In Focus - Slate financing - Storm Warning

By its nature, the film industry is predacious, but irresistible to investors. From its earliest days, the film industry has relied successfully on outsiders to spread its capital and mitigate the high risk of producing and distributing movies.

Despite all the risks, and well-known stories of investor losses in the past, some $12bn in equity and debt has been committed to the film sector since 2004 - not a particularly large number in the overall capital markets, but a substantial increase for the studios from historical levels.

The recent, well-publicised and promoted wave of Hollywood slate financing deals has occurred even though film, as an investment class, is non-transparent, illiquid and unpredictable. But to call film a "subprime" asset class, as some have, is an overstatement because film, as an asset class, is not large enough to take down a bank. But it sure would if it could.

The reasons for the recent flow of institutional capital to Hollywood are well documented. Until the recent credit crisis, the capital markets were awash with liquidity. Seeking alternatives to traditional, liquid investment classes, hedge funds and investment banks saw film as an inefficient asset class that offered predictable yields as both a fixed income (meaning debt) and equity investment strategy.

As of early 2005, cash-on-cash returns from film production and distribution were reportedly on the increase due to growth in DVD revenues. The shortening of exhibition windows created higher velocity for investment capital, meaning the life of the investment was shortening, thereby increasing internal rates of return (IRRs).

Film assets held the promise of further upside because of new exhibition technologies via the internet. Also, international markets were showing impressive growth. In short, there were all the makings of an investment bubble.

Drawing on historical box-office figures, brokers and underwriters relied on "Monte Carlo" simulations (a computer model for analysing risk) to determine and promote a proposed film slate's expected returns. The notion was that, rather than qualitative analysis, Monte Carlos could objectively predict downside risk, as well as the upside of a given slate of 18 pictures or more over the life of the investment.

For investors (read hedge funds) accustomed to quantitative, as opposed to qualitative or creative analyses, this decision-making tool had great appeal. But such algorithmic computations are only as good as their underlying data, and with the advantage of hindsight, investors can now question the efficacy of Monte Carlo simulations as the core basis for investment decisions in a film.

The illusion of predictability

A fundamental problem with film, from an investor's point of view, is the lack of visibility of both past and future performance. As we all know, film performance is susceptible to multiple factors and is highly volatile. Studios are reluctant to share cost or performance data - they do not want the liability for investor losses. As a result, the historical data from secondary sources (including those that promote the investment) that is used to drive predictive models is either inaccurate or stale.

Moreover, the market has no way of knowing how existing slate deals are really performing. And as investors began to recognise this through, among other things, conflicting reports of existing film slate performance in the press, hedge funds stopped buying.

Currently, about half a dozen banks have "uncleared" or "hung" slate financing deals. For the banks that were active in underwriting film slate deal syndications, this leaves "permanent" balance sheet exposure - anathema for a dealer that expects to have balance sheet exposure for only a short time when it underwrites a debt or equity offering.

With diminished demand for both debt and equity investments in slate deals and unsold deals still in the marketplace, no bank or dealer is currently willing to offer a "firm underwriting" of such a structured finance transaction. Dealers are now only willing to undertake "best efforts" underwritings in film deals.

Credit crisis = lack of liquidity

This market reaction could not have come at a more inopportune time, coinciding with the subprime mortgage debacle. Since last July, we have seen massive credit losses and write-downs by banks. The credit crisis has spread to other asset classes - including film - and led to a loss of liquidity in the debt markets.

Why is this lack of liquidity so important to the film industry' Because hedge funds - which make up most of the investors in passive slate deals - do not "hedge" for the most part: they borrow. As the credit meltdown sucked up more and more liquidity from the capital markets, dealer balance sheets that might otherwise be available to leverage fixed income investments in film deals were also shrinking.

Dealers that had been providing various forms of leverage to institutional buyers of debt have suffered well over $100bn in asset write-downs as of January. Some have obtained replacement capital from foreign "sovereign wealth" funds, but the appetite for principal or balance-sheet risk has surely changed. This is particularly important to the film industry, as many of the most stricken dealers are the same banks that had been engaged in underwriting large film slate financing deals since 2004 (see chart 1, Credit crisis).

In today's environment, investing in film does not compare well with other alternative asset-class investment opportunities now available to hedge funds. For example, why should a hedge fund invest in senior bank debt in a film deal at par (or face value) when it can buy senior bank debt in the secondary market at a deep discount, even when the underlying credit is relatively safe' The same can be said about cheap mortgage bonds being forced-liquidated in the secondary market as a result of margin calls on hedge funds by the dealers.

When we consider the liquidity crisis in the capital markets alongside the unique competitive and economic challenges facing both major studios and independent labels (see chart 2, Then and now), we see a significantly changed environment for film slate financing. None of this has fully come home to roost yet, but it will once the existing funded slate deals run their course and the studios return to the "capital well" for co-finance funding.

Films do not behave in a vacuum

A serious flaw of predictive Monte Carlo simulations is that they cannot anticipate changes in the marketplace; they rely on historical, outdated numbers. Data on drivers of film performance are in a state of constant change. Film revenue drivers do not reside in a vacuum. There are material intervening factors in the passage of time between the data set origins and actual release dates of films in a given slate deal.

