Financial News Online adds to today's theme: the venture capital world is awash with hedge fund money. The cumulative collection of today's venture capital and hedge fun capital observations (venture deals, hedge fund capital, inactive and sedentary management and far too much fertilizer) prompts me to hereby coin the term "Vegetable Capital," to refer to this growing trend.
Financial News Online's take? Average deal size is being pressed up along with everything else.
The Wall Street Journal reports (subscription required) on the increasing role of hedge funds in the movie business. It is not immeidately clear if they picked Ryan Kavanaugh, famous primarily for having made a series of missteps in the dot-bomb venture capital business that got him sued more than once, because he is a likely rags-to-riches story, or to gently remind the reader of the meaning of "dumb money." Either way, it makes for outstanding "Vegetable Captial" material here.
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. It must feel quite like being a later stage investor coming in behind a massive wall of pre-existing preferences. (That sounds redundant). The Journal gives "Batman Begins" as an example. $150 million in budgeted costs, $372 million in worldwide ticket sales and Kavanaugh's investment entity, "Legendary Pictures LLC," is still in the red by "several million dollars."
Considering that Legendary put up 50% of the budget for the film (the standing arrangement) and that even if a film has is a pretty big hit in the box office Legendary has to make their money back on notoriously fickle DVD sales, even a slight downturn in the film world could be pretty lethal.
And that's not all. Studios seem to be smart enough to keep the good stuff for themselves, either funding the "sure things," (Harry Potter is the Journal's example) internally, or using debt rather than parsing out equity. This locks in the upside for studios, who don't have to share a percentage of the take on these big franchise hits. Instead they are looking to outside money to fund their riskier capital needs.
Nope, that's not even all. Even McBusiness Week has figured out that the trend today is away from the box office. The industry has been pushing up ticket prices and dumbing down theater size and the experience of going to the cinema for years. Consumers are beginning to grow annoyed. Luckily for us we have Mark Cuban to tell us that the studios should just release for DVD, Video on Demand and theaters on the same day. As if the compression of the "lag time" between theater release and DVD release wasn't already headed that way on its own. Less time to work off those preferences before investors get their take. As a percentage of revenue for a film the box office has gone down to 17.5%. Robust DVD sales might buoy the stakes of the likes of Legendary. We'll see.
So how does Legendary intend to add value and pick winners? Monte Carlo simulations.
Abnormal Returns (yummy!) cites a piece in Paul Kedrosky's Infectious Greed on the growing overhang in venture capital. Part of the issue for both venture and buyouts, I think, is not that there is an overhang, or not just that there is an overhang, but that a huge number of people are in
complete denial that an overhang even exists. As if the runups in prices we are seeing have nothing to do with the cash-up-to-the-eyeballs funds crawling out from under every banker's box.
A reader wrote me the other day to chide me for being "out of touch" with the market on this point. To quote a certain someone, "That's Absurd."
From the Kedrosky piece:
Doug Leone (Sequoia Capital): ...for some reason, there appears to be an insatiable appetite by limited partners to invest in a category (venture capital) that cannot sustain even a fraction of the capital currently within it. It is the craziest thing that LPs are willing to invest so much in a category that has yielded so little and from so few.
E&Y: Why is it crazy that LPs are willing to invest so much in venture capital?
Leone: The returns have been miserable. If you take away a couple of exits, such as Google and MySpace, there haven't been meaningful returns generated. There are [venture] firms that have never generated a positive return or have not even returned capital in 10 years that are raising money successfully. And that surprises the heck out of me. People talk about the top quartile-- its not about the top quartile, it's barely about the top decile, or even a smaller subset than that.
Of course, the problem in the U.S. is more severe than it is elsewhere. I happened to come across some figures from a 2005 PriceWaterhouse/VentureEconomics report on private equity. This little tidbit on all cumulative private equity investment and fund raising 1996 1998-2004 tumbled out:
That's only through 2004. Given the massive fund raisings that have gone on in 2005 and the first quarter of 2006, overhang is beyond unreasonable at this point. Further, I doubt very much that these figures include the multi-strategy hedge funds that are increasingly throwing their hats into the private equity rings.
It is, I feel, a sign of the general myopia on the subject that someone tried to convince me the other day that the fact that hedge funds are doubling the salaries of venture and buyout professionals to jump ship and move over the the dark side is a sure sign of the innate competence of these funds. No, it is not anything like the dot-bomb era. Not at all. (Gee, I wonder if he worked for a hedge fund).
Some time ago I pointed out that the Wall Street Journal had subtle ways of making predictions without smacking readers in the face with their bias. One method, which is sneaky but kind of amusing, is to pick a rather questionable figure as the representative for a questionable trend. The Journal had this particular tactic in full force back in April when they picked (subscription required) former dot-bomber Ryan Kavanaugh as their feature for hedge and "private equity funds" that invest in Hollywood movie productions.
The Journal didn't make too much more than a paragraph of the fact that Hollywood has sucked in "dumb money" from outsiders for decades without even a Christmas card to the dozens of bankrupt shells of investors they left behind. And with respect to Ryan Kavanaugh, they might have done better if they picked Benjamin Waisbren. An astute attorney reader forwarded me an article in the LA Times (who else?) describing the fallout from the Poseidon debacle. Now, maybe it's just me, and maybe it's hindsight but I think Poseidon might have been near the top of my list for bomb predictions had I been paying attention. Says the LA Times:
One person who worked on "Poseidon" is already out of a job. Just days before the film opened Friday with audience surveys showing scant interest, Benjamin Waisbren lost his position running Virtual. Waisbren, who also served as a "Poseidon" executive producer, did not return telephone messages Monday seeking comment. Stark Investments, the primary hedge fund behind Virtual, declined to comment on the film's performance but said Waisbren's leaving had nothing to do with the film.
Under Waisbren, Virtual signed a deal to invest $528 million in six Warners films. Returns so far have been unimpressive. The first co-production, March's "V for Vendetta," collected good reviews and grossed $85.6 million domestically but less than that in overseas theaters. "Vendetta" cost more than $50 million to produce.
As I mentioned back in April, one of the major issues cutting against outside investors is the preference order on these deals. The LA Times doesn't miss a beat here:
In the case of "Poseidon," Warners and Virtual split production and marketing costs. But Warners will recoup prints and advertising costs, collect interest and pocket a distribution fee of 12.5% before it shares any revenue with Virtual, according to people familiar with the deal. The film's gross-profit participants are also paid first.
