The numbers behind the industry.
Romancing The Hedge Funds
Hollywood's New Golden Goose
since Hollywood established its powerful hold over the global
imagination, its leaders have sought outside investors to
help pay for their movies. The list of these "civilians"
stretches from William Randolph Hearst, Joe Kennedy, and
Howard Hughes in the 1920s to Edgar Bronfman Sr., Mel Simon,
Paul Allen, and Philip Anschutz in more recent times. The
problem with such super-rich investors is that they want
to participate in the selection, casting, and production
of the movies. (Hearst, Kennedy, and Hughes, for example,
all insisted that their mistresses be given choice roles.)
Other civilians, such as the thousands of investors in Disney's
Silver Screen partnerships, sought only the tax-sheltering
benefits. Yet, by the 1980s, those loopholes had been almost
entirely eliminated by the IRS. Studios can borrow money,
of course, but such debt does not look good on their books.
Indeed, the studios face a perennial hurdle: how to get
equity money that does not dilute their shares or their
Just about two years ago, Isaac Palmer, a young senior vice
president at Paramount, came up with a brilliant solution.
Studios could offer hedge funds a cut of their internal
rate of return. This internal rate of return is not limited
to so-called "current production," or the theatrical
releases, on which studios almost always lose money. Rather,
the rate subsumes every penny the studio makes from every
source—including pay-TV, DVDs, licensing to cable
and network television, in-flight entertainment, foreign
pre-sales, product placement, and toy licensing. So, even
in a bad year, such as 2003, when Paramount released such
box-office bombs as Timeline, The Core, Dickie Roberts:
Former Child Star, and Paycheck, its internal rate of return
was around 15 percent. This return also included the profits
from more arcane (and rarely discussed) deal-making, such
as copyright lease-back sales to foreign tax shelters. (Palmer
himself had structured one such deal that netted Paramount
$130 million.) Plus, if the studio has a single big breakout
movie, a Titanic or a Spider-Man, the internal rate of return
can leap as high as 23 to 28 percent.
safe 15 percent return, with a possible kicker in the event
of a hit, proved very attractive to Wall Street. Palmer
and his associates at Paramount worked out a deal with Merrill
Lynch through which the hedge funds will put up 18 percent
of the capital for 26 consecutive Paramount movies in 2004
and 2005 (including War of the Worlds) through a vehicle
called Melrose Investors. (A follow-on deal, Melrose Investors
2, will extend though 2007.) In return, the investors will
receive 18 percent of the money Paramount makes from all
these movies and its offshoot deals.
What Paramount gets out of this partnership is an off-the-books
equity investment, that—crucially—neither dilutes
the stock nor weakens the balance sheet. Since Paramount
can use less of its own money to produce its films, the
studio improves the return on the invested (on-the-books)
capital to its shareholders. What makes a sweet deal even
sweeter is that Paramount also takes a 10 percent distribution
fee off the top on all the revenues (this is also the only
money in which the hedge funds do not share). Since this
cut comes from the gross, it makes Paramount, like superstars
such as Tom Cruise, a dollar-one gross player in its own
the Melrose Investors deal closed in July 2004, Wall Street
began sounding out other studios about the prospect of hedge
funds providing "equity slate financing" for their
movies. Legendary Pictures, for example, was organized as
a vehicle through which hedge funds such as ABRY Partners,
AIG Direct Investments, Banc of America Capital Investors,
Columbia Capital, Falcon Investment Advisors, and M/C Venture
Partners could sink a half-billion dollars into Warner Bros.
movies. But, unlike the Melrose Partners deal, the Legendary
Pictures investors do not participate in the entire slate
of Warner Bros. movies, which means that they do not really
participate in the internal rate of return. Instead, they
get to invest in five movies a year for five years, which,
in theory, will be "mutually agreed upon with the studio"
but, in fact, will be selected by Warner Bros. (since Legendary
hedge-fund investors are on the hook for $6 million a year
in overhead charges if they reject Warner Bros.' choices).
So if Warner Bros. remains true to the hoary Hollywood tradition
of giving civilian investors the short end of the stick,
it will steer this hedge-fund money to its riskier products
while concentrating its own capital on franchise films with
a proven record of success, such as the Harry Potter movies.
As one savvy studio executive explained, "it's a great
hustle" of the hedge funds.
such subtle pitfalls in the deals, even normally staid Wall
Street bankers remain keen on going Hollywood. In April
2005, for example, the illustrious bank JP Morgan sent out
a "teaser" to hedge funds, reading, "Despite
compelling economic returns, major film studios are capital
constrained and often must seek co-financing arrangements
with other studios and other outside sources." Through
a vehicle named Hemisphere Film Partners, JP Morgan planned
to raise $825 million from hedge funds that would then be
used to finance half the production and marketing budget
for studio movies. JP Morgan described the venture as "a
unique opportunity to participate in the most profitable
segment of the motion picture industry," projecting
that returns on investment might "exceed 25%."
intoxicating as these projected earnings sound, the danger
for Wall Street is the extrapolation trap: assuming that
what is (or was) true in 2004 will be so in the future.
Things change, especially in Hollywood. The magical German
tax shelters </id/2117309/> that the studios dependably
milked for substantial profits up until 2004 may soon be
put out of commission by the German authorities. The zooming
DVD sales that supplied such a large part of studios' profits
between 2000 and 2004 could taper off and even decline if
viewing habits change with the use of the TiVo-like digital
video recorders and high-definition TVs. And, of course,
management is always in flux. (The Paramount team, including
Isaac Palmer, upon whom Melrose Investors placed its bet
is no longer at Paramount.) If so, the studios' internal
rate of return might prove, like so much else in Hollywood,
to be more of a mirage than a reality.
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