Dr. P.V. Viswanath

pviswanath@pace.edu

Hollywood's new golden goose.

By Edward Jay Epstein, Posted on Slate Monday, July 11, 2005, at 3:47 PM ET

Ever 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 control.

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.

A 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 movies.

After 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.

Despite 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%."

As 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 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.

Questions:

1. Why are hedge funds interested in making movies?