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."