As a result, Virtual covered about $125 million, or half of the $250 million it should cost to make and market "Poseidon" around the world. At the current rate of ticket sales, Virtual could end up with $75 million or so from "Poseidon" — meaning it could lose more than $50 million on the movie, said two people familiar with the film's finances. A Stark executive disputed that worst-case scenario and also said its Hollywood investments should not be judged on the domestic box office of one movie.
And who comes to the rescue for Dumb and Dumber Money?
The "Poseidon" premiere should not be seen as a referendum on private equity investing, said one prominent person in the field. Ryan Kavanaugh, chief executive of Relativity Media, among the biggest suppliers of private equity film financing, said that "while no one is jumping for joy over the domestic performance of this one film, its future is yet untold as the international markets have yet to open. There are also other ancillary platforms where revenues will be made that will help to define this picture's outcome."
The Wall Street Journal points out (subscription required) that Dan Rather not only is finally cutting his ties to CBS (and complaining about how CBS gave him the finger) but is joining forces with my Vegetable Capital hero Mark Cuban, on Cuban's HDNet cable channel. Because what we really need, aside, of course, from more vapid reporting, is a high definition broadcast of the 74 year old Dan Rather.
Rather indicated that the deal meant CBS was admitting that "...after a protracted struggle, that [CBS] had not lived up to their obligation to allow me to do substantive work there." I guess you have to read "protracted struggle" to mean the entire 44 years of Rather's relationship with CBS.
DealBreaker, first with a John Weisenthal "Opening Bell" spot and then via its indespensible, daily Reader's Digest DealBook feature (thanks to John Carney who also has the good taste to link to me on occasion), that points us via witty link titled "Bono = Corporate Tool" to a DealBook entry, which then channels a David Carr missive that puff-pieces Elevation Partners (a.k.a. Bono's Press Release and Private Equity Playground, LLC) while purporting to cover that firm's acquisition of a minority stake in Forbes Magazine parent Forbes Media. Harder to find a better example for my "Bono" catagory.
Selective reading is required to give you the real story though, which, when seasoned with my gratuitous speculation and a garnish of Hollywood hypocracy, is actually pretty juicy. To wit:
This is the third deal for the fund, after investments in a video gaming partnership and a real estate Web business.
No one in the group has any significant experience in print properties....
Forbes’s competitors have significant corporate backing — Fortune is owned by Time Warner, BusinessWeek by McGraw-Hill, and Condé Nast will soon introduce a magazine to be called Portfolio.
For the last 25 years, Bono has stayed atop a fickle business by embracing the latest technology in order to build global reach, constantly renewing the creative product and engaging in public stewardship along the way, including work on trade issues and global poverty.
(Read: Debt Forgiveness).
Mr. McNamee said the stake in Forbes did not necessarily clash with his politics and his rhetoric, saying, “The way you solve poverty is giving people the tools to overcome it.” Bono could not be reached for comment.
"Bono could not be reached for comment." Bono? Could not be reached for comment? Are you kidding me? Attempting to separate that guy from a microphone is akin to a demonstration of the nuclear residual strong force. One wonders if the honeymoon with private equity is actually over for Bono and, having already extracted value from his brand- as evidenced by the fact that every acquisition Elevation makes, no matter how silly, will result in a shower of "Bono buys Greenland ice cube producer" press releases- the other partners have now taken over the reigns. "Thanks, we'll take it from here. Loved your Chicago show. Call me for squash next week." I just can't see Bo"world economic forum"no voting "yes" in an investment committee meeting on "Project Flat-Tax-Magazine."
...Steve Forbes, whose hobbies run more toward flat-tax advocacy, said that “One” is his favorite U2 song. It begins somewhat portentously with a plaintive pair of questions: “Is it getting better, or do you feel the same? Will it make it easier on you, now you got someone to blame?”
...Mr. McNamee said that Elevation — the word is a U2 song, the name of one of its tours and an equity fund — was Bono’s idea.
Steve Forbes: “This is a natural step for the company with right people. Forbes as always been about entrepreneurial capitalists.”
So remind me why Bono is involved again?
From where I stand
I can see through you
From where youre sitting, pretty one
I know it got to you
I see the stars in your eyes
You want the truth, but you need the lies....
Oh, yeah.
Your author's reaction to the news that Paramount had shown Tom Cruise the door and cited his behavior as the primary reason was probably predictable. The story has driven the Wall Street Journal, among other publications, absolutely mad with print and resulted in any number of articles in other publications. Ironically, Paramount had a reputation for being a difficult place for "top talent" owing to its overly cautious management. The Financial Times was tickled pinkish orange then to relay the news (subscription required) that Brad Gray, who had been hired by Viacom to assist Paramount because of his "...close ties to Hollywood's creative community" (read: actors) did the firing. God damn it Maverick.
A variety of problems plague the industry now. DVD release times have crept, and continue to creep, closer and closer to theater releases. Theater sales, aside from a brief recent blip, have been way down- and why not? Who wants to pay money to be threatened with lawsuits, encouraged, Soviet bloc style, to snitch on your seat mate, and watch 10 minutes of advertisements for coke and cellular service? DVD sales have begun to flag also. DRM technologies, which attempt to solve an unsolvable problem (namely, how you can permit digital data to be played but not recorded) instead impose unreasonable restrictions on customer's use of their own data, not to mention attempt to sell less product for more money, are finally beginning to create serious customer push back (and indeed, outrage). That's not even to mention the ill will the MPAA has been spawning by suing its own customers with a capriciousness that should offend even the most hardened Italian fascists. Of course, the MPAA is just an anachronistic force, desperately trying to hold together a distribution model that is simply outdated and broken.
The signs of strain are beginning to show. Disney has cut workforce. Time Warner has followed suit. Universal has lost its chairman. Cruise is forced to go crawling to the dark side of financing: hedge-funds. Or has he?
Apparently, it is often said that Cruise is one of the most certain "sure things" for large blockbusters (the last 7 films of his each pulled $100 million). Says the Financial Times of his star power at its peak:
Mr Cruise had become one of the industry's best-paid stars, with a so-called "20 and 20" contract that gave him $20m up front for each film and 20 per cent of gross ticket sales.
