Never has so much money from Wall Street been flowing into studio coffers, mixing two storied worlds. Are firms like Merrill Lynch and JP Morgan Chase changing what we see on screen?
One day early last year, Marvel Entertainment CEO Avi Arad, the Harley-Davidson-riding former toy designer, stood at the front of Paramount’s 200-plus seat Sherry Lansing Theater and pitched a group of executives who had little to do with traditional studio life — and little interest in its trappings.
They were Wall Street investors, the type of people who for decades have shied away from Hollywood. This was a road show, and Arad’s goal was to sell them on the idea of loaning him more than $500 million, with Captain America and Nick Fury and The Avengers as collateral.
“I don’t know who was in the audience,” he says of a crowd that included representatives from large banks and financial institutions, “but I think there was a lot of money in there.”
There was. Just after Labor Day, Marvel rolled out a $525-million debt facility to finance the production of up to 10 big-budget ($165 million a pop) live-action films based on comics characters. “It’s taken time for the financial markets to recognize the incredible value of these properties,” Arad says. Wall Street will help transform Marvel from licensor to producer in a deal that will give it complete creative control and allow the company to build a film library.
It’s one example of how the long-held mutual suspicion between the Dream Factory and the Deal Factory is slowly giving way to mutual trust. This trust is changing the way that movies are financed and may, in time, change the way they are made. The result is a sort of Bizarro World, in which investment road shows for hedge-fund managers are held on studio lots and meetings in the glass towers of lower Manhattan are filled with the discussion of P&A; casual Friday bankers authoritatively hold forth on the importance of tent-pole films, while Armani-clad producers rhapsodize about the beauty of a diversified portfolio of assets.
While this type of financing is nothing new, what is different is the size and scale. In the past year, several nine-figure deals have been struck to finance multi-year production slates worth about $2 billion. With Wall Street firms like Merrill Lynch and Credit Suisse First Boston acting as matchmakers, Disney, Paramount and Warner Bros. have all linked up with sophisticated private-equity investors through a range of transactions to finance portions of their entire slate.
There’s also the role that Wall Street has played in mergers and acquisitions. The sale of MGM in September 2004 was made possible after Sony and Comcast joined forces with three large private-equity firms: Providence Equity Partners, Texas Pacific Group and DLJ Merchant Banking Partners. Viacom financed its purchase of DreamWorks with private-equity money, and the Weinstein Co. launched with an infusion of such funds. Private equity also is heading into the coffers of talent reps, most recently with ICM’s unprecedented deal to raise $75 million from Suhail Rizvi, a Wharton graduate who runs a Greenwich, Conn.-based private-equity fund.
The timing is fortuitous. Studios are thirsty for cash as production and marketing costs continue to escalate. And while Wall Street firms were once wary of funding film production, the stability of DVD sales and foreign rights have made the $50-billion industry more worthy of investment. For example, given the track record of “Blade,” “Spider-Man” and other franchises, Arad says, “We can virtually guarantee the opening weekend, and a great following on the DVD.”
Of course, in certain cases companies have to accept the whims of investors. When DreamWorks Animation went public in 2004, a big promise for investors was the returns on “Shrek” sequels, but the stock was battered when the DVD sales of “Shrek 2” proved disappointing.
But by and large Wall Street firms have given in to a desire to get greater returns on their capital, even if it means warming up to an industry they are not familiar with, where the drip-drip pace of film production stands in sharp contrast to that of, say, real estate or technology.
“The studios are very traditional, and these Wall Street firms are very traditional,” says Phil Alberstat of William Morris Independent, “but they are traditional in different ways. [The financing] is making these cultures see eye to eye.”
LOSING THEIR SHIRTS
Over the years, a long parade of financiers from New York to Japan have toured back lots with stars in their eyes only to leave with their wallets empty, victims of frequently inscrutable accounting and poor judgment. These weren’t just naive mogul wannabes: Legendary sharpies like Joseph Kennedy, William Randolph Hearst and Howard Hughes all had difficulties.
The landscape is dramatically different today. As parts of gigantic conglomerates, the studios surely can afford to finance all the films they produce. But as components of a highly diversified portfolio of businesses, studios have to compete with less-volatile broadcast, cable, radio, magazine, online and publishing operations, not to mention the pressures of shareholders.
