GUIDE TO THE DA VINCI CODE OF FILM FINANCE 2006 The Producers Guide.pdf · business currently. The...

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GUIDE TO THE DA VINCI CODE OF FILM FINANCE 2006

Sample Article

THE ART AND SCIENCE OF MOTION PICTURE INVESTMENT

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MMAAGGAAZZIINNEE Welcome to the HHOOLLLLYYWWOOOODD BBAANNKKEERR MMAAGGAAZZIINNEE.. This is a sample article which has been written and designed to show potential contributors and intellectual copyright providers the style and content of our upcoming Inaugural Issue. This article and related material are not for publication and provided purely for purposes of respective parties’ approval processes. Copyright to the material and sample images are specifically reserved in favor of the owners these respective interests. HB is a new industry magazine that uses the Art of Motion Pictures to provide cutting edge commentary on the Science of Film and Television financing.

HOLLYWOOD BANKER.COM

Contents: Intra Nationalism- De-verticalization- Hedge Fund Mania- Demise of Star Power- Financial Innovation First Wave Intra Nationalism of Soft Money- Capital Markets Implosion As Soft Money Exits- UK- Germany- The Fall Out-The Present Second Wave Global Corporate De-verticalization- Disaggregating Core Functionality/ New Capital Structure- The Pod Revolution Third Wave Hedge Fund Equity Players Enter the Game- Capital Market- Off Balance Sheet- Private Equity Finance- The New Brides Soft Money Distortions-Law of Large Numbers- The De Vany Mathematics- First Cracks Appear- The Ultimate Demise Fourth Wave The Demise of Star Power & New Rules of Talent Acquisition No New Stars-Bloated Cost Formulae- Re Inventing the 25% Team Fifth Wave Innovative Capital Market Production Finance Tools- New Business Process Structural Models- Approach Thinking- WACCO- SPAMM- LIPS- SPV- SPA- SPV – POD New Deal Techniques- Rise of the PODS- Soft Money Capital Market Strategy-Monetization- Equity On Sale- Self Monetization- Incentive Maximization-2006 Style- Shelter to Shelter- Shelter to Subsidy-Subsidy to Subsidy- Internal Subsidy on Subsidy- I Never Knew What I could Not Know Thinking-Deal Analysis Decision Matrix- Hard Equity Financial Innovations-The Lake- Fractionalized Equity Ownership- Revenue Participation Agreements- Synthetic Notional Securities- 12 x Equity Innovations 2006


The last year has been spring time for the Hitler’s of film finance. New seductions weaved from the same old bag of deal tricks, were artfully repackaged and sold once more to a new breed of hopeful investment gurus driven by a Dr Robert Langdon code breaker style rationale. Neophyte genius came to the Hills of Beverly seemingly unaware that the spirit of the Bailystock and Bloom mentality thrives deep in the Hollywood heart. A dark place where battle rages on between the Opus Dei conservative proponents of the Studio game and the Priory Sion of would-be free agent players seeking the right to practice art. At stake is nothing less than the future of the film businesses core religious focus - money! Production coin is the Holy Grail of sustainable long term economic freedom for the film business. True wealth and freedom to pursue creative thought is what all reel believers truly seek, no matter what their faith maybe and the film business is no exception. The faithful still strive to unlock the movie industry anagram which is the critical keystone to finding the Holy Grail of long term production finance. Like the “SO DARK THE CON OF MAN” anagram unraveled in The Da Vinci Code movie, the words THE MOVIE INDUSTRY themselves hide a dark prophetic secret. One that, if you still cannot work out after reading this article may, if you look carefully appear at the end of this work.


“ Opening Night…. Will it flop or will it wow! We can’t believe it! How’d he achieve it! Against all the odds! It’s the worst show in town! We have seen crap but never like this! What a disaster!

We are in shock who wrote this schlock! Max Bialystock!”

The Opening Chorus from The Producers reveals that art does in fact imitate life in Hollywood 2006.


