The narrative in Hollywood films tends to follow a three-act boilerplate — certain things happen to the protagonist at specific points over the course of the movie.
The financial returns on commercial films are never that predictable. Audiences are fickle; technology changes at lightning speed; a star actor draws audiences but also draws an over-the-top salary — whatever the reason, forecasting the net return on a movie can seem like anyone’s guess.
It shouldn’t be shocking then that a number of film-rights securitizations that came out in the mid-2000s slapped junior investors with steep losses.
Not unlike the last survivor in a horror movie, those who took the fewest risks upfront — the senior investors — may have been rattled by what happened to those lower on the capital structure, but they ended up doing fine for the most part.
Everyone, we can assume, is wiser now. But there is still discussion about what structural features, if any, should be rethought to attract new junior investors, or to convince former disgruntled ones that the sequels of the mid-2000s deals are more apt to have Hollywood endings for everyone.
Financing Dreams
Historically, the large filmmaking studios have looked for ways to smooth out the volatility of their revenue streams. We’ve all heard of the blockbuster with a monstrous budget that nearly sinks an established studio when the movie bombs big-time. One of the most high-profile disasters of our time, the sci-fi mess “John Carter,” was the primary catalyst of the Walt Disney Company’s loss of $84 million in the quarter ending March 2012, according to news reports. Rich Ross, the head of Walt Disney Studios, resigned shortly thereafter, apparently as a result of the film’s spectacular failure.
One of the ways for studios to mitigate these risks is to bring financing partners on board. In co-financing arrangements, a studio surrenders a share of the film rights — and the vicissitudes related to a movie’s performance — while maintaining the distribution rights, which is a percentage of the gross receipts. As integrated entities, studios not only make films, they also own the distributor of those same films. This obviously creates a huge incentive to hang on to the distribution fee.
“Studios feel that the distribution fee compensates them for the large distribution overhead they have to maintain in order to exploit the films produced,” said Richard Reiner, the owner of Shooting Star Pictures, a shop that specializes in structured investments in film and media.
The distribution fee is also a more predictable flow for studios.
Co-financing can involve a single film, a slate of future productions or movies at varying stages of production, or a library of films that have already been released and have something of a track record.
Many other arrangements are possible as well, including vehicles that seek to profit from tax incentives.
In the case of independent studios, known simply as independents, deals often have to be structured in a way that reflects an arrangement in which the distributor is not part of the company that made the film. As a result, a producer will pre-sell the film to distributors here and abroad. “Independent deals tend to have more parts as opposed to a studio deal, [where] you’re the investor and you have one partner in the deal,” Reiner said.
Enter Securitization
Securitization was a natural evolution from co-financing arrangements, particularly for studios and independents looking for longer-term funding.
The seed was planted in the mid-1990s. In November 1995, Citibank closed New Millennium, a $1 billion transaction for 20th Century Fox. “New Millennium was really the first deal of this type to utilize the structured finance and securitization technology we know today,” said Patrick Russo, senior managing director of FTI Consulting. He was until recently a principal co-founder at Salter Group, which joined FTI in early January. The Salter Group specialized in forecasting and valuing intellectual property rights in the entertainment industry and other sectors.
A couple of years after New Millennium came a slightly larger deal for Universal called Galaxy Film: $1.1 billion. Galaxy funded a combination of pre-sales and Universal’s own estimates on their movies’ returns. Although they used securitization methods, these transactions were still bank deals, according to Reiner.
The embryonic securitizations that appeared in the mid-’90s were a recognition of the benefits of diversification. As a Merrill Lynch report from 2006 put it, they reflected the notion “that the portfolio theory of stocks could also be applied to films.”
Pre-Crisis Bonanza
The mid-2000s saw an upsurge of structures that attracted plenty of non-bank capital. (See the Merrill chart.) Dominion Bond Rating Service (DBRS) estimates that between 2005 and mid-2010, there were roughly $14 billion issued among 35 film-rights securitizations.
As with many other asset classes, investors were willing to take more risk, which in this industry meant the performance of the slate of films.