“The movie business, which arguably saw itself as the center of the universe, is now a pretty small part of the media business,” says Harold Vogel, president of Vogel Capital Management and author of “Entertainment Industry Economics.” Before Viacom split, Paramount provided just 10% of its revenue, he notes. What’s more, investors and managers alike have lost patience with the boom-and-bust nature of the film business. Simply put, the publicly held parent companies of the studios have less margin for error.
At the same time, filmmaking has become a more capital-intensive proposition. The average film cost $98.4 million to make and promote in 2004, according to the Motion Picture Assn. of America. Tentpoles cost much more: Universal’s “King Kong” weighed in at a reported $207 million. While studios have the infrastructure to release 20 to 24 films per year, they only have the financial capacity to make a dozen. So they are willing to part with a chunk of the profits to gain financing and insulate themselves from potential losses.
That’s meant studios have been more willing to open their books to third-party investors, something once unthinkable in an industry used to keeping the numbers close to the vest. Some predict that the industry is ripe for a greater level of financial and legal sophistication, not just at the studios, but at smaller companies as well. Regent Entertainment, distributor of such movies as “Hellbent” and the doc “The Hunting of the President,” and parent of the gay TV network here!, completed a $50 million credit facility last fall that was structured by Merrill Lynch. The money will be used to cover prints and ads for the company’s slate of motion pictures over the next three years.
“The challenge these [Wall Street] firms will have is finding suitable customers,” says Stephen P. Jarchow, Regent’s chairman and CEO, whose background is in Wall Street and entertainment. “Once you drop below the major studios, there are not that many candidates that are this sophisticated in finance. [Many smaller companies] just are not used to the rigorous due diligence that Wall Street does. They don’t take things on conjecture. It can be a jarring thing.”
Luckily for Hollywood, the supply of potential financing has been rising just as the industry’s demand for cash has grown. With the emergence of a global savings glut, investors all over the world are seeking new, higher-yield opportunities. “A few years ago we began to see huge demand for U.S.-dollar investments from Asian investors in particular,” says Michael Blum, the low-key head of global asset-based finance at Merrill Lynch. Blum’s team specializes in securitization — turning pools of assets like mortgages, credit-card bills or car loans — into investments for sophisticated investors. If bonds can be backed by pools of mortgage payments, why can’t they be backed by box-office receipts and DVD sales of a studio’s production slate? Wall Street has been more than willing to invest. As one finance veteran notes, a bit wryly, “There is a lot of money chasing not enough films.”
And as such, the private-equity investors and investment banks are challenging one of the dominant forces in film financing: commercial banks. Already, in an analogue to Moneyball — Oakland A’s General Manager Billy Beane’s method of making investments in players by the numbers — commercial bankers have brought the science of number crunching to bear on the art of film production. The dominant commercial (or traditional) banker in Hollywood is John W. Miller of JP Morgan Chase, who has financed four of the last six Oscar winners for best picture — “Million Dollar Baby,” “A Beautiful Mind,” “American Beauty” and “Gladiator” — and owns about 80% of the commercial-bank film-financing market. Miller and his Century City team don’t care much about who is attached to the projects that cross their desks and have little interest in meeting stars. Rather, they’ve devised a system for measuring and mitigating risks — a proprietary database of how films have performed, given variables like release date and genre. As a result, the bankers have a good idea of how horror films released in the summer or how romantic comedies debuting at Christmas are likely to perform.
“His deal is very simple,” says Slate columnist Edward Jay Epstein, author of “The Big Picture: The New Logic of Money and Power in Hollywood,” who recently dined with Miller at Mr. Chow’s in New York (thus proving that the banker isn’t completely detached from the media business). “He makes a point of never reading a script or looking at the content. His operation is simply making a bet that a distributor won’t go out of business.”
