These pages have thoroughly enjoyed being critical of the many dazzled investors who have, in the absence of even the most basic filters, poured hundreds of millions of dollars down the sewer that is motion picture investment banking. The list of swooning and once rich, but now poor, who have been led to slaughter by the studios (typically sharp Going Private readers will immediately recognize an information asymmetry problem when they see it) is amusingly long. One of the primary reasons is the massive preferences and other (to the layman) esoteric financial instrumentation that tended to characterize external motion picture financing deals. As I commented some time ago:
Certainly, funding films must feel a lot like the venture business. Reading the Journal article it becomes clear that all the people in line in front of an equity investor when it comes time to pay out, including exhibitors, the studio distribution fees, payback for production and marketing costs, actors and directors, make up for a pretty large black hole that has to be filled before investors see a dime.
So when a breezy piece in the Los Angeles Times (avoid brainless registration requirement via bugmenot) spins the apologist tainted back-story behind the great fleecing of the star-struck and naive, it is hard to extend the courtesy of a good-faith credibility assumption to the paper. This is particularly so when the piece opens with:
On paper, "Evan Almighty" looked like a sure thing.
Uh huh. To whom?
The spin continues:
Studios were looking to mitigate the financial risks of producing movies. Traditionally, they had relied on bonds and bank loans that produced dependable profit for lenders. But the studios bore all the risks of failure.
When the idea emerged to offer backers a piece of the action, rather than merely fixed interest payments, it looked like a win-win proposition. Although the studios would have to share some of the profit from hit movies, they also would shed some of the risk of losses.
Poor, poor studios.
I am not sure exactly how to characterize the recurrent figure of Ryan Kavanaugh in this drama, because his description varies wildly depending on the source. The spectrum seems to range from "important, innovative genius," to far less charitable versions of "nefarious cad." Tellingly, the Los Angeles times sits on the apologist side of the continuum for the first half of the article, before actually slipping into fact-based discussion. One wonders how many editors touched the piece before it went to press. To wit:
The most prominent intermediary between Hollywood and the hedge funds is Ryan Kavanaugh, a 33-year-old former dot-com deal maker. His West Hollywood investment firm, Relativity Media, put together some of the largest and most publicized financing packages, including the one that backed "Evan Almighty."
Kavanaugh sold hedge fund managers on the idea that investing in a dozen or more films at a time would reduce the risk that a single bomb would sink the portfolio. He also touted a computerized system he said he had developed to distinguish between potential hits and misses.
"He figured out how to create a financing formula that satisfied studios and investors and banks," former Columbia Pictures Chairman Mark Canton, a friend and business associate of Kavanaugh, said in an interview.
The Times then describes the typical structure:
The investors would collect their returns once all the films in a slate had opened and started to generate DVD and television revenue, usually five to seven years after their theatrical openings.
I have, below, corrected this text to remove any sell-side marketing slant:
The investors would collect their returns
once allif the films in a slate had opened and started to generate DVD and television revenue, usually five to seven years after their theatrical openings.
And then, the passage that should have had regular Going Private readers looking with palpable excitement for a proxy to short these instruments and their holders:
At meetings in studio back lots and Wall Street skyscrapers, hedge fund managers heard investment banks and promoters project annual returns of 18% or better. They were so jazzed that they agreed to forgo some of the protections that bank lenders had imposed on film companies, such as limits on marketing budgets. (Emphasis mine).
What absolutely astounds me, but then again, doesn't, is the tenor of "If only we knew" that permeates the remainder of the article.
One of the first movie transactions Kavanaugh helped broker was a $528-million fund called Virtual Studios, through which Stark Investments, the Milwaukee hedge fund, co-financed a slate of films at Warner Bros. beginning in 2005. The second picture in the package, the would-be blockbuster "Poseidon," bombed.
"Poseidon" cost more than $150 million, eating up a sizable portion of the fund's capital. As a result, the other films in the slate would have to do better than originally projected for the package as a whole to generate the desired returns.
Disappointments such as "Poseidon" prompted some slate investors to take a closer look at the structure of the deals. Some concluded that the terms tended to favor the studios at their expense.
I am shocked, shocked to find there there is structural inequity going on here.
The studios, for instance, typically were permitted to recoup their marketing costs up-front. They also collected distribution fees of as much as 15% of revenue before investors started to see any payback. These provisions reduced the incentive for the studios to control their costs.
The studios could also choose which films to put in the slates. They customarily gave the funds their most uncertain projects -- such as costly films lacking overseas appeal -- while keeping the surest blockbusters to themselves.
The slate funds were essentially "risk management vehicles," said entertainment industry analyst Harold L. Vogel of Vogel Capital Management in New York "The studios are pushing the risk to the investors."
The most basic downside analysis should have caused even the most vanilla straight-out-of-b-school analyst to wonder aloud "what is the story with all these preferences?" Stepping back, "the story" here is not just the predatory nature of large and medium scale movie studios (and realizing that this is an apt description does not require much imagination) but the absolute brain-dead investing process employed by the eventual holders of these instruments. You can now pick up many of the interests in these funds for $0.70 on the dollar. That is, if you like paying $0.70 for a quarter.