Paramount's deal with Cruise was more complex than it seemed. Technically, Cruise did not even work for Paramount. Instead, Cruise and his partner, Paula Wagner, own Cruise-Wagner Productions which, in exchange for having their overhead covered (apparently about $5-$8 million per year) and a spot on the Paramount lot, gave Paramount first-bid on their projects. The trade off is that Cruise-Wagner were taking 22% of theater and television revenues and 12% of DVD revenues. This is, according to the Financial Times, unusual in the business, where even the brightest stars get their cut of DVD sales after 80% is already taken off the revenue line. This held until the recent release of Mission Impossible III, whereupon, according to the Financial Times (subscription required):
After the DVD industry began altering Hollywood's profit landscape, and because it was complicated to track all the expenses, Mr Cruise revised the deal with Paramount. His cut of the gross was increased to 30 per cent and, for purposes of calculating his share of the DVDs, he accepted a "royalty" but it was doubled to 40 per cent. So, he would get his whopping 12 per cent of DVD receipts with no expenses deducted by Paramount. From the DVDs alone, Mr Cruise gained more than $30m on Mission: Impossible II. With Mission: Impossible III, Mr Cruise still got his huge percentage of the gross. Both he and Paramount were, however, disappointed with the theatrical gross - $393m (£208m) - even though it has been Paramount's highest grossing film in 2006. Mr Cruise blamed Paramount, whose new regime, headed by Brad Grey, had fired a number of Paramount's top marketing and distribution executives in Europe, and Paramount blamed Mr Cruise's tiffs with the media. The bottom line was that Paramount could not make much of a profit from even a high-grossing film such as Mission: Impossible III. Faced with this disaster, Mr Redstone turned it into a morality play, with himself in the role of Mr Morality. with Mr Cruise getting a 40 per cent royalty of DVD sales. When Mr Cruise refused to reduce his cut, Paramount "played hardball", as an executive put it, and lost the Mission Impossible franchise.
So what's the truth of it? Cruise fired because he is a moron? Paramount using hard-ball tactics to force a better contract? The end of the reign of spoiled star? The decline of "star power" seems in the cards, at least if the New York Times is to be believed (not a sure thing, that call). Says the Times (requires free registration evadeable via bugmenot):
“There is no statistical correlation between stars and success,” said S. Abraham Ravid, a professor of economics and finance at Rutgers University, who, in a 1999 study of almost 200 films released between 1991 and 1993, found that once one considered other factors influencing the success of a film, a star had no impact on its rate of return. Employing a star had virtually no discernible impact on the box office itself. Mr. Cruise would no doubt object to that assertion. And to be fair, there is some theoretical pedigree to the idea that he may be worth every penny. In fact, there is a whole branch of economics that aims to explain how talented people generate so much more money than competitors who are only slightly less good. It’s called “superstar economics.”
Superstar economics, which has been used to explain the astonishing fees of top lawyers and the skyrocketing pay of star chief executives, dates back to the insight in the late 19th century of the British economist Alfred Marshall, who observed that “the relative fall in the incomes to be earned by moderate ability ... is accentuated by the rise in those that are obtained by many men of extraordinary ability.”
The dynamic was explained by a University of Chicago economist, Sherwin Rosen, in a 1981 paper entitled “Superstar Economics.” Mr. Rosen posited that improvements in technology that would make it easier for top performers in a field to serve a larger market would not only increase the revenue generated by stars, but would also reduce the revenue available to everybody else.
Or was it all, as the LA Times speculates, a publicity stunt?
Does it matter? (The street thought so. Viacom shares were up on the news of Cruise's departure). I don't know. But I do enjoy the drama. And, of course, the opportunity to watch a pair of hedge funds take a bath. Enter the Vegetable Capital angle. Quoth the Wall Street Journal (subscription required):
During an internal presentation on film financing last year, Merrill Lynch & Co. executives entertained employees with the famous video of actor Tom Cruise manically bouncing on Oprah Winfrey's couch as he sang the praises of his new girlfriend.
Amid the laughter, recalls someone who was in the room, Michael Blum, Merrill's head of structured finance, asked: "How does one hedge that risk?"
Hedge funds will be the ones to worry about it, according to Wagner. And there are plenty that might line up. Quoth the Journal:
That's a rich vein to tap into: More than $4 billion in new movie financing has poured into Hollywood from hedge funds and other institutions recently. Outside financiers ranging from hedge fund Stark Investments to the private-equity arm of Bank of America Corp. have put large sums of money into movie slates at studios including Time Warner Inc.'s Warner Bros. and News Corp.'s Twentieth Century Fox.
After I thought about it, however, I realized what this move really is. If he gets hedge fund backing, Tom Cruise is doing a management buyout of himself. The key issue with an MBO, is of course, the management. That doesn't bode well for Cruise who, while he might have a stellar track record, is beginning to show more and more symptoms of Howard Hughes syndrome. The absolute worst thing you can have in a MBO is a gifted but eccentric manager. They tend to command deep loyalties and are difficult to remove without creating significant trauma to the organization, even when performance is beyond dismal.
Going Private has noted before that outsiders (and hedge funds in particular) have a particular habit of taking seriously cold baths on Hollywood investments. The combination of preferences to production and studios (or in this case, Cruise) and a lack of expertise in the business tends to spell disaster quickly.
An MBO here with hedge funds at the helm presents some issues. First, the vertical integration of distribution that a deal with a major studio offered Cruise is gone. Those costs will end up passed along at auction now, and the lack of a sure feed into a large studio (Paramount is unlikely to entertain Cruise movies in future) presents additional transaction costs. Further, it is not clear to me that a liquid market for production projects actually exists. There seems to be quite a lot of buyer power in large studios, and one of them has effectively blacklisted Cruise. Any seller power Cruise had is in retrograde now, and I suspect Cruise will find Hollywood studio bosses akin to care bears compared to his new hedge fund masters. In short, I predict disaster.
News on the MBO of Tom Cruise moves fast. I regarded with skepticism the news that hedge funds were lined up to liberate Cruise from the evil and repressive forces of Paramount. ("I am not a destroyer of companies, I am a liberator of them." And speaking of Gekko, maybe we should buyout and breakup Tom Cruise. Somewhere, right now, someone is desperately waiting in an ICU for Tom Cruise's kidney). So imagine my non-surprise to learn from DealBook that Tom Cruise has taken a 70% salary cut and now works for Mark Cuban.
By "Mark Cuban" I mean someone who managed to dump a mostly valueless business at the hight of the dot-bomb boom and used the proceeds to buy a sports team. The only difference is this time "Mark Cuban"'s name is actually "Daniel Snyder" and he also owns a big hunk of the flagging Six Flags, Inc. (because you know what Six Flags, Inc. really needs to turn itself around is an investment in a manic Scientologist movie star). Not exactly the $100 million deal from well-funded hedge funds we were promised. I'm disappointed. Says DealBook:
While Ms. Wagner said they were eager to work with entrepreneurs, Mr. Cruise and his representatives have actually been shopping for another home in Hollywood all summer without success, talent agents and movie executives told The L.A. Times. At least three studios had rejected Mr. Cruise’s terms, they said.
