Author:  Paul Kent Senior Vice President, Structured Corporate Finance, Citibank

Investment Conditions in the Film Industry

Market conditions are generally very good for investing in the film industry and, despite a great deal of reluctance from the City to invest in British films, have been for many years. Global distributor revenues from film have risen by more than average stock market returns in the past ten years and have not experienced a single year of negative growth in that period. Indeed, this pattern of regular growth in distributor revenues can be charted back over thirty years and is reliably forecast to continue at a rate of almost 8% per annum to the end of 2005. Furthermore, the industry is regarded by Standard & Poor's as "generally recession-proof" because people tend to continue to spend on low-cost forms of entertainment, particularly films, whatever the state of the economy.

In the UK in recent years, the availability of sale and leaseback deals has definitely encouraged private investors to consider film as a suitable medium for investment by providing them with a tax break to offset against other taxable income. The same is true of a number of other international jurisdictions. However, as the major studios suffer increasingly from capital constraints imposed on them by their parent companies and recently popular financing markets (such as German Neuer Markt) collapse, there is a real need for a new source of capital to be injected into the industry. Small, lean production companies backed by private investment structured in the form of a partnership may go some way to filling the gap that is becoming apparent. With the major studios increasingly focused on the business of distribution and the production and release of expensive franchise movies, these new companies may become the providers of traditional low- to mid- budget film product into a system that is desperately in need of quality, independently-financed product to fill its distribution pipelines.

Alternative Equity Financing Models for Film

Typically, film investment vehicles have tended to be structured around a separate special purpose vehicle set up to make the film, into which are poured debt and a limited amount of equity financing that has been raised by the producer. The producer then sells the finished film to the providers of the sale and leaseback finances (in return for a contribution to the production budget) and leases it back for theatrical distribution and other forms of exploitation. Usually, the equity investment in any film financed in this way is very low (representing a portion of the present value of the tax benefits derived from transferring ownership of the underlying film rights) - most of the production budget is provided by loans backed by pre-sales of the film into different territories and different media. However, increasingly, banks and other financial intermediaries are seeing film as a yield product: i.e. an investment product that, if structured properly and with appropriate risk controls applied, can give a reasonable rate of return over a period by generating distributable profits from the slate of films invested in.

Partnership Film Financing

Citigroup has developed a new form of limited partnership - Partnership Film Financing - intended to create a more substantial equity investment vehicle for high net worth individuals wanting to invest in film with a reasonable expectation of making returns at least commensurate with, and potentially significantly in excess of, other investments with a similar risk profile. Partnership Film Financing is structured as follows:

Equity is raised from a number of individuals wishing to invest in the film industry. A proportion of the total amount raised is transferred into a limited partnership established with the purpose of investing in film production. The partnership enters into a service agreement with a film production company to develop and produce a slate of films, for which they will have a distribution deal in place guaranteeing North American distribution (typically with one of the major studios). This gives the benefits of North American distribution without the disadvantages of financing films through the studios, such as studio overheads and fees which take away a large proportion of any upside from the film.

For each film to be made under this service agreement, a separate special purpose vehicle is established, into which is directed cash from the partnership for a defined portion of the production budget, with the rest being raised using the traditional methods of borrowing against pre-sales (or perhaps through a direct investment from the studio in return for certain distribution rights beyond North America) and trying to attract any subsidies that might be available if the film qualifies as British or is made as an official co-production. The expectation is that the US distributor will be involved in the greenlighting decision on each film, but that this process will be streamlined because of the ongoing relationship between the distributor, producer and financier. Effectively, the partnership will become an important source of supply of films to the studio, which is constantly in need of film product to fill its distribution pipelines.

The equity to underwrite the partnership must all be in place before the first production investment takes place, and the first films typically be financed from equity before any debt is drawn down. This enables a revolving debt facility to look to the equity portion of financing as a buffer providing additional security such that the debt financing effectively can be seen as a revolving liquidity facility for the partnership. Any net revenues returned to the partnership will also be re-invested to reduce the call down of the debt and keep financing costs to a minimum. Once a given number of films have been made (typically at least 20), any income accruing to the partnership will be held for payment out to the investors either as dividends or as a lump sum at the end of the partnership. At the end of the partnership (which is intended to run for just over five years to allow all of the films produced to go through their first run of theatrical exploitation), the rights remaining within the partnership will either be sold off to an established film library and the proceeds from the sale added to the investors' equity to be divided between them, or the entire structure will be refinanced with new debt and equity raised to allow for another cycle of production, this time additionally supported by the library income from the existing film rights that would be bought into the new partnership.

Using this vehicle, each investor's risk is spread across a sufficient number of films to give the best possible chance that, over the course of the whole slate, the profits from the successful films will outweigh the losses from any films that do not recoup their costs. By working with well established production companies, and ensuring that US distribution is in place for the whole slate, analysis suggests that across a slate of 20 films, equity investors would be expected to achieve double digit returns on their investment over a five year period. One reason for the skewed distribution of returns that exists for film releases i.e. it is typically the case in the industry that hit movies always make more money than poorly performing films lose. However badly a poor film performs there is always a limit on the downside to the partnership - if not one single person ever sees the film at the cinema or in any other medium, the biggest loss the partnership will make will be its portion of the production investment and marketing spend, which is always less than the whole because of the risk borne by pre-sales distributors and the main studio distributor through their share of the up-front expenditure. If, however, a film is successful, there is almost limitless upside potential. Small budget films like Four Weddings and a Funeral and The Full Monty have demonstrated the extraordinary returns that can be generated by unexpected low budget hits, while the studios regularly make triple figure returns on films that have cost a fortune, but go on to take many times that amount at the box office and through home entertainment and ancillary revenues.

The size of the slate, involvement of producers and distributors with a good track record and structure of the financing should minimise the risks involved in this form of partnership. The remaining risks are that the film industry itself will suffer a major decline (although projections would suggest this is unlikely, issues such as piracy and copyright theft are not yet fully resolved) or that the slate will not achieve any hits early enough in the partnership to keep it in funds (and it is here that the track record of the production company that backs the partnership will be a major factor).

Top Tips 

• Market conditions in the film sector are good, with a history of unbroken revenue growth which is forecast to continue into the future. There is no reason why film should not be an attractive proposition for investors looking for above average returns.
• Market conditions in the film sector are good, with a history of unbroken revenue growth which is forecast to continue into the future. There is no reason why film should not be an attractive proposition for investors looking for above average returns.
• New financing mechanisms like Partnership Film Financing look to generate a good return for investors from a slate of films whilst providing rigorous protection against the risks inherent in provided financing to the film industry.
• The key to the partnership's success is the relationship with a production company with a good track record and having US distribution in place to support a sufficiently large slate of films. These elements bring reasonable confidence that the slate of films will be successful.
• A hit movie always makes more money than a poorly performing movie loses. Across a slate of 20 films, just two or three hits will all but ensure a positive return for investors, based on over 30 years of historical performance data from the film industry.