In a number of cases, many of them private, investors took serious hits.
“There were a number of deals where equity holders were wiped out,” said Chris O’Connell, senior vice-president at DBRS.
Russo said that in the earlier, pre-mid-2000s bank structures, if there was a shortfall in repayment, the lenders had the ability to clawback against those distribution fees that the studio had previously collected. That structural element became far less prevalent in the mid-2000s.
Distribution fees in the eyes of some were too high (it varies but 15% is not unheard of) and had priority in the waterfall structure. In addition, print and advertising reimbursement shifted up the repayment ladder in the 2000s vintage deals.
This exacerbated a misalignment of incentives, according to some observers. In a recent roundtable on film securitization sponsored by Standard & Poor’s, Simon Sominsky, an associate at Guggenheim Partners, noted that a studio can overspend on print and advertising to enhance gross performance to the detriment of net performance. Indeed, there is scarcely a disincentive for them to do this in an arrangement where the net performance will primarily impact junior investors.
When the crisis hit, these structural aspects made junior investors particularly vulnerable. Of course, there were a variety of reasons why deals failed. “Some of the structures had problems from a capitalization or waterfall standpoint — in some cases they had mezzanine debt which was a burden to the deal itself,” Russo said. “And some structures didn’t work because the films simply performed poorly.”
O’Connell added that some transactions suffered because of a high concentration in a limited number of films.
Inglorious Transaction
One of the more notorious film securitizations to leave investors in the lurch was linked to the Weinstein Co., which was started in 2005 when Bob and Harvey Weinstein sold their Miramax studio to Disney.
The transaction came out in late 2005 for $500 million and originally had a maturity of January 2014. It formed part of a financing bundle that also included $490 million in equity and $200 million through other commercial arrangements. Goldman, Sachs & Co. was the advisor on the deal, which initially received triple-A ratings from Moody’s and S&P.
In announcing the securitization, the Weinstein Co. said that it would retain the distribution rights of the films backing the deal.
A wrap from the then-sterling guarantor Ambac Assurance Corp. bolstered the triple-A rating. But then the crisis began to eat away at the insurer’s portfolio.
The deal was initially downgraded to keep it in line with Ambac’s deteriorating creditworthiness as its financial standing eroded over the course of the crisis. But the deal’s collateral was not doing well either. And by the end of March 2009, the transaction — now worth around $463 million — stood at a default-teetering rating of Caa2.
“The erosion in the transaction’s collateral base is largely a function of continued weakness in the home video sector, which prompted a downward revision [of the underlying film assets] earlier this year,” Moody’s said in a report announcing the early 2009 downgrade.
The “ultimates coverage ratio” had tanked. Ultimates refer to a statement of the revenues, costs and related profit associated with a film’s initial distribution cycle, roughly the first 10 years.
Moody’s ’09 downgrade turned out to be the last one the agency performed on the deal.
Its fate was sealed when Ambac, as the control party, waived some of the bond’s covenants, allowing flows from the receivables to be redirected from the waterfall to the originator, according to a source familiar with the situation.
Ebb and Flows
The weakness in “home video flows” cited by Moody’s — while only part of the Weinstein portfolio’s unraveling picture — is another risk that any kind of film financing must address: the evolving mix of revenues.
There are several main sources of film revenue, and they each come into effect at different stages of a movie’s cycle (see chart XXX). But these sources are far from constant, and even their timing can change slightly.
As a general long-term trend, there has been a relative growth in international sales, a shift to home entertainment, and shrinking DVD sales with the rise of digital delivery, said DBRS’s O’Connell.
But the shifting weight of each of these revenue streams can accelerate or suddenly stop. “Recently, there’s actual growth in physical DVD sales, believe it or not, which is really a function of Blue Ray coming on board,” said FTI’s Russo. “And if you look at the development of home entertainment, inclusive of streaming platforms, it appears to have stabilized in North America.”
Reiner added that the future rests largely with foreign audiences (see table XXX). “The international market is not only more important than the domestic market, it’s more important than the so-called digital market, which is very nascent,” he said. “I don’t care if you’re working for Sony or Weinstein or some little production company, international is where it’s at.”