Says the Wall Street Journal (subscription required), cited by DealBook:
First and Goal LLC, whose backers include Six Flags Inc. Chairman Daniel Snyder, who owns the Redskins, and Six Flags CEO Mark Shapiro, will put up cash each year for offices, staff and costs associated with developing movies at Mr. Cruise's Cruise/Wagner Productions. Their investment, which sources familiar with the deal said was about $3 million a year, doesn't include movie-production financing, which the production company will have to come up with separately.
So, let's review. The smartest money in the business tells Cruise to pound salt, and people with no background whatsoever in the business (except that they have seen some Cruise films, oh, and they stayed at Holiday Inn Express) pick up his deal at 30% of the overhead, provide exactly zero of the production costs, and end up with some undisclosed terms on his cut of revenues.
Another thing to note. Cruise isn't exactly poor. Why isn't he putting together his own studio? Investing $3 million a year in himself for a larger cut of the revenues? Always beware MBOs where management won't put skin in the game.
If Cruise was going to take a bath like this anyhow, you wonder why he didn't stick with the studios. Or perhaps they simply wouldn't have him except at a much larger discount rate for his risk than the Vegetable Capital entrants who have now funded him. When even the hedge funds (and let us not forget that they funded Poseidon) won't touch you... well, I leave the rest as an exercise for the Going Private reader.
One thing occurs to me. Maybe Vegetable Capital is what Cruise was looking for. An absentee manager with no experience in the business who can be led around eagerly for the chance to hob-nob with the stars and when asked about the supervision of Cruise issue vague platitudes like: "We have our day jobs to do."
Nah, I think Cruise has just outlived his usefulness, botched his own valuation, and was played like a cello by the world heavyweight champions of the business.
Someone needs to give Nicole Kidman a job at a hedge fund with an event driven strategy. She shorted Cruise and, though her positions haven't been disclosed, seemingly went long on Jude Law, with admirable timing.
With signs that all is right with the world once again, specifically, the return of the always yummy Abnormal Returns, it seems safe to emerge from the quiet period I have enjoyed the last many weeks. Much has passed since I hosted your interest, dear reader, but it took Tom Cruise to finally rouse me from my literary slumber.
Abnormal Returns points us to a DealBook piece on Cruise, a piece that contains all the needed offense elements for an offensive vegetable capital offense. To wit:
Hollywood
Hedge Funds
Massive Preferences for "Certain Investors"
Vanity Premiums
Tom Cruise, and, of course,
Dr. Mark Klein
Sayeth the New York Times (circumvent tedious registration with the always useful bugmenot) via the DealBook entry:
For MGM, which is owned by private equity firms in partnership with the Comcast Corporation, and the Sony Corporation, the deal offers an alliance with a major star on terms more manageable than the huge fees he commanded from Viacom’s Paramount Pictures for expensive films like last May’s “Mission: Impossible III.” It also offers a way to unlock the value of the United Artists name, which carries enormous cachet, but has been attached to only a few films lately.
The deal also offers a fresh twist on recent trends that have seen investors become directly involved with film producers, even as stars seek more creative and financial control over their careers. Established producers like Joel Silver and Ivan Reitman are among those who have made partnerships with outside investors, allowing them to finance films intended for distribution by studios.
Initially, Mr. Cruise and Ms. Wagner will have authority to produce about four movies a year, for distribution by MGM. Neither Mr. Cruise nor Ms. Wagner put up any capital, Ms. Wagner said. Mr. Cruise may or may not star in the pictures, and will remain free to work as an actor for other studios.
Mr. Sloan and his team have been working to revive MGM as a full-blown movie and television distribution company. Last year, several producers in Hollywood had sought to buy United Artists but were unsuccessful. So far MGM’s recent track record as a distributor of other producers’ movies is unimpressive.
Both the DealBook piece and the New York Times suggest this is a new and revolutionary form of financing for film production. In fact, it is not anything like new and revolutionary finance. What is new and revolutionary is the wonderfully refreshing spanking delivered to spoiled stars like Cruise, and a formalized setup to drag Vegetable Capital into Hollywood.
We've gone over this topic, that is the exploitative nature of Hollywood finance with respect to outsiders, more than once here at Going Private. We've also touched on the somewhat silly, former state of affairs for "the talent" (to clarify, that means Tom Cruise in this context).
This recent news is sort of amusing, because back in August the Wall Street Journal was quipping:
First and Goal LLC, whose backers include Six Flags Inc. Chairman Daniel Snyder, who owns the Redskins, and Six Flags CEO Mark Shapiro, will put up cash each year for offices, staff and costs associated with developing movies at Mr. Cruise's Cruise/Wagner Productions. Their investment, which sources familiar with the deal said was about $3 million a year, doesn't include movie-production financing, which the production company will have to come up with separately.
Sounds like that deal fell through, quietly. Interesting, however, that now Cruise's deal is thinner still. That is, his return is burdened by investor preferences senior to his cut. Cruise is suddenly in a similar situation that outsiders looking to absorb some of the warm glow of Hollywood stardom by investing in a film or two used to find themselves in. I outlined this setup with the help of the Journal and the New York Times back in April thusly:
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. It must feel quite like being a later stage investor coming in behind a massive wall of pre-existing preferences. (That sounds redundant). The Journal gives "Batman Begins" as an example. $150 million in budgeted costs, $372 million in worldwide ticket sales and Kavanaugh's investment entity, "Legendary Pictures LLC," is still in the red by "several million dollars."
The balance of power has shifted significantly against stars. Part of that might be explained in this DealBook quote here: "Neither Mr. Cruise nor Ms. Wagner put up any capital, Ms. Wagner said." The rest might best be understood by reading between the lines here: "If investors are not interested in financing the films, MGM said it would pay for them all."
What we have here is a Vegetable Capital fishing expedition. MGM wants to pull in outsider money into the coffers so it can direct its attention to sure things. Meanwhile, as to the the riskier projects, those that aren't part of an existing franchise, well that's where the Vegetable Capital comes in. What's interesting is that, while this had become the norm, the only way the deal would fly this time was to throw Cruise and Wagner on the other side of the preferences. Apparently this segment of Vegetable Capital is getting a bit smarter, even if it is still part of the Platyhelminthes phylum. Even Cruise won't invest in his own films. What does that tell you?
