In a prescient speech more than a month ago in Berlin, financier Ben Waisbren talked of impending calamity for the US wave of slate financing - banks won't touch such mega-deals again until there is more transparency and a better alignment of investor and studio interests.
Waisbren is president and chief executive officer of Continental Entertainment Capital, a Citicorp-backed merchant banking business focused on film and television. CEC invested in Wild Bunch in France, and has backed Frank Miller's The Spirit and The Laundry Warrior, both in production.
Here are edited excerpts from Waisbren's presentation given at Berlin's European Film Finance & Sales Summit hosted by Screen International:
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 in investment class, is non-transparent, illiquid and unpredictable. But to call film a 'subprime' asset class, as some have suggested, is an overstatement; for film, as an asset class, is just 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 to determine and promote a proposed film slate's expected returns. The notion was that, rather than qualitative analysis, Monte Carlo scenarios could predict objectively 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 don't 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 recognize this through, among other things, conflicting reports of existing film slate performance in the press, hedge funds stopped buying. Currently, about half 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 as it did 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.
The deterioration began in February 2007 with the rise in defaults and bankruptcies among subprime borrowers, which, in turn, caused massive losses to sub-prime originators, their underwriters and investors (including hedge funds) in securitized investment vehicles (SIVs).
By spring 2007, news that Bear Stearns' hedge funds suffered large losses in subprime mortgages and of other hedge funds preventing investor withdrawals caused many dealers to sharply restrict the leverage that they provide to hedge funds. Massive write-downs were taken on positions and margin calls were made on deteriorating fixed income investment portfolios; mark-to-market requirements impacted positions even where underlying credits were sound.
The crisis spread beyond subprime mortgages in July and August as asset-backed commercial paper programs (ABCP) in the United States, Europe, and Canada began to sputter. Liquidity concerns spread to the interbank market because banks began hoarding liquidity that they might need in their capacity as liquidity providers for ABCP programs.
Why is this lack of liquidity so important to the film industry' Because hedge funds - who make up most of the investors in passive slate deals - don't actually '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.
Deteriorating film economics
There is a long-held assumption that film is so ingrained in popular culture that movies are non-market directional and non-correlated - immune to fluctuations in the equity markets and economy as a whole. But how is film, as an asset class, really performing'
A stunning research report by Global Media Intelligence (GMI) published last year paints a very grim picture. GMI projects a cash loss of $1.9bn for the entire slate of 132 films released in 2006 by the six major studios, plus DreamWorks, taking into account five years of revenue. This, after a record $19.5bn was spent to make and market those films.
The report spotlighted many worrying trend-lines. Talent gross participations have grown as major studios focus on event pictures for peak holiday seasons. The average negative cost of the 25 highest-grossing films in the first eight months of 2007 was 10% higher than the comparable films from 2006. The average box-office adjusted revenue from the DVD release of major titles was down 12.5% for the first half of 2007 compared to 2006.
The bottom line is that film is a mature asset class. There are, after all, only so many sets of eyeballs, so many theaters, and so many weekends. Indeed, in both the US and the global marketplace for theatrical films, there has been insignificant top line dollar growth at the box office since 2002. And, all the while, costs have been rising and DVD sales have been declining.
The decline of the profitability of film production and distribution is not only affecting big-budget, wide-release studio films. Hollywood's specialty labels have also been spending more in the face of fierce of competition. This situation will only become more acute as the capital that was provided to other labels, such as The Weinstein Company, Summit, Overture, MGM and United Artists, results in even more specialty films fighting for market share over the next two to three years.
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 along side the unique competitive and economic challenges facing both major studios and independent labels, 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 new 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 during the passage of time between the data set origins and actual release dates of films in a given slate deal.
Such factors 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 wouldn't 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 VOD and SVOD in three years hence' Of course we don't, and no statistical model prediction in the world is going to change that.
Square peg in a round hole
There are now enough indicia in the market to allow one to question whether the performance of existing slate deals can support the capital structures engineered by slate deal promoters and Wall Street. Will there, in fact, be any value left for equity investors in slate deals after the fees charged by dealers and promoters/middlemen, the cost of production and P&A, talent participations, a 12.5% distribution fee, and the interest charged on senior debt and 18% mezzanine debt' In fact, one might suggest that an 18% PIK (payment in kind) mez debt tranche is a 'Pac Man' security that will, through its high coupon rate, 'eat up' all the residual equity value over the term of the slate deal.
Film is generally considered a high single digit asset class - meaning its overall cash-on-cash returns are in the area of 8 or 9%. That's the 'round hole' here. And an overly-burdened capital structure of a slate deal is the 'square peg'.
We know that equity in existing film slate deals is already challenged, as the performance of those deals has been questioned by reports in the media. If we consider the substantially increased cost of senior debt borrowing that has occurred due to the liquidity crisis in recent months, matching realistic projections of film slate performance with an appropriate capital structure will become all the more difficult in the near future. Something - or better, somebody - will have to give here, and that 'somebody' will be the studios.
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 now stand, co-finance equity investors are not the studios' 'partners' at all; they are prey. This disconnect between what the studios know and control vs. what passive investors know and control can be characterized 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's 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 SIV 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 realty, become the 'partners' that the studios currently call them.
T his 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 don't 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.
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 specialty 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!