Wall Street wise to summer box office

Investors, studios more focused this year

The romance between hedge funds and Hollywood came out into the open last summer. But despite an inauspicious beginning — “Poseidon” may have sunk Virtual Studios’ ship — the pairing continues at full bore. Dozens more deals are in the works, but both sides are honing the fine points in order to make the pacts more beneficial for both sides.

While some of the biggest titles this summer — the third “Spider-Man” and “Pirates” pics and the next “Harry Potter” — were kept from funds by jealous studios, funds are invested in “Evan Almighty,” “Ocean’s Thirteen,” “Live Free or Die Hard” and “Fantastic Four: Rise of the Silver Surfer,” among other titles.

Coming off a turbulent 2006, this summer will shed more light on the shape of financing to come.

Last year “was really important. It was a pivotal year in educating investors how to navigate in choppy waters. And the waters are choppy,” says Laura Fazio, managing director and head of media for the Americas at Dresdner Bank. Dresdner put together two successive deals for Fox with Dune Entertainment as well as Paramount’s $300 million Melrose 2 pact.

Wall Street clearly still likes showbiz sizzle. Funds are as flush as ever. Some are making money in Hollywood, and others hope to do so soon. Lionsgate just inked a $210 million pact through Goldman Sachs.

But a year of feverish dealmaking, hype and experimentation is evolving into a more focused approach on refining and structuring deals so that investors and studios can become long-term partners.

One major issue is how to more closely align investor and studio interests. That mostly means funds are seeking greater flexibility in studio distribution fees, which have been a bone of contention for investors since these deals started. Another issue is whether funds feel more or less comfortable with a producer-businessman such as Thomas Tull or Ryan Kavanaugh in the middle.

“There’s still some uncertainty about whether or not passive investment in anything the studio does, or a solid producer in between the studio and you, might improve your odds,” says Stephen Prough of Salem Partners, who advises funds. He says pacts with middlemen place “a high degree of confidence in those individuals,” who now include producers like Ivan Reitman and Joel Silver, who have inked their own deals.

It also depends on the studio. Warner Bros. picks producing partners — Village Roadshow, Legendary — and sticks with them long-term. Others, like Paramount and Fox, prefer to pick all the product and seek purely financial investors.

How successfully the partners confront these questions, among others, could determine whether hedge fund cash ultimately trickles away as German money did, and as insurance money did, or whether it becomes a permanent fixture of the movie business.

The big headache of last year was the Virtual Studios-Warner Bros. pact: Aside from “Poseidon,” titles included “Blood Diamond” and “The Good German.” The lesson was clear: A deal for only six pics can be punitive. Investors need a dozens or more films over a number of years to have a fighting chance.

“That deal was not well structured or thought out,” says one Wall Streeter. As a result, Stark Investments, the primary hedge fund, fired its Hollywood frontman, Ben Waisbren, who put it together.

Tull’s Legendary Pictures also hit some speed bumps — remember “Superman Returns”? In the typical three-tiered structure of slate deals, “I hear the mezzanine is OK, the equity is not,” says one Wall Streeter. It’s early days yet, since the pact runs for five years. But consensus is Legendary needs some big hits to make it work.

An investment bank leading a slate deal gets mainly fees and interest. So-called senior debt, mezzanine and equity partners, in that order, take increasingly higher levels of risk for potentially higher returns.

“If you look at any of these deals, the ones that do well are the ones that have access to pretty much any picture. The studio is not just saying, ‘Here’s a select group of films and you can pick from them,'” says one Wall Streeter. That would be Virtual and, to some extent, Legendary.

Even in more comprehensive slate deals, studios will cherry-pick big tentpoles and franchise films — a “Spider-Man,” “Harry Potter” or “Pirates of the Caribbean” pic.

Walt Disney’s slate deal, called Kingdom Films, also excludes all animation.

Some funds are debating when, or if, financial partners should be able to decline a picture — called selection — or if they’re better off going “straight slate,” like Dune and Melrose.

For instance, any gains for investors in Gun Hill — a combination of pics from Sony and Universal — from “Talladega Nights” were wiped out by “All the King’s Men,” notes one investor who favors selection.

People close to Gun Hill 1 say it has been profitable. As it comes to a close, the studios have launched Gun Hill 2, again through Deutsche Bank, again brokered by Relativity Media’s Kavanaugh.

Yet the most felicitous marriage of the year was the straight-slate deal between Fox and Dune. That’s due in large part to Fox’s tremendous run, burnishing its image as the best managed studio in town. From “The Devil Wears Prada” to “Borat,” Dune and its investors shared in the rewards. Since Fox holds nothing back, investors also will partake of big summer projects “Silver Surfer” and “Live Free or Die Hard.”

At Fox, “There’s a difference in perception. I think the other studios are probably taking note,” Fazio says.

Fox kept the same straight-slate terms for the second Dune deal. “The studio could say, ‘Why would we do another deal like that? It’s been such a good year. How can I defend this to Peter Chernin?'” says one person close to the deal. Because “it’s a way to foster new institutional investment vehicles and longstanding relationships with financial investors.”

Also, studio luck can change.

Investors have come to accept a studio, which has heavily invested in a franchise, wants all the upside, and that they’re unlikely to get in the door on Spidey.

But they don’t want problematic pictures. They don’t want overly expensive comedies that tend to work domestically but may not work overseas. They don’t want pictures with big gross participants — so that after the studio takes its guaranteed fees, and after gross payouts, there’s nothing left to divvy up.

Funds have always felt the distribution fees create an automatically unlevel playing field. They’ve been pushing for lower distribution fees until a certain performance level is reached, and then the studio can take its higher fee. And, in response to pressure, fees in general have come down. “There are a lot of 10% deals now, where the standard was at least 12.5%,” says one investor. The Lionsgate-Goldman pact is said to carry a 15% fee.

“No studio is going to say we want to screw our partner. And they don’t greenlight movies they think will lose money,” says one investor. “But a studio’s bottom line is how much money will it make. There’s no recourse, or penalty if you give (financial partners) the riskier projects. Some of the top-grossing movies ever started out being the riskiest, so they’re not doing anything wrong, just being good managers.”

That said, he adds, “If a studio feels like you’re a good long-term partner it will try to keep you around. We’ve seen some studios retroactively lowering the distribution fee and cutting the client a check … and maybe identifying a promising film for them that will help their economics.”

“I’d characterize it as a very rational marketplace,” Prough says. “No one is panicking … and a lot of the players who have invested are trying to figure out ways to improve their structures with the studios to make it permanent.”

The pie may be growing. Wall Streeters note more foreign institutions are stepping up. And bankers Stateside have begun courting investors in Europe and the Middle East. Dresdner, for instance, is planning a conference in London next month to introduce slate financing across the Pond.

But some doubt the slate business will expand much beyond U.S. and Canadian cash. Hedge funds are much scarcer overseas. And, notes one financier: “Wealthy individuals in Dubai and the South of France are usually the ‘ever chasing and never showing up’ money.”