Well, MGM's Chairman, Harry E. Sloan has it all figured out. How do you avoid scaring off investors with a film flop or two? "We’ll take the model out to investors before the first picture opens." Still, don't worry, Dr. Mark Klein won't be investing. According to him:
Besides terrible scripts and relentless anti-male propaganda, contemporary movie soundtracks are very distracting and much too loud. Don’t need much of a sound track with a really good story played by properly directed strong actors. Almost no music in “On the Beach”, “Paths of Glory” and the “Best Years of Our Lives”.
That also goes for store music. One reason I shop mostly online is I hate being bombarded by love songs. For most men nowadays reminders of romantic love doesn’t bring up pleasant memories!
Definitely sounds like projection to me.
It is hard to think I didn't personally open the floodgates when, just after I hissed my latest piece on Tom Cruise through clenched teeth, I find this piece on Hollywood financing by young inexperienced upstarts in the New York Observer via a DealBook entry. The old guard is suitably annoyed and skeptical:
Old-timers are apparently not thrilled with Hollywood’s new money guys. “It used to be,” the aforementioned disgruntled agent said, “that wannabe producers would start off as assistants and then become C.E.’s (creative executives), and read and read and read, and start sitting in development meetings, seeing how movies are put together, how notes are given to writers—learning the tools of the industry.” Now, it’s “all about the formula, the numbers. It’s the conglomeratization of the business, and it’s why movies are getting worse.”
Vanity Premiums (those extra lifts in the price of an asset beyond fair intrinsic value that is related entirely to the ego boost it will give the new owner. See e.g., Mark Cuban, most professional sports teams, newspapers, purveyors of luxury goods, etc. etc.) being what they are, we should expect to see more of these. After all, who could resist funding a film when Russell Crowe is slated to play you?
But that's not the real horror-show. The real horror-show is what too much surplus cash is putting in the drivers seat in Hollywood. To wit:
Suddenly, Mr. Rizzotti burst through the door, a can of sugar-free Red Bull in one hand. (Normally he downs four to five cans a day; lately he’s been on a “Red Bull diet,” limiting himself to two.)
“Dude, I was just on a fucking amazing conference call!”
The Financial Times yesterday reports that Borat's runaway success has opened the door for more investment by hedge funds into Hollywood, a theme that has caused rolling eyes here at Going Private just as long as it has been a flash in the pan.
Sayth the FT:
20th Century Fox is set to announce a hedge fund-backed film financing deal worth more than $520m thanks to the box office success of Borat and The Devil Wears Prada.
The agreement, which comes amid increasing hedge fund and private-equity interest in Hollywood, will see Dune Capital Management refinance a slate deal – or agreement to produce several films – it struck with Fox at the end of 2005. An announcement on the new slate could come in the next few days, according to a person familiar with the situation.
I predict disaster.
After reading the FT I found that the "Film Funding Blog" thinks I'm being hard on Cruise and seems to think this financing structure is all old-hat. But, then again, they don't seem to know the difference between revenue and net income (in my not entirely limited experience a very common problem in Hollywood). I'm not sure they understand the structure of film production financing, or the nature and purpose of the many preferences that plague such financings. Clearly, the ramifications of changes in these structures in the Cruise case and way they give Cruise a major pay and status cut are lost on the authors. This is a pity, since they purport to be experts on the subject.
Suddenly apologist for MI3, the Film Funding Blog quips:
MI3 is widely considered to be a flop, but that seems to be more the characterization of some bitter Hollywood types. MI3 has a worldwide box office gross nearing $400M. While more of these revenues were generated outside of the U.S., that is less a commentary on the film and more a statement of the importance of international distribution.
Budget estimates on the film vary, but range between $150 - $220 million in production, marketing and development costs. Just to keep things in perspective, The first Mission: Impossible grossed $181M in 1996, ten years ago, to MI3's 133.5 million domestic gross now that it's run is basically over. Note that the MI3 figures are not adjusted for the 10 years of inflation since the first installment of the franchise. Note also that MI2 took in $215.4M in 2000. Any way you cut it, MI3 was a domestic bomb. The domestic box office didn't even break the movie even, and the studio's cut is subject to other preferences before they see a dime.
As for the international box office, which our favorite film financing blog claims is the gem in the rough for MI3, MI2 has pulled in $330 million to date. MI3 is stuck at $262 in foreign sales and, again, that's without an inflation adjustment for the 6 years between the two films. This leaves MI3 82nd on the list of worldwide box office receipts and 187th for the domestic box office. Not all that stunning.
Once you understand the dynamics of Hollywood finance, specifically the comprehensive and willful blindness to real results and their concentration on obscure revenue numbers without the most basic profit analysis, it is easy to see why those without basic finance skills, or the inability to shade their eyes from the glow of star power, are drawn to invest in the industry. $400 million in revenue! Wow! Who do I make the check out to?
It is also pretty easy to see why Cruise was sent packing, and, reading the apologists, why Hollywood film financing is among the least financially competent fields around.
But the real hint on what's going on here with the new hedge fund money lies in the middle of the FT article. Right about here (emphasis mine):
Under the refinancing, Dune, formerly controlled by George Soros, the billionaire financier, will invest in at least 15 new films. These will include the fourth installment in the Bruce Willis Die Hard franchise and Fantastic Four: Rise of the Silver Surfer.
Hah! Suckers.
"Flyboys" Production Budget: $60,000,000
Larry Ellison's investment in "Flyboys": $30,000,000
"Flyboys" reported worldwide revenue: $14,812,244
Satisfaction of knowing 'ole Larry is a moron: Priceless
An editor at a large publishing house whose name you would certainly recognize forwarded me a quick link to a New York Times article on the rise and fall (but mostly the fall) of Henry Winterstern. Winterstern follows a long line of outsiders with big Hollywood dreams. The sidewalks of Hollywood are littered with the impressions of their broken bodies left in concrete sidewalks, remnants of the high-energy impact created by their massive falls from grace. Says the Times in what should have been the article's opening sentences (subscription required unless you use bugmenot):
The 49-year-old Mr. Winterstern, who has the craggy looks and hunched-over affect of a street fighter, never claimed to have much movie experience. But convinced that distribution was the place to make money, he planned to build a studio using his talents at raising money and strategic thinking that were successful in his turnaround of the Wet Seal, a maker of clothing for teenagers, in collaboration with Prentice Capital earlier this decade.