After running proposals through its spreadsheets, the bank makes loans to several films at a single studio at the same time. “If you get up to 15 films, it’s hard to lose money on a slate,” Miller told Business Week. The bank then chops the loans up into smaller, more digestible portions, and sells them off to other banks, removing risk from its balance sheet. Finally, it rides herd on producers to bring films in under budget, even if that makes it less likely that stars will see big salaries in smaller projects. Miller has proved that if you diversify enough as a lender to this industry, you’ll considerably reduce your risk of losing money on the overall portfolio. Although JP Morgan Chase doesn’t break out such figures, the consensus is that Miller has a very good track record. But such loans generally cover only the production of the films.
These days, marketing and distribution represent huge costs and box office is only one of several possible windows for recouping them, so producers have to take a broader view of what it means to finance a film. That’s why the recent spate of deals involving studios and private-equity funds marks several steps in evolution. “With multiple revenue streams generated by the film, there’s more potential cash to pay down the debt,” says Jay Eisbruck, managing director at the credit-rating agency Moody’s. “Also, when the whole slate is being securitized, successful films can offset the failure of others.” Even as DVD sales have seemed to plateau, investors are given comfort by the fact that films today have multiple windows through which to recoup their costs. “When people change formats, it will simply be another revenue stream,” says Alberstat.
That has changed the way private-equity investors look at films. In summer 2004, Paramount created Melrose Partners, which raised $231 million to fund 20% of the production costs of every Paramount movie. Much the way that seafood restaurants chop up clams into strips, bellies and whole clams for people with different budgets and tastes, Merrill Lynch sliced and diced Melrose Partners into three pieces: high-yielding debt, lower-yielding debt and equity. Each drew different types of investors: banks for the main debt, and institutional investors and hedge funds for the riskier pieces, in chunks of $5 million or $10 million. The fund, which closed in July 2004, backed films such as “Mean Girls” and “War of the Worlds.” As cash flows in from box-office, DVD and pay-TV receipts, the debt is repaid and equity investors begin to receive proportional cash flows. Payments come from gross, not net, receipts, sheltering firms from notorious industry accounting practices.
In a similar deal, Credit Suisse First Boston last summer securitized a $370-million line of credit for Kingdom Films, backed by Kingdom’s 40% stake in the production and distribution of the next 32 live-action films to be released under the Walt Disney Pictures or Touchstone labels. The line of credit is backed by ticket sales, merchandising, DVD and TV rights. Last fall, in a deal structured by Relativity Media, Warner Bros. completed a $528 million co-financing deal with Virtual Studios to fund a slate of six films, including “The Good German” and “Poseidon.”
Private-equity firms have historically invested in movies on a smaller scale to take advantage of wrinkles in the tax code, which is changing. “These investors are not tax driven,” says Clark Callander, managing director of the Perseus Group, a San Francisco-based investment bank that helped Legendary Pictures raise capital. “These are pure economic vehicles.”
Michael Mendelsohn, who presides over Los Angeles-based Union Patriot Capital, commits to individual film financings and then brings in hedge funds and banks. “We’ve been working with funds picture by picture, showing them that this space is profitable,” he says. For example, Union Patriot arranged about $35 million of production financing for the Lions Gate–Nicolas Cage vehicle “Lord of War,” bringing in Citibank and hedge funds Fortress Investments and D.B. Zwirn & Co.
Sitting in his corner office at Merrill Lynch, overlooking New York Harbor at the Statue of Liberty, Blum admits that the investments do “make me more interesting at cocktail parties.” But production credits and premiere tickets aren’t in play. The process of securitization really shields the studios from the influence of many of the investors. “They’re all money guys, which is a positive,” Blum says. Because they are paid with a healthy chunk of the returns, usually 20%, they have every incentive to maximize profits on every transaction. For private-equity and hedge-fund managers, a deal like Melrose Partners may be one of dozens that cross their desks every week.
It may seem like a clash of cultures: numbers-obsessed sharp-elbowed investors accustomed to measuring returns by the minute doing business with smooth-talking executives who routinely manage and massage huge egos for profit. But there are similarities. “Both Wall Street and Hollywood have a star culture, both have behind-the-scenes power wielders who the public doesn’t know,” Vogel says. “And both are based on trust, which surprises people, because outsiders have a view that each is a den of thieves.”