AARRTTIICCLLEE SSYYNNOOPPSSIISS Hollywood Banker borrows from the wit and wisdom of Mel Brook’s timeless emblematic work, The Producers, and underscores how Hollywood still adopts a take no prisoners business posture in dealing with civilian investors new to the game. The Da Vinci Code provides inspirational direction as HB seeks to unravel the latest plays in how film finance technique and practice impacts on the art and science of motion picture investment. TTHHEE PPRROODDUUCCEERRSS GGUUIIDDEE TTOO TTHHEE DDAA VVIINNCCII CCOO DDEE OOFF FFIILLMM FFIINNAANNCC EE In a year characterized by seminal events, the whole economic base upon which the film business operated was once more transformed. Money flows constantly into Tinsel Town and in 2005/2006 it came from heaven to replace ever widening critical holes in production financing models that depend on “dumb” equity. A gap caused by the demise of tax shelter finance from countries around the world. As usual the waves of short term relief from this new cash came at an as yet unknown long term cost to the future financial fabric of how the movie business can weave deals. Hollywood business logic is in for a shock as it feels the stings of a new industrial revolution in multinational corporate culture. This new economic age will change forever the mosaic of how all film deals can be done. Film industry fame and fortune now more than ever is caught up in a deepening maelstrom of economic uncertainty. Whilst the new “dumb” money lasts it is truly spring time for “the producers” of 2006. Yet despite the light of economic nirvana a darker reality is on the way to visit all seekers of the Holy Grail. Our romp of timely insight goes behind the veneer of factual industry reportage. HB provides readers with detailed commentary on the real meaning behind the new rules of the dream factory’s latest money game.


Dialogue from The Producers Leo Bloom sings........ The industry hymn! “I want to be a Producer! A Producer is what I want to be! I want to be a Producer and lunch at Sardis very day! Sporting a top and cane I want to drive those chorus girls insane! I want to be a Producer of a smash who covers himself in cash! I want to be a producer and sleep in until 2 every day! I want to be a Producer with a great big casting couch! I want to be producer and wear a tux on opening night! I want to see my name LEO BLOOM up in lights! I want to be the biggest and the greatest producer in the world! I want to be, I want to be, I want to be a Producer because it’s everything I am not!” Leo Bloom expresses in song the daily life aspirations of would be industry players and the inner desires that feed so many of the Hedge Fund investment managers of 2006. Many like Leo have embraced the dream, falling for the timeless seduction of being a producer.


FIVE WAVES OF CHANGE

Prequel The Producers hit theatres late in 2005, a remake of Mel Brook’s satire on what it takes to be a Broadway producer. This timeless work bears an uncanny similarity to the reality of the film business currently. The film finance business from early 2005 can best be described as life imitating art. Max and Leo’s thinking shapes and exemplifies much of the life of those who seek production finance in 2006. The finance culture of the film business was hit with 5 distinct waves of change over the 2005/2006 period. First was the wave in intra-nationalism to hit soft money finance that left a gapping hole in capital markets. Second was the wave of de-verticalization seen in the precursors of off-shoring and out-sourcing that lead to the Studio’s reducing their “risk” operating capital available for production. Third was the wave of hedge fund lead private equity that came to plug the hole in the capital markets, but at what long term cost to the business? Fourth was the wave of the demise of star power status and compensation value. Fifth and here today, is the wave of financial innovation and core business model realignment. The film industry after the roller coaster ride of the last 2 years, must realize that repackaging old tricks is not the way to achieve the Holy Grail of a mature, long term global capital market. A new day has already dawned and the reality of a leaner, meaner film business model is already biting deep into the fabric of what once was the comfort of the Hollywood life.


Dialogue from The Producers In the scene where Max and Leo will do anything to get Franz to agree to sell them the Broadway rights to Spring Time for Hitler! Even if they have to go so far as to pay for them! Leo “Max we shouldn’t have started this, we shouldn’t have started this.

