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Earlier this month, the UK government closed a tax loophole which had promised to finance a number of British films. It was the second year running the Treasury had cracked down on so-called sideways loss relief, through which investors wanted to offset expected losses on film investment against profits in their annual tax returns.

The government has portrayed such changes as a decisive shift towards support for producers of, rather than investors in, film. The UK's year-old tax incentive has now taken centre stage. But investment companies have been irritated at their portrayal as mere middle men looking for a quick buck.

Martin Smith, policy adviser to Ingenious, one of the biggest investment groups, argues that an effective partnership with media investors is vital if the UK is serious about a sustainable industry.

'The film industry is both an important contributor to the UK's cultural output as a nation and a vital driver of the creative economy, directly employing more than 40,000 people, and indirectly tens of thousands more.

However, from an investor perspective it is also both financially fragile and commercially under-developed. To be frank, the goal of sustainable investment remains as distant as ever.

In November 2002, the then chairman of the Film Council, Sir Alan Parker, delivered a landmark speech (see box, opposite). It was entitled, 'Building a sustainable UK film industry' and he started by observing that: 'We can never be the biggest film industry in the world, but we should be right up near the top of the league, not permanently hovering in the relegation zone.'

He continued by remarking that the UK film industry had had enough of 'quick fixes and Band-Aids' and needed nothing less than 'radical re-invention'.

Why can't the UK develop a sustainable film industry' This question was also asked by the House of Commons' Culture, Media and Sport Select Committee in 2003 and it identified a key structural weakness of the UK industry - that it was producer-driven. By contrast, it noted, a winning film industry is distribution-led.

The committee cited a blistering analysis of the problem that had been submitted by the Film Council.

'The scattered and fragmentary nature of the (British) financing model contrasts sharply with the integrated model which forms the basis of US studio financing. The 'cottage industry' approach of the UK production sector, comprising scores of film companies, is remarkably successful at delivering excellent, culturally significant but ultimately unprofitable British films.

'This industrial structure (also) fails to deliver a consistent flow of films such that risk can be spread across a slate of projects. This inability to run a portfolio of films to mitigate financial risk acts as a very strong disincentive to private investment into the production sector.

'Obviously this approach (also) does nothing to build the significant corporate structures which are essential to achieve a sustainable industry.'

Quite so! That critique remains definitive and applies a fortiori in the new digital environment.

The digital revolution

What, objectively, has changed over the last five years' Globally, the scene has of course been progressively transformed by the deepening of the digital revolution and the consequent fragmentation of the media industry.

The commercial impact of these developments was explored by several speakers at this event last year. Especially striking was the reference to an interview with Dick Parsons of Time Warner.

Asked what the future held for Time Warner, Parsons replied with an analogy. He said: 'Imagine 1,000 buckets on the floor all catching little raindrops of revenue - that's what Time Warner is going to look like.'

There is no point going over that ground again, except to point out that in film, as in music, it is the profits made in the distribution part of the value chain, the profits that for many years sustained these industries globally, that are now most at risk in an online world.

In the UK, one of the things that happened after 2003 is that Ingenious created a number of integrated film funds. These were based on the realisation that the keys to commercial success in the film business were, exactly as the select committee had described, distribution, sustainable financing and an uncompromising practice of working with the best creative talent available.

This allowed Ingenious to raise several hundreds of millions in investment capital which was invested, alongside a variety of partners, in such films as Girl With A Pearl Earring, Vera Drake, Hotel Rwanda, Bride And Prejudice, Notes On A Scandal, Hot Fuzz and The Golden Compass.

The period after 2003, in fact, marked a relative boom in the production of British films. It was stimulated to a degree by government tax reliefs, notably at the lower budget end of the market, but was due mainly to equity investment.

Much of this investment was attracted thanks in part to decades' long accounting rules known in recent times, somewhat inelegantly, as 'sideways loss relief' - the principle that investors' losses can, for accounting purposes, be offset against profits.

As everyone knows, the rules changed in March 2007. Whereas private investors previously stood to lose only $118 (£60) out of every $197 (£100) invested, now they stand to lose the lot in an unsuccessful venture.

What difference does the arrival of the online age make to investors' Answer, it magnifies uncertainty and thereby amplifies investor risk. Why' Well, first, it lowers barriers to market entry. Second, it generates greater competition throughout the value chain. Third, it whittles away the famed power of the 'gatekeepers', who effectively controlled prices at both ends in the pre-digital age, resulting in reduced margins.

Market fragmentation continues to proceed apace. We have more channels, more platforms and more 'choice'. The customer is truly king and, speaking as a consumer, this is surely a wonderful thing. I personally look forward to enjoying weekends of wall-to-wall Eisenstein or Chabrol, and more generally the development of a new world of specialist micro-markets.

Can anybody make money'

But can anybody make money in this environment' Can they make enough money to build sustainable businesses' The talk everywhere is of new business models, new delivery platforms, new 'windows', the so-called 'long-tail' effect, and so on.

But would you really advise your best friend to invest their hard-earned cash in funding any of these new market entrants' Would you advise your clients to do so'

There certainly are new opportunities out there, some of them very exciting indeed. From an investor perspective, however, deepening fragmentation is making life much more difficult.

I was therefore interested in December to read a paper on investment in the creative industries, including film, by a firm of economic consultants, mainly ex-Treasury people, which had been commissioned by Nesta. Not surprisingly, market failure was diagnosed everywhere. The consultants' report ends, nevertheless, on a note of tentative but, in my view, questionable optimism.

Salvation may lie, they speculate, in the long-term growth of the activities of so-called 'alternative' or 'non-correlated' investors, and specifically hedge-fund investors.

I think this is fanciful, especially for independent production. We strongly agree that the hedge-fund model should work on the distribution side of the film business.

However, in our view it is less appropriate as a model for the industry as a whole. The model is based on the idea you can analyse the key characteristics of a studio's entire slate of films over a period of, say, five years, and project forward from there.

It is questionable because unlike, say, the credit-card market or insurance industry, where very large numbers of customers provide a solid mass of statistical evidence, in film the data sets achievable are not wide enough.

There are four factors at work here:

lFirst, each film is different.

l Second, the total number of films made is small, even in the US.

l Third, market conditions, meaning the state of the theatrical market and the availability of distribution technologies, change so quickly that past experience is never a guide to future performance.

l And finally, costs are rising, so a well-performing historical slate would certainly return less if recreated today.

In our view, hedge funds in the US have invested in film in spite of this logic because, at least before the credit crunch, they had mountains of spare cash - $13bn of which was invested in some 150 movies over a three-year period.

There have, to be fair, been some noticeable studio-slate successes - Fox and Dune come to mind. But several hedge funds are beginning to wish they had never touched film. A number of big losses are being sustained - and being swept under the carpet.

In any event, as we all know, US experience is not transferable. The big studios run gigantic slates and have a total grip on distribution and other rights. These conditions do not obtain in Europe.

The fact is that most independent films lose money, and all investment in film is a calculated gamble. Even when talking up our credentials in this business, and proudly demonstrating our track record of success, we never attempt to hide the fact this is high-risk stuff.

It is hardly surprising therefore, that as far as film production is concerned the UK is still chronically short of investment. Yes, we have creative talent in spades. Yes, we can go on making the 'excellent, culturally significant but ultimately unprofitable British films' the Film Council talked about in its select committee submission.

Yes, cinema admissions are rising and the industry's contribution to UK GDP has increased by 39% during the last two years. All of this welcome 'good news' was highlighted by the minister of state at the Department for Culture, Media and Sport, Margaret Hodge, in her speech to the UK Film Finance Summit on October 18 last year.

But these achievements conceal some uncomfortable financial truths. The total annual film-production budgets of the Film Council, Channel 4 and BBC combined add up to some $65m (£33m) annually.

If we assume that between them they account for 30%-50% of a film's budget on average, and add in pre-sales, some bank finance and the tax credit, this would give us an independent UK industry worth $130m-$217m (£66m-£110m) annually. On an international scale, this is pathetically small.

Faced with these facts, the response from government worries me. I think ministers have, frankly, been in denial, on one occasion deriding investors who form part of 'wealthy partnerships'. This raises an obvious question: where is the required risk capital going to come from'

The Treasury response to this question privately is that it is not their job to 'second-guess' the markets. So we have made zero progress on this, the most vital issue of all.

Let me conclude with Sir Alan Parker again. This was his warning in 2002: 'Now is the time, once and for all, to recognise that our industry's obsession with public funding for production is taking us nowhere.'

That remains true. And the UK film 'industry' is still only the cottage industry it was five years ago, and so it will remain unless more sustainable investment is generated.

The effect of digitalisation is to magnify our competitive weaknesses. This does not mean the end of film-making in our time, of course. There will always be passionate film-makers and visionary cultural entrepreneurs who are able to get the money together somehow. And thank heavens for that.

But we need to understand that we, in UK plc, are likely to find ourselves capturing a smaller and smaller proportion of the commercial upside generated by our creative talent.

We may gradually be consigned to the role of suppliers of commoditised, off-shore film industry support services while bigger rewards are enjoyed in Los Angeles, or Mumbai or, who knows, Shanghai.

Some will be satisfied with that. At Ingenious we would prefer to raise our sights a little higher. But to be in a position as a nation to capture more of the commercial upside, we will have to start building more business capacity.

To achieve that we need sustainable investment which, in turn, would then enable us to attract more talent - business and creative talent - to work with us.

To some extent this is a circular problem, but we will not make progress without developing sustainable investment models. To do that, we need to understand what risk-adjusted rate of return would bring in new investors in significant numbers.

Investors know we do everything possible to mitigate their risk and so persuade them to stay in the game. They know that we know investors will only commit capital to an investment proposition that earns a return on capital greater than the cost of capital. That's the test.'

This article is based on a speech delivered to a meeting of the British Screen Advisory Council

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