You have to love an article that manages to work the phrase "earlier this decade" into the mix. And, of course, the first person I would search for to lead such a project would be the former manager of "Wet Seal," fine purveyor of slutty apparel for tweenagers of all ages, the mothers of said tweenagers seeking to re-live the golden years of promiscuity and home of the "Shark Bite Halter Dress" (pictured right) priced at an ultra-reasonable 7.588 Toyota Prius miles. (I think I will check out their Hello Kitty intimates collection when I'm done with this post).
The studio he endeavored to rebuild was First Look Pictures. Of course, this wouldn't be a true Veritable Capital story without the dumb money. In this case it came in the form of the hedge fund Prentice Capital that put $70 million into the project and Merrill Lynch, which issued a tasty line of credit for another $80 million.
Winterstern dove right in to the cashbusiness. There were warning signs right away. Like the firm's mission statement: "First Look is a maverick. We are primarily accountable to ourselves...." Not enough warning? Let's hire 140 people and put $4 million into the Century City headquarters offices. That will impress our visitors. Yep. It did. Said one:
[The headquarters are] excellent, really fantastic, but you kind of go, ‘Wait, this isn’t Paramount, where you’re expecting to do a $70 million movie...'
They’re an independent, and they’ll come back and say, ‘Make it for less.’ And we’ll say, ‘The amount less you want us to spend to make the movie is what you spent on the receptionist station."
$50 million in losses (that's the rumor anyhow) didn't impress, apparently, and our hero is politely invited to leave after he argues for more acquisitions. Now what will he do?
Asked about a rumor that he might attempt to reacquire the studio, the deposed mogul laughed and said, “Absolutely not.” Then he called back to say, “It’s possible.”
Yet another socially responsible fund (in the form of a fund of funds) hits the market, giving investors yet another way to pour money down the drain while feeling (nonsensically) good about themselves (albeit without the formal tax deduction). According to HedgeWorld (subscription required), Kenmar Global Eco Fund SPC Ltd was introduced this week. Why? Far be it from me to editorialize. Let's just get it from the horse's mouth (i.e. from Ken Shewer, co-chief executive and co-chief investment officer- thank the maker they have two) shall we?
"An Inconvenient Truth" helped inspire the idea for the fund, as the film "has done quite a bit to bring environmental issues to the fore...."
No, seriously.
The fund, set to launch July 1, primarily will invest with asset management companies whose underlying investments are considered economically sustainable as well as eco-friendly. "Our goal is—with the merger of Wall Street and environmental concerns—to have a fund that is environmentally friendly but also profitable...."
Accordingly, Going Private would like to announce the introduction of the "Spider Global Technology Fund SPC Ltd." Says Co-Multi-Founder and Co-Joint-Secondary Portfolio Manager Equity Private:
"The success of the Spider Man franchise helped inspire the idea for the fund as the film has done quite a bit to bring 'Spidey Sense' and Spidey Technology issues to the fore.... Our goal is- with the merger of Wall Street and Spider concerns- to have a fund that utilizes Spidey Technology but also be profitable."
"The fund, set to launch July 1, primarily will invest with asset management companies whose underlying investments are focused on new technologies related to Spidey Technology, webs, advanced adhesives, superhero law enforcement and security, gymnastics and silk twine technology."
The Spider fund will, reportedly, issue statements on April 10th of every year so that the most exact loss figures will be available to investors for Tax Day.
Faithful Going Private reader, the "Inscrutable Chicken" reports that Elevation Partners just changed their website such that it now includes "consumer related businesses" in its investment criteria description. (Perhaps the Elevation "investment team" reads Going Private?) Of course, they seem to have done a rush job on the change as the supporting pages still don't contain any reference to "consumer related businesses." (Oops).
If I were a limited partner I might be a little ticked off at the wide divergence from their original investment model. Making PIPEs in PDA manufacturers seems a bit wide of their original mark, but then, I don't have their PPM so I have no idea what their original mark was (aside, of course, from "Hey, Bono, wanna be in our private equity firm?")
Don't change your brand Gimme what you got
Don't listen to the band
Don't gape Gimme what I don't get
Don't ape
Don't change your shape Gimme some more
Have another grape
Too much is not enough
I feel numb
I feel numb
Reader mail has been on fire today. Perhaps it is a consequence of the new draconian white list policy I was forced to institute. Perhaps not. Whatever the cause, I am basking in reader mail goodness. Most recently, loyal reader "JN" points me to the blog of an alleged associate at Elevation Partners. (One more example in the rather full quiver of reasons I post anonymously). The peek into his world is a fascinating tour of rudderless and inept piloting through the narrow straits of the pacific ocean with all the pointless intoxication you'd expect from a sailor. But then, what did we expect from a blog named in part for a popular, foreign vodka? This, I suspect:
"Myspace's best use has got to be for checking how drunk you were the night before."
Or perhaps, this:
Tales of Fattiness
This weekend was a complete disaster. Friday night I was partying with some friends at Vessel and we ended up getting bottle service, which is never a good idea for me. I remember eating at Yuet Lee afterwards but not much else beyond that point. The next day when I was hanging out with some of the same people, one of them mentioned how a friend might have left their camera at the pho place.
As if your taste buds had not already been literally burned off, in between the descriptions of the guilty pleasures of business class travel- awkwardly made "California Appropriate"(tm) via the addition of class warfare themes in which the airlines are segregating villains- and puzzling over the meaning of happiness (related to gambling in Vegas it seems) any number of topics are obliquely addressed with strangely intoxicating misdirection. The gems of wisdom that can be harvested therefrom include:
The author on the dangerous nature of expectations:
When you come to expect things, it becomes more difficult to exceed those expectations and create happiness.
The author on the relationship between financial model size and social skills:
Size of excel model says nothing about technical competence of employee...it's really about how you use the model. If anything, there is a positive correlation between model size and creator's lack of social life.
Of course, I violently disagree. Large unwieldy models are almost universally produced by financial "professionals" who have no clue whatsoever about their predictive value (hint: it is vanishingly small) and therefore the size of the model is, in my view, inversely proportional to the technical competence of the employee. And what does this say about the author? Let's see:
Usually I work with models that have file sizes around 1-2 mb. Well this one particular deal I am working on requires an unusually large model. Each version I save is a little larger and I'm up to about 250 mb. To give you an idea, I've saved 52 versions which implies total hard drive space of 13 gigs (not completely accurate since previous versions smaller). I'm sure the company keeps multiple instances on various days, which means this could easily require over 100 gigs of storage.