We are getting in too deep…… Max we are getting in too deep…” Max “Nonsense, I will tell you when we are getting in too deep.... this is nothing…..” Franz “What niceshhhha guyyyys…… I haven’t been this happy since we crushed Polannnnnddd.. ! Here Leo first gets a hint unlike many real Hollywood players, that breaking the Siegfried Oath means Deassstttthhhhh! Max, like many who take free cash can’t see that the price of the coming tide is already lapping around them.


FIRST WAVE

The Intra- Nationalism of Soft Money

Capital Markets Implosion as Soft Money Equity Exits In early 2005, HB wrote an article entitled BE COOL GET INTRA-NATIONAL which as it turned out, predicted every major change in the film finance business that came about in the last year. This approach thinking, predicted a tsunami was coming to drown the world of production financing. A world that was dependent on soft money tax incentives post the demise of gap and short fall insurance based financing. More significantly this article identified what would be the likely impact on film deal making and Hollywood’s operational mantra. Many countries (and states/provinces within certain countries) modified their incentives to more intra-national focused models, driven by the need to protect themselves from potential or actual abuse. Two major cross currents hit the world’s shores at the same time, dealing a double blow to the film business’ core economic viability.

1. The demise of bottom tier equity finance from tax shelter driven deal models

2. The move from complex tax

shelters involving 3rd party investors, to activity based subsidies paid direct from government to producers.

The UK and Germany, the 2 key lynch pins in the world of tax driven film finance, were taken away from the game at almost the same time.


United Kingdom Dialogue from The Producers Cop “Hey Sergeant!! I found two accounting books, this one says SHOW TO THE IRS and this one says, DONT SHOW TO THE IRS…!” Sergeant “The three of you better come with us….” Max “The three of us but….??? Sergeant “Three, you and them two sets of books….” As Max found out to his cost , keeping two sets of books one driven by form the other by substance is a recipe for trouble. The loss of Section 48 & Section 42 Sale and Leaseback financing in the UK was more significant than the mere numbers by themselves reveal. Sale and Leaseback structured finance deals contributed approximately 8-15% to a film’s finance puzzle. Due to the nature of the deals constructed, this finance contribution was also “free money” to a producer as it usually had no or very limited recoupment rights. However more critical was the fact that UK’s status based incentive allowed the film to double dip other nation’s activity based programs under the co-production model. This was a critical side benefit of

deals involving the UK. HB’s, Be Cool Get Intra-national article explains the benefits to the producers and the resultant cost to the UK tax base in more detail. In summary, the 8-15% finance contribution to a film was being provided by the UK government at a cost of approximately 40% and the resultant deals usually saw at most only 30% of the production activity (usually post production) occurring inside its borders. In 2005, the UK announced that it was switching to a new intra-national incentive program created by way of direct tax subsidy at 20% or 16% of qualifying spends (depending on total budget levels). This program will cost the UK tax base approximately half that of the former program. The subsidy on the surface while generous comes at a price, as it does not facilitate the double dips of the past. The new rules will provide for UK subsidy payments in co-production models, however the amount will be minimal unless UK is the majority partner. In limited circumstances double dips using the UK can still happen, but they require the minor nations in a co-production deal to assume the former UK position in deal making. Global tax office intelligence communications between countries within the OECD means structuring aggressive deals on unsuspecting territories is likely to lead to harsh outcomes for those promoters.


Germany Dialogue from: The Producers The Opening Chorus from “Springtime

For Hitler! “It is Spring Time for Hitler and Germany the Rhineland’s a fine land once more! It Spring Time for Hitler and Germany we are marching to a faster pace look out here comes the master race! We are going on tour and it is winter for Poland and France! It is Spring Time for Hitler and Germany……!” This opening number was more than an emblematic representation of how German Media Funds worked and how they were used in Hollywood before 2006. 2005 also saw the demise of the German media funds, which in the preceding 5 years pumped billions of dollars of equity into Hollywood film deals. Typically a German deal contributed 30-35% of a production’s total budget. Similar to the UK Sale and Leaseback deals, this money was free or had very little recoupment entitlements. The wiring diagrams for these German deals looked like something from The Da Vinci Code. The deal structures created up-front Year 1 leveraged tax write offs equal to the total production cost for German investors. Economic gain was created by the deferral of taxes until a much later tax year, where a revenue

