, but it is senior by virtue of the order of payment, which is effectively like being senior secured in that the revenue from the film—after the distributor is paid—pays P&A first. Last in, first out.”
Producers can also earn money from product placement (think ET and Reese’s Pieces, think George Clooney’s character in “Up in the Air” flying American Airlines).
And then, there is slate financing.
Hedging Your Cinematic Bets
Whatever the structure of the film-financing deal, those entering one hope for a Hollywood ending, i.e., the film is a smash hit and everyone involved gets fabulously wealthy.
The odds, however, are stacked pretty steeply against this. A large-scale, independent studio making 12 films a year will probably get “eight losses, two break-evens, one pretty good film and one hit,” says the hedge fund manager. Smaller-scale institutions with the wherewithal to make only four films could find themselves with four losers and end up closing shop.
As a business proposition, it’s better to spread the risk over a larger number of films. That’s an ability the studios have always had—they can release 20 films over a season and, says the hedge fund manager, “are virtually guaranteed, if they did their math and everything else right, to make a profit because they would distribute risk and return expectations in such a way as to have a normal statistical distribution.”
A slate of films, as it’s called, probably won’t bring great wealth but will prevent the investors from losing their shirts, and that’s often the goal in film production financing—not to hit the ball out of the park but “not to lose everything. Because it is one of the most volatile industries that there is.”
Borrowing a page from the studios’ book, hedge funds and other investors entering the film-financing world decided to create their own slates. Slate financing is a “term of art” for a financing arrangement in which an investment group provides capital to a major studio-distributor or its subsidiary. Every deal is different, but in an article on the subject, entertainment lawyer Jeffrey C. Foy says that generally, the investment is in the multi-millions and the studio receives a distribution fee between 10% and 15% and is allowed to recoup its marketing costs before splitting the profits with the slate investment group.
Slate financing funds can offer senior, mezzanine or equity packages, depending on investor risk appetite.
Slate financing agreements put financiers into relationships with major studios and large independents.
Most studios, says the industry insider, have “a real culture of partnership.” They will step in to protect investor money when necessary—and it can be necessary, because the movie-making business is a constant battle between creative and commercial forces. Give money to creative types and they’ll spend it. Not, says the insider, “to put it in their pockets” but to “create something all that much more spectacular.” Sometimes, allowing the creative team to spend millions pays off—James Cameron’s films being a case in point. But more often, it’s money—investor money—down the drain.
These studios, says the insider, are basically looking to share the risk (and, along with it, the higher returns) inherent in filmmaking with hedge funds or private equity firms. In return, the studios get distribution fees, which give them steady returns, which can be shown to analysts who might give the thumbs up to the studio’s stock, pleasing shareholders.
Other studios are more opportunistic about third-party financing, seeing it as a chance to off-load an ugly slate of films. These are the sort of deals that can go south—the final scenes played out by lawyers.
Still other studios are so expert at managing their cash flows that they “play this distribution fee/tax game perfectly well, to where the amount received by the provider of capital is effectively the same as something better than an investment grade bond.”
Who Invests in Film?
Film financing, says the insider, is a complex business that requires “good information, strong experience and a balanced approach that avoids emotion about being in the business.” It is not for the faint of heart. So who is it for?
According to the hedge fund manager, film investors fall into three main categories:
First, there are angel investors—family and friends of the filmmaker who invest for other than strictly financial reasons.
Second there are those who think they can “beat the house.”
“Everyone else has been burned, many people in Hollywood are charlatans, but they think they can beat the house anyway—they’ll pick better films, they’ve met a very trustworthy guy who has a slate of films that can’t lose—and the hallmark of those people is they claim very outsize rates of return.”
The third category of investor is able, by virtue of scale of investment or some other means, to truly diversify across a number of different investment opportunities. This investor looks at films the way others look at real estate—knowing many things could go wrong, but that if he’s truly diversified and invests on a significant scale, and is very diligent, then over a reasonable period of time, he’ll reap a “very handsome return.” Which is basically what the studios do—although even the studios get it wrong.
Another answer to the question, ‘Who invests?’ might be, ‘People who see an opportunity.’ Box office demand is currently strong, but the number of films being made with U.S. distribution is down significantly. To Kevin Frakes, that represents an opportunity.
Frakes founded L.A.-based PalmStar Media Capital in 2010. It has just closed the initial capitalization on its first investment fund, which will invest in production gap financing, P&A financing and equity co-financing.
“We will be in a position to fully finance pictures. We will invest a limited amount of equity in each film, but the focus is debt financing and distribution financing. The movies will be $5 to $25 million and genre fare—horrors, thrillers, action, romantic comedies, in that range.”
Frakes started out on the development side of the business and says his move to “from the sell to the buy side” was prompted by a 2009 wake up call: “In 2009…only about a third of the movies were getting made compared to previous years and our ability to convert projects from development into production was really hurting us, so we decided we really needed to get on the other side of the industry.”
How to Succeed in Film Financing
Frakes clearly believes there’s money to be made in film financing, and the hedge fund manager agrees, but offers three pieces of advice to those considering taking the plunge:
First, you must take the time to truly understand the many elements of film production finance and distribution, in particular, the legal components and how the rights are created, distributed and paid for.
Second, you have to have some kind of connection to the industry at a fairly high level, meaning, you need to have access to trustworthy people and have a good mechanism for filtering out people who are not reliable business partners. That, he says, means using good lawyers and consulting with the people best qualified to analyze your proposed deal. Frakes echoed this, saying he couldn’t imagine having started PalmStar Media Capital without having experience in the film business. That said, he says in starting the company he “took more of a path that a fund or a finance company would take. I hired a CFO, I hired a financial consultant firm—I hired the Salter Group, to come in and consult with us and build our investment model…I can see doing this without my background, but you’d have to invest considerably within the industry to bring in people who really know what they’re doing.”
The third piece of advice to would-be film financiers, says the hedge fund manager, is “remain vigilant.” Hollywood likes to fleece people, he says, but if you follow steps one and two, you are more likely to enter good deals with good people.
For a final word on film financing, FINalternatives decided to follow the hedge fund manager’s advice (and Kevin Frakes’ example) and turn to someone who really knows the business. We asked The Salter Group’s Roy Salter to tell us what he tells those who ask his firm’s advice on investing in film. His response was both discrete and succinct:
“Just don’t be stupid.”