More on the danger of expectations and the purposeless of hope:
Hope leads to high expectations, which thus far seems to be a non-constructive emotion. I've mentioned how it slows down the healing process and can create dispair [sic] if the expectations are not met. This is what I have thought for quite some time now.
On the genius that is his fund (Elevation Partners?):
I was sitting there the other day thinking...I work at a media fund. I see the future. The future is online. Every part of my life is moving online. So why don't we ever hear about online dating?
Before long you'll be able to consummate the relationship without leaving home or missing a WoW session.
Who hires these people? Who invests in these funds? Oh, yeah wait....
If I just got a job, learned to be a street sweeper
I dance to the beat, shuffle my feet
Wear a shirt and tie and run with the creeps
Cause it’s all about money, ain’t a damn thing
Funny
You got to have a con in this land of milk and
Honey
There are certain moments when a good antiperspirant is simply critical. Perhaps your husband comes home early. Maybe Third Point acquires 8.5% of your common stock while you are on vacation in the South of France. Mike Wallace makes an unannounced visit to your corporate headquarters with a camera crew in tow. Then again, maybe it's that Vipal Monga and company highlight your losing (or soon to be losing) investments. Given the sting of these sorts of moments, I'm long Southern California distributors of Right Guard after seeing the Richard Morgan and Vipal Monga piece on the new face of film finance, which just happens, aside from exposing the folly that is outside investing in Hollywood, to include a little dig at an old Going Private favorite, Ryan Kavanaugh.
These pages have often cast a dark eye on the "new money" in motion picture finance, often times to the loud protests of industry apologists who, tellingly, don't seem to know the difference between revenue and profits and instead crow- shades of the many "new metrics" popularized by the dark era of dot-com finance- about "domestic release ratio" or "first weekend box percentage."
Where as once, dreamy millionaires would happily pour large portions of their capital into film production just for a chance to hob-nob with the stars, to read the modern private placement memorandums pressed by the likes of "Gun Hill Road I" and "Legendary Pictures," you would think there is finally some adult supervision behind these ventures. Unfortunately, it seems that Vanity Premiums, star allure and Vegetable Capital are all still very much alive in the world of film financing. Monga and Morgan pull back the curtain on this twisted finance mess for us via the latest piece in The Deal:
The $600 million fund, named Gun Hill Road LLC, entrusts Universal with $200 million to co-finance seven films and Sony Pictures Entertainment Inc. with $400 million to co-finance 11. It was put together in January 2006 by Relativity Media LLC, a Beverly Hills, Calif., operation that in a few short years has made itself synonymous with movie-slate financing. Gun Hill Road I, as the fund is now called, marks the first time two studios received third-party financing from the same source. Relativity essentially replicated the deal five months later by assembling a $700 million package for the same two studios. This second fund, Gun Hill Road II, is co-financing nine films from Universal and 11 from Sony.
Aspects of Gun Hill I and II are similar to the two dozen co-financing deals in place at every major Hollywood studio and many self-styled "indies." Taken together, they represent a capital infusion of more than $10 billion and, for the six major studios, an estimated 30% of their respective slates' negative costs (all film expenses, including financing costs, bond fees and contingency reserves, necessary to create a filmed product). But the one element these co-financing deals share most — with Dune Entertainment LLC's $725 million funding of Fox Filmed Entertainment serving as the exception that proves the rule — is they'll wind up bad investments.
The open, dirty secret in these arrangements is that the riskiest money is typically supplied by outside investors, formerly the star dazzled captains of other industries, eager to touch a bit of grace and not particular about their returns as a consequence. Today that takes the form of massive preferences for everyone from actors, to studios to inside investors.
...the reality is that Hollywood's structured financings may be the worst way ever to invest in the film industry. This is especially true for equity investors, located at the bottom of a movie slate's so-called waterfall. Mezzanine-debt holders, who often expect a double-digit return, are immediately above equity investors, and senior-debt holders, who usually secure a LIBOR-plus rate, are higher yet. Revenue from movies in a slate, after expenses and distribution fees are deducted, repay debt first, starting with the senior-most piece and moving down through the mezzanine. Whatever's left then falls to the fund's equity investors.
Fortunately, there are still some brains in the business. These sort of arrangements seem to turn off some of the smarter money. "The trouble with investing in Hollywood is that your money goes to paying for the champagne on the G4 that's flying the movie stars to Cannes," according to one hedge fund manager Monga quotes. But even before that, studios take their "sure things" off the investing table, preferring to protect the more certain cash flows for themselves and let the outsiders take fliers at wild pitches. Say M&M:
The separation of investors from their investments is a hallowed Hollywood tradition. Early on, with uneven results, the siren call of films plus femmes drew William Randolph Hearst from newspapering, Howard Hughes from oil drilling and Joseph P. Kennedy Sr. from bootlegging. The parade continued, though with less august glamour seekers, in the persona of industrialists, financiers and the proverbial dentist from Dubuque. Hollywood has attracted a stream of foreign capital as well, its klieg lights intermittently cast on Dutch, English, French, Israeli, Italian and Japanese wannabes.
So it went until the late 1990s — two decades after domestic film-financing incentives were written out of the U.S. tax code — when studios found themselves awash in billions from Germany. For good reason, considering that regardless of where a film was shot, German tax law permitted the immediate deduction of its entire negative cost. "With [German] tax rates in excess of 50%, the up-front deduction is a substantial benefit, which is magnified if the investment is leveraged with debt," Schuyler Moore, a partner in the corporate entertainment department at Stroock & Stroock & Lavan LLP, writes in his film industry text, "The Biz." As for Germany's location loophole, since tightened, the attorney remembers it as "an unintentional subsidy for worldwide production."
What is amazing is the speed and efficiency with which studios have found new, willing and careless investors to diversify away studio risk in "iffy" projects.
The story of how the film industry is about to leave more investors than ever holding the bag has a cast of hundreds. Much of this cast is new — by definition, given "The Biz" author Moore's depiction of Hollywood as "a roving predator ever searching for the next victim to suck dry of cash." And much of the story stems from the rise of hedge funds and private equity just when Hollywood's German investors began their retreat.
And how have these ventures fared now that it looks as if this next cycle is about to close?
Ultimates for "The Kingdom" will complete the Gun Hill I slate, leaving investors with a collection of projections that, in turn, provides a reliable measure of the fund's overall performance. What's being whispered in Hollywood corridors today will then resonate all the way to Wall Street. "My understanding from people who invested in the equity is that they are totally wiped out," says the expert on studio economics. "When this first deal formally implodes, much will be written and lawsuits may start. I think you're going to see these deals dry up completely."