guarantee supported by long term bank deposits, would pay back the loans made available to the investors initially to sign on to the deal. The problem was that despite many special purpose entities being created to affect the form of these deals, the circular nature of the money-go-round and lack of real commercial value undermined the economic substance behind them. In reality the German investors got to split tax savings from the film deal with the producers but were never really at risk and there was very little intention to share in the real revenues generated during its exploitation. The German money also came with few constraints in relation to spending the money inside the country. It could fit seamlessly with other nations such as the UK, Canada and New Zealand and their soft money programs to create double dip benefits for the deal. OLD MULTI DIP GAMES As an example, when combining these deals under the European Convention model, many films could with 35% German money, 15% from a UK Sale and Leaseback arrangement, say 10% from a 3rd nation’s program and pre-sales of 20% over minor territories, leave Studios with most rights intact at a cost of only 20% and that seems to match the overhead they charge to the film.


The Fallout

Dialogue from The Producers “Bom Da, Bom Da, Bom da… Unhappy! Unhappy! Very Unhappy! Very Unhappy! Very very very very Unhappy…… Unhappy!” The Whitehall & Marks accounting clerk chorus is a seminal mantra for many nation states whose soft money tax shelter laws were taken to the edge costing them billions in unintended losses of tax revenue. In both countries the deals and the laws were attacked by the corporate and revenue authorities. Tax deductions were declined or reversed from the past, warnings announced about future deals and the laws modified or withdrawn completely. In Germany, some media fund promoters were even charged with criminal fraud, something that has yet to happen in the UK, but could. The deals at securities law level failed to realize, let alone cover and also never disclose, the lost of the opportunity cost of the tax savings going to the film investment. The loss of this tax money via the split into the film combined with the unlikely event that no further returns outside of the initial structures created, needed to be disclosed and signed off by the investors. Such a disclosure is unlikely to be included as part of an offer document. Real equity has a real price and while risk can be mitigated to a low level, the lack of a real price for the money meant the whole deal form

lacked substance. Despite the form and illusion of being an investment, these contributions were called a subsidy in many deals and a straight contribution to the budget. Where soft money deals lack substance then the precise legal form and detailed wiring diagrams of inter- linked SPV entities to affect the money magic are doomed from inception. In situations where the economic house of cards is stacked to ensure not even the capital invested is returned, then the only true intent that can drawn is to make a loss not a profit. The combined losses of the German and UK contributions to a project’s finance plan came as a brutal shock to the unprepared. Now this massive loss of deal making capital meant the gap had to be filled and quic kly, either with the house’s own money or OPM, who not only do not want a return but may not even get their money back. Not something that is easy to find….The new soft money world post the demise of UK and Germany, has seen many countries provide subsidy incentive programs instead of tax shelters as they are cheaper to provide. However, the loss of tax shelter investors around the world has created a loss of deal flexibility as their involvement came often at a lower price to the producer. The “dumb” tax shelter money was off the books, tax free and often carried few if any negative economic trade offs. Today, new soft money programs are harder to double dip, taxable when repatriating them back to the ultimate deal motivator and come with a number of mutually exclusive creative and activity constraints under the co-production model.


The net result is the amount being kicked into every deal is less. Some deal makers are slow to give up their favorite party tricks and new rules mean new attempted plays. Some are trying to create new UK tax shelters in the UK while others are trying to export the previous culture out of the UK, onto some virgin territory or state. For example, Nation A pays labor incentives on resident salaries of its cast & crew and Nation B has an activity based program whereby the labor from Nation A will count as qualifying spend in Nation B. These can be legitimate plays albeit complex when one has to deal with double tax treaