Thursday, March 10, 2011

In A Perfect World

A new guest piece on Movie Beach, this time from our friend and film finance guru Jeffrey Taylor.

He recently published a great piece on film finance trends and strategies which he has kindly allowed us to mash-up here:

In a perfect world, a winning movie transaction would look like this: equity investors receive a multiple of their initial investment within a prescribed time frame; mezzanine investors get all their interest and principle paid; senior debt is fully serviced—and possibly re-cycled for another favorable round of financing. Deals like this have been done for years, frequently involving hedge fund managers, investment bankers and private equity fund managers.

Like cinematic movements, film financing seems to come in waves. 30 years ago Japanese money was prevalent; 20 years ago, insurance companies; 10 years ago, German film funds with tax reasons for investing in films; and this last decade major US hedge funds. Each wave has its own characteristics:

  • In the early 1980s, much of the investment was tax driven: investors could purchase films as they were being completed and effectively lease them back to distributors. They could accelerate the depreciation and amortization of the asset to defer income and other taxes. In the 1990s insurance companies offered to insure gap loans on films. Banks would provide gap financing to producers, then insure the loans in case sales targets were missed and producers couldn’t make good. Emboldened by their insurance policies, banks increased the gap loans to as much as 50% of film budgets. Many films failed to reach their sales targets, many insurance companies were called in to repay loans, and litigation ensued.
  • Past cycles have also included periods of public underwriting, such as those in Australia, the UK and the German government’s development of a public market in tax-shelter vehicles - the Neuer Market - to raise money from wealthy investors. German film funds invested hundreds of millions of dollars in independent production companies like Newmarket and New Line Cinema. Then in 2001 the Neuer Market melted down, a victim of bankruptcies and insider-trading scandals, and with it went the money. This collapse left major studios and large independents looking for new sources of production financing.
  • Most recently, between 2004 and 2008, an estimated $15 billion was invested in so-called “slate funding deals”. Players like Merrill Lynch, Credit Suisse, Deutsche Bank, Goldman Sachs, Citigroup and JP Morgan Chase all arranged co-financing deals with Hollywood studios, raising money from U.S. hedge funds and private equity firms.

Through all financing cycles, one group of investors can always be counted on. These people invest for emotional reasons, such as, "my daughter is in the film, my son has always wanted to be a film producer, my son wrote the script, my wife wants to be a movie star." Such investors tend to lose their entire investment.

Producers have a number of ways of financing their films

  • First, and most basic, is equity: this is the early-stage financing that turns a script into a film in progress. As with much venture capital, angel and other seed capital seeking high returns against high risk, most equity investors in independent movies fail to see returns on their money. On the bright side, most equity investors in independent movies don’t expect their money back - they’re the ever-dependable investors mentioned above, frequently the family and friends of the filmmaker.
  • Next is senior debt, which accounts for a significant portion of the film’s total financing. Traditional providers of senior debt (banks like JP Morgan Chase) require a security interest in the film and all revenue streams associated with it in priority to equity. So, before a film is completed, a producer might sell the distribution rights (including theatrical, home video/DVD, pay TV, free TV and other rights) for various countries. The producer can then use the value of these contracts as collateral against a production loan from a bank.
  • Another form of financing, which is an important part of the funding for independent films, is ‘soft dollars’ or tax credits for shooting a film in a certain state or country. Since 2005, according to BusinessWeek, US states have granted $3.5 billion in incentives to makers of films, TV shows and commercials, but many of these programs are currently under assault as states struggle to balance budgets.
  • Still another component of film financing is print and advertising financing—prints need to be made for theatrical distribution, but the main part of the tab is advertising. The typical P&A budget today is equal to or greater than the film budget. An insider gives the example of a $16 million film with a $20 million P&A budget. The financiers offered to provide $8 million senior debt at 20%, which, he says, is a very common interest rate range for P&A financing.
  • Producers can also earn money from product placement (think ET and Reese’s Pieces, think George Clooney’s character in “Up in the Air” flying American Airlines).

Whatever the structure of the film-financing deal, everyone hopes for a Hollywood ending by producing a smash hit with everyone getting fabulously wealthy. The odds, however, are stacked pretty steeply against this. A large-scale, independent studio making 12 films a year will probably get eight losses, two break-evens, one pretty good film and one hit. Smaller-scale institutions with the wherewithal to make only four films could find themselves with four losers and end up closing shop. As a business proposition, it’s better to spread the risk over a larger number of films. That’s an ability the studios have always had—releasing 20 or more films in a season. A slate of films may not assure investors of great wealth but it prevents them from losing their shirts.

Who Invests in Film?

Film financing is a complex business that requires good information, strong experience and a balanced approach that avoids emotion about being in the business. It is not for the faint of heart. According to a hedge fund manager, film investors fall into three main categories:

  • First, there are angel investors—family and friends of the filmmaker who invest for other than strictly financial reasons.
  • Second there are those who think they can beat the house. “Everyone else has been burned, many people in Hollywood are charlatans, but they think they can beat the house anyway—they’ll pick better films, they’ve met a very trustworthy guy who has a slate of films that can’t lose—and the hallmark of those people is they claim very outsize rates of return.”
  • The third category of investor is able, by virtue of scale of investment or some other means, to truly diversify across a number of different investment opportunities. This investor looks at films the way others look at real estate—knowing many things could go wrong, but that if he’s truly diversified and invests on a significant scale, and is very diligent, then over a reasonable period of time, he’ll reap a “very handsome return.” Which is basically what the studios do—although even the studios get it wrong.

Another answer to the question, ‘Who invests?’ might be, ‘People who see an opportunity.’ Box office demand is currently strong, but the number of films being made with U.S. distribution is down significantly.

How to Succeed in Film Financing

  • First, you must take the time to truly understand the many elements of film production finance and distribution, in particular, the legal components and how the rights are created, distributed and paid for.
  • Second, you have to have some kind of connection to the industry at a fairly high level, meaning, you need to have access to trustworthy people and have a good mechanism for filtering out people who are not reliable business partners.
  • The third piece of advice to would-be film financiers is “remain vigilant.”

Hollywood likes to fleece people, but if you follow steps one and two, you are more likely to enter good deals with good people.

To order your own personal copy of "Film Finance For Beginners" please visit: Books by Jeffrey Taylor

The Out Of Obscurity team.