They include shifts in audience tastes and viewing trends, emerging technologies, competition from other media, and competition among releases, release timing, and marketing campaigns.

Consider the top 10 movies in the US last year. Proving once again that we in America have adolescent tastes with a porn aesthetic, audiences were drawn to youth-oriented fantasies, while rejecting serious adult-oriented fare. Did the "market" know, when it funded an over-crowded field of specialty films, that those films would not find an audience in 2007' Did we predict this much competition in specialty films' Did we, in 2005, predict the decline of DVD revenue as a percentage of box-office revenue' And do we know what kind of penetration to expect from video on demand and subscription video on demand in three years' time' Of course we do not, and no statistical model prediction in the world is going to change that.

Asymmetrical warfare

The problem is that the studios have, and jealously guard, all the current data on film performance. That data is not shown to investors. As things stand, co-finance equity investors are not the studios' "partners" at all; they are prey. This disconnect between what the studios know and control versus what passive investors know and control can be characterised as "asymmetrical warfare".

Studios control release dates and patterns, and they control the p&a spend. Slate performance depends most on the studio's management team and its execution of production, marketing and distribution - factors that have very little to do with the historical data behind a predictive Monte Carlo simulation.

In the end, it is all about how effective the management team executes. The studio's future decision-making, taking into account current and projected market conditions, will determine how investors will fare; for effective marketing can make a bad movie succeed, and a poor marketing campaign can cause a good film to fail, but a bad movie can never succeed with bad marketing.

The challenge, therefore, is to align the results of the decision-making between the studio and the passive investors. Unfortunately for existing film slate investors, the studios can now make a profit, via their distribution fee, while equity investors lose money after the application of that fee.

How' Because the studio collects its distribution fee at the top of the cashflow "waterfall" before any revenues are received by the film slate structured investment vehicle and made available to pay debt and, ultimately, a return to equity investors. And that distribution fee applies to p&a cost recovery, as well as the recoupment of the cost of production. It is a structure that encourages p&a spending by the party in control, the studio management, since the distribution fee applies to gross revenues - revenues that can be enhanced by an excessive p&a spend.

Re-alignment of interests

The solution to all this is a far better alignment of interests between passive investors and the party in control of current information and execution, the studio. Distribution fees should be capped, p&a costs controlled, and the studio's distribution fee subordinated so that, at the very least, the distribution fee will not be paid unless and until the principal amount of the equity investment has been recouped by investors. This would better align the break-even point between the studios and the equity investors. In other words, the equity investors would, in reality, become the "partners" that the studios currently call them.

This modification to current co-financing arrangements would still allow studios to spread their capital and mitigate the high dollar risks of major motion picture production and marketing - something clearly mandated by the studios' corporate parents. With their interests better aligned, the focus can be more on execution of production, marketing and distribution by the studio's current management team than on historical data that will likely be stale by the time the films are released.

The message here is that there is a real need to restructure and re-price risk based on what we as investors know and do not know or control. In the wake of all that has happened, Wall Street and Hollywood will have little choice but to move in that direction together in order to continue their financial ties (see chart 3, Change is afoot between Wall Street and Hollywood).

Given the reports of investor losses and unsold paper held by the dealers in existing slate deals, as well as the dramatic tightening of credit in the capital markets, film slate deal structures will evolve, leverage will be appropriately set and risk will be appropriately priced.

Moreover, competition will weed out weak market participants in the speciality film area, new exhibition and exploitation technologies will eventually come on line, and liquidity will return to the capital markets. And with improved conditions, the investment cycle we just witnessed will happen all over again. Because Hollywood is just plain irresistible!

Ben Waisbren

Ben Waisbren is president and chief executive officer of Continental Entertainment Capital (CEC), a merchant banking business focused on film and TV. Backed by Citicorp, CEC lends capital to, as well as invests equity in, production and distribution companies via its project finance and structured finance businesses based in Los Angeles, New York and Paris. CEC invested in Wild Bunch in France, and has backed Frank Miller's The Spirit, and The Laundry Warrior, both in production.

2 then and now

THEN

- Low volatility in traditional asset classes drew investors to film

- DVD at its peak

- Available wraps for senior bank debt

- Successful syndications spawned more deals

- Firm underwriting by dealers

- Leverage for hedge funds

- Warehouse and swap lines

- Opportunities for specialty films

- No recent failures and horror stories

NOW

- High volatility in traditional asset classes

- Decline in DVD revenue contribution

- Ambac and Mbia downgraded

- Hung deals/uncleared trades at many dealers

- No firm underwritten deals

- Pull-back on warehouse and swap lines

- Collapse of CLO market

- Glut of speciality films

- Performance of existing deals and asset class questioned

3 Change is afoot between Wall Street and Hollywood

- Balance sheet crisis at dealers and banks

- Need for liquidity during volatile times

- Credit insurer rating issues

- Loss of cheap leverage for hedge funds

- Collapse of structured vehicles for bank debt

- Film costs rising on flat revenue

- DVD declining

- Specialty films declining while competition rising

- Film slate syndications "hung" at dealers

- Lack of transparency and visibility of film asset classes

- Slate deal performance being questioned.