In fall 2003 at a dinner party in the Hollywood Hills, Thomas Tull fell into an extended conversation with MGM President Chris McGurk. Then 35, Tull was a serial entrepreneur with some experience in Hollywood: In the 1990s, he helped arrange a deal to make video games based on Tom Clancy thrillers. But his expertise lay in high finance, having made his bones rolling up hundreds of Jackson-Hewitt tax-preparation franchises, along with a venture-capital company created by the founder of WebMD.com.
While Tull and McGurk came from different backgrounds, they seemed to ease into talk about the intricate techniques Hollywood uses to raise cash for film production. But the type of money that Tull played with was largely not in the picture.
“It was the biggest industry I could think of in which private equity hasn’t played a significant role,” Tull says. Private-equity firms tended to focus on manufacturing with lots of hard assets, while venture-capital funds were obsessed with start-ups in technology and health care.
The conversation gave Tull an idea. He banded together with a group of Hollywood veterans — former TriStar Pictures production chief Chris Lee, marketing executive Scott Mednick and former CAA CFO Larry Clark — to form Legendary Productions. With $500 million in cash from some of the country’s savviest investors, including private-equity and hedge funds and venture-capital firms, Legendary and Warner Bros. announced a far-reaching deal this summer in which they would co-finance and co-produce films for the next several years as equal partners.
While many of the hedge funds, banks and institutions involved in film finance are content to put up their money and collect interest payments or dividends, part of the goal of forming Legendary Pictures was to become more involved with production.
After putting up half the money for “Batman Begins” and next summer’s “Superman Returns,” Tull and his team at Legendary plan to develop their own projects and scripts and develop them in consultation with the studio. And like a venture-capital firm, they will treat the slate of films as a portfolio — insuring against big losses by making films of different sizes and different genres. “With our portfolio approach, it’s not just the number of films, but a basket of budget ranges that we think make sense,” he says. Legendary will be based on the lot at Warner Bros. and use Warner Bros. as a distributor. Says Warner Bros. chairman and COO Alan Horn, “They’ll get access to a distribution operation they could never replicate, and we’ll get distribution fees.”
As ample a supply of capital as there is, Tull ran into skepticism. After reaching the agreement with Warners, he and his partners set out to raise a minimum of $400 million in funds for Legendary on a road show that took them to the usual money centers: New York, Boston, San Francisco and Chicago. “The hardest thing was getting people to take a serious look at the data and to conquer the perception that nobody makes money in Hollywood but the talent and the studios,” he says.
But Tull set up an arrangement in which investors and managers own shares in Legendary, not rights to certain revenue streams. He also brought investors to the Warner Bros. lot to meet Horn and Steve Spira, head of business affairs. In the end, Legendary wound up with commitments of $500 million from groups like ABRY Partners, a Boston private-equity fund that specializes in media.
“Part of the issue we have with just a blanket slate deal is that sometimes in Hollywood, films are made for reasons other than the quality of the project,” said Scott Mednick, chief marketing officer at Legendary Pictures. “We don’t want to participate in that end of the business.”
As the demand for production financing is expected to grow, Wall Street and Hollywood are likely to find new ways to collaborate. After leaving Disney, the Weinstein brothers engaged white-shoe investment bank Goldman Sachs to raise hundreds of millions of dollars to create their new filmmaking vehicle. And in October, they closed on $490 million in equity investments from investors such as private-equity funds GLG Partners and Perry Capital, and the ad agency WPP Group. Last summer, Isaac Palmer, who as senior vice president for corporate development at Paramount was the architect of the Melrose deal, joined the New York-based hedge fund Fortress Investments.
The question is, how long will it last? As great as it is for Marvel to finance its own movies — quite a turnaround from its bankruptcy filing less than a decade ago — unlike other deals if it ends up defaulting on the debt, a bunch of banks could end up with a group of superheroes. “If we screw up, the investors own the IP,” Arad says.
And investments can be just as trendy as filmmaking. The failure of one fund might imperil the creation of new ones. Ultimately, studios may think better of giving up the potential upside to films. What’s more, even as investors are still bullish, last year wasn’t exactly a renaissance at the box office. All the Wall Street talent combined can’t change one of Hollywood’s financial laws of nature: “There’s no surefire way to avoid risk,” Horn says. “If you put up half the money, and if the movie doesn’t work, you still lose half the money.”