Big Deals Are Sequels to Tradition In Hollywood

By Steven Pearlstein
Wednesday, May 17, 2006

It's a story line almost as old as Hollywood itself.

Guy makes a fortune bootlegging whiskey, or manufacturing TV sets or selling his dot-com. Thinks he can replicate his success with movies. Posts an early success but quickly succumbs to the glitz. Gets snookered by the studios and the actors and winds up paying too much money for too much risk. Loses shirt. Leaves town.

There were Joseph Kennedy, Howard Hughes, the Japanese and those dentists from Dubuque. Now, in the latest remake of "The Carpetbaggers," hedge funds and private-equity boys have arrived noisily in Hollywood. Having already bid up the price of stocks and junk bonds, real estate and commodities, and with cash pouring in at the rate of $12 billion a month, they are about to create another bubble, this time in "entertainment assets."

The "deal factory" meets the "dream," as Daniel Gross described it in Variety earlier this year.

In truth, Wall Street has quietly been financing the movie business for years. It was Wall Street, after all, that took the studios public and still makes good money arranging for them to be bought and sold with some regularity. And over the years, J.P. Morgan's office in La-La land has painstakingly built a $7.5 billion portfolio of movie loans with the help of a computer model that has been remarkably prescient in calculating box-office success and failure based on genre, actors, directors, target audience and the season of the year. By spreading its risk over scores of different films, imposing tight covenants on production spending and syndicating 80 percent of the loans to other banks, J.P. Morgan has enjoyed a steady stream of above-average profits for its movie-lending business.

With the arrival of the hedge fund and private-equity cowboys, however, things have moved far beyond the traditional banking and investment banking relationships. Last year's $1 billion purchase of Dreamworks by Viacom was financed with the help of private-equity money. And when Bob and Harvey Weinstein wanted to launch their own studio after breaking away from Disney, Goldman Sachs put together a $1 billion package of equity and debt financing, most of it from private investors.

But the real breakthrough came two years ago, when Merrill Lynch raised $230 million for the Melrose Partners fund, which will pay as much as 20 percent of the production costs of any movie produced by Paramount studios. That was followed by Legendary Pictures' five-year, 25-picture, $500 million deal with Warner Bros. And earlier this year, Deutsche Bank helped raise $600 million for Relativity Media to finance roughly half the production costs on 18 movies to be produced by Universal and Sony in the next two years.

All of those deals are premised on the knowledge that roughly a third of all movies lose money, a third break even and the rest strike it big enough to cover the losses and generate a 10 to 15 percent overall return. Like other structured finance arrangements that are all the rage, they involve a mixture of debt and equity that is sliced and diced according to the risk appetites of banks, pension funds and private-equity investors.

The details vary from movie to movie, fund to fund. But in general, the gamble is that with all the new markets for entertainment products and the new media for distributing them, the odds have improved that even mediocre movies can turn a profit.

I have no idea whether that is true. What I do know is that the people who are probably in the best position to know about all this are the movie studios, which are now parts of giant conglomerates that throw off lots of cash, have plenty of access to capital and are structured to take advantage of a diversified portfolio.

So if this is such a great investment, why are they so eager to let others in on the deal?

Maybe the answer is that in many of these deals, the studios have the right to hold out some of the best prospects from the joint-financing arrangements.

Or that by the time the movie theaters take their 50 percent of ticket proceeds, and the studios take their 15 percent distribution fees, and the banks get their loans back with interest, and the insurance companies are paid 3 percent of production costs to insure against cost overruns, and the studios are reimbursed the $150 million it takes to produce and market the average film -- and once the big-name actors and directors and their agents take their "points" off the top -- there's not a whole lot left over for the equity partners.

It will take years before the last of the DVDs is sold and the last check received from Showtime to determine how it all comes out. But my guess is that when that day is reached, the returns on these movie investments will turn out to be rather mediocre, and that the flood of hedge fund and private-equity money will have simply bid up the incomes of Tom Cruise, Steven Spielberg and their agents.

And where do you think Cruise, Spielberg, et al. will put all that money? In hedge funds, of course.

Steven Pearlstein can be reached atpearlsteins@washpost.com.

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