But everyone agrees that, however you expect digital to perform or the tastes of Chinese moviegoers to develop, structures must keep pace with those forecasts.
Recent Activity
Unstable flows and collapsing deals have not prevented the securitization of film receivables, although activity has not quite reached the peak of the mid-2000s.
Russo said that, in the past 12 months, there has been over $1.5 billion worth of structured finance deals closed.
He added that activity in this market has centered on more refinancings and recapitalizations of prior deals with a sizable slate or library of films. “It’s the heavy asset-based deals that have been driving the market in the last couple of years,” Russo said.
A $500-million, two-tranche deal for Miramax that came in November 2011 is a case in point. Led by Barclays, the transaction was backed by a library of over 700 films, among them such iconic titles as “Pulp Fiction,” “Good Will Hunting” and “No Country for Old Men.”
Rated on the cusp of investment grade by Moody’s and S&P, a $350-million A tranche with a weighted averaged life (WAL) of 1.83 years priced at 6.3%. A $150-million tranche with a 4.85-year WAL and a double-B from S&P priced at 13%.
The library-style transaction that Miramax did is not as common as the slate type in the world of proper securitization, according to sources. “Most of us would look at [the Miramax deal] as partial factoring,” Reiner said. “They bought a pile of movies from Disney for which they paid a certain amount of cash, and those movies have a living life.”
Calls for Change
The fallout from the mid-2000s is that some players are seeking to change structures to attract junior capital. Everyone acknowledges that senior investors fared very well in those transactions. Even transactions in trouble that paid off late generally left those at the top of the capital structure relatively unharmed.
Not all structures put subordinated investors in a precarious position. Russo said that there are transactions that feature a put option in which an investor with an ownership interest in the film can sell it back to the studio several years into the deal. “There’s a few deals that have this structural element to them,” Russo said. “From an investor standpoint, that does provide some downside protection, as opposed to not having an exit.”
Speaking at the S&P roundtable, Sominsky said that the approach to distribution fees needed to be changed. He calls for an arrangement where the investors receive a pro-rata portion of the distribution fee that reflects their investment in the negative cost of the film. “That way you increase the velocity with which any film funding facility can redeploy capital and align the incentives of the studio and the co-investor,” he added. This eliminates the incentive that the studio has to overspend on print and advertising to potentially help boost fees that go to them and not the financiers.
Reiner said that the perception that the distribution fee puts investors in a secondary position instead of real partners in securitizations — and indeed other co-financing arrangements — has led capital market investors to eschew the movie industry in the past several years.
“To attract more deals, waterfalls will have to change to incentivize investors to take motion picture performance risk,” he said.
Asset Class’s Appeal
Although junior capital investors might be more wary of the industry than they used to be, transactions have drawn in a wide variety of buysiders.
The effects of the recent crisis notwithstanding, one of the salient appeals of the asset class is that its performance does not move entirely in synch with more mainstream securitization products. “[It’s] not correlated to housing prices and foreclosure levels, demand for new automobile purchases, or levels of consumer unsecured indebtedness on credit cards or repayment,” said Lewis Cohen, a Clifford Chance partner at the S&P roundtable.
He added that these secure financings, when they perform, can deliver a higher rate of return than plain vanilla instruments.
Russo said that the sector has historically attracted a mix of investors apart from banks, including private equity funds, hedge funds, pension funds, and high-net-worth individuals.
What’s Next
Reiner of Shooting Star Pictures said he was working on a couple of deals and believed there would be more transactions this year, concentrated in the major studios.
According to Sominsky, a number of legacy financings are reaching the end of their reinvestment periods. He sees this as a challenge for the moviemakers to consider rethinking their approach. “I think that will be the year where studios are forced to decide whether to capitulate on terms, rely on more in-house financing, or look for risk-mitigation sources outside of the American and European capital markets.”
Russo said that there are several structured finance vehicles in the movie industry currently in the market. “Some of them are new entities that are being formed and are now in the process of raising capital,” he added.