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.
Not all that long ago, Armin said something that frightened me. We were traveling between one meeting or another and, in the midst of waxing poetic on operational improvements, a topic on which he had much to say and for which I had an endless appetite, he announced, "...but you will eventually outgrow Sub Rosa." He must have seen the sudden protests I was already composing in my head coming a mile away, for I didn't get the chance to verbalize them.
"No, no, you will. You have already matured as an investor to the point where private equity will bore you, if it does not already. As you have no doubt already discovered, few deals are about the kind of smart investing you seem to crave. Yes, Sub Rosa can and does realize gains through operational improvements, but consider why that is so. Usually, we find targets where the owner-operator simply did not have the will to execute on difficult decisions because of the attachment to the company." It struck me that he said "owner-operator," as if the sellers we had courted all this time were long-haul truck drivers. "Often, I suspect, a sharp management consultant would have done just as much good and cost the owners far less in opportunity costs. In reality, most of the transactions we have managed to complete are about our access to capital and the luck of opportunity." It is pretty hard to argue with that kind of self-reflection in a senior partner.
This is the kind of conversation with Armin that, as is often the case, caused me to slip into a deep meditative state, thinking about the economic lenses through which I view the world.
I can probably best describe my thinking, to the extent regular readers of Going Private haven't already gotten a strong dose, by example. That is, in the form of the kinds of ideas and concepts that interest me and prompt further thought (or in some cases, even sleepless nights).
Bubbles, and the dangers of investing into them and out of them- as well as the dangers of betting against them, have occupied a good part of my investment brain of late. No surprise then that the yummy likes of Abnormal Returns picks a Sunday (damn you and your Sunday links, Abnormal Returns!) to drag to the surface old concepts from the deeper reaches of my economics education. This Sunday? Information Cascades. Therein we are pointed to real estate bubble reflective articles in the New York "Were all these people stupid? It can’t be." Times and the always interesting Calculated "inaction of policy makers" Risk.
The take-away from the Maxwell Smarts at the New York Times, or in this case Professor Robert J. Shiller "professor of economics and finance at Yale (draw your own conclusions here) and co-founder and chief economist of MacroMarkets LLC", is that certain hardwiring in the brain causes questionable decision making. This, it seems, contributed in large measure to the housing bubble.
A long line of study in this area has resulted in a deeper understanding of a number of cognitive phenomena including the likes of bounded rationality, confirmation bias, endowment effect, hyperbolic discounting, irrational escalation, mere exposure effect, pseudocertainty effect, zero-risk bias, loss aversion, base rate fallacy, and so forth, which may tend to color otherwise rational decision making.
Categories of these phenomena and their study, like Heuristics, Framing and Anomalies, make up the larger schema of "behavioral economics," which, removed from the obfuscating umbra of academia, is probably more commonly understood as "ways market actors can be irrecoverably stupid."
One of the problems I see with behavioral economics is that the tendency is to diminish the perceived agency of market actors in the investing process. One or another cognitive feature easily becomes reason to throw up collective hands and attempt to redesign (or unwind) markets or market actions to compensate for flawed thinking. Let us, dear reader, focus for a minute on the most ready example, information cascades.
The term stems from an article, A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades, written in 1992 by Sushil Bikhchandani, David Hirshleifer and Ivo Welch. From the abstract:
An informational cascade occurs when it is optimal for an individual, having observed the actions of those ahead of him, to follow the behavior of the preceding individual without regard to his own information. We argue that localized conformity of behavior and the fragility of mass behaviors can be explained by information cascades.
And from Professor Shiller?
As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.
Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.
Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.
And here is the part that disturbs me. It is subtle, because it is so tempting to be lulled into the thinking that enables it. Take another look:
Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.
Optimal behavior is defined relatively, but, more over, cognitive flaws are now apparently part of "absolutely rational and calculating." There is a careful nuance added to the information cascade definition that permits this interpretation, but it strains the bounds of credibility in my view. More on this later.
And less we conclude this was a momentary slip, the Professor concludes:
It is clear that just such an information cascade helped to create the housing bubble. And it is now possible that a downward cascade will develop- in which rational individuals become excessively pessimistic as they see others bidding down home prices to abnormally low levels.
Excessively pessimistic rational individuals. Yep.
In any other context this sort of rationalizing of rationality would sound fantastically naive. How well could any of us be expected to respond to "Well, Cindy and Bob were buying a house, so I thought I should do the same"? If your mother were present to hear this pale excuse, surely she would quickly intone "So if Cindy and Bob jumped off a building, would you do it to?" Granted, I don't know your mother. Perhaps she has a Ph.D. in behavioral economics, but I suspect an easier explanation: she simply isn't stupid.
As an excuse put plainly, it is merely sad. As a cognitive flaw, however, it quickly becomes a reason for bailouts, and curbs on those of us uncaring and cold enough to resist the herd mentality, and who may have taken some sheep to the cleaners in the process.
Still, informational cascades have some other features which make them less than compelling excuses for investment missteps.
In our model, individuals rapidly converge on one action on the basis of some but very little information. If even a little new information arrives, suggesting that a different course of action is optimal, or if people even suspect that underlying circumstances have changed (whether or not they really have), the social equilibrium may radically shift. Our model, which is based on what we call "informational cascades," explains not only conformity but also rapid and short-lived fluctuations such as fads, fashions, booms and crashes. In theories of conformity discussed earlier, small shocks lead to big shifts in mass behavior only if people happen to be very close to the borderline between alternatives. Information cascades explain why society, on the basis of little information, will systematically tend to land close to the borderline, causing fragility.
As you might expect from this passage, cascades exist where decisions are borderline. This is, in fact, the nuance I referred to above that allows all actors to be individually "rational" in making the correct selection where the aggregate of the information available to them would clearly point to the opposite "correct" decision. This implies either that little information to make a decision exists, or that it exists but that little has actually been collected. This, at least in my mind, begs the question, why are such information light dilemmas resulting in major investment decisions?
As I pointed out in an earlier post:
Debt can either magnify returns generated by true alpha, or disguise (that is increase information asymmetry in) returns that may or may not have anything to do with alpha. The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand[ing] is not to invest.
It strikes me as quite tortured to label a market actor who possesses so little actual information about the contemplated transaction that he or she might be caught up in a cascade as "rational." Particularly where, as here, the costs of an erroneous decision are extremely high and the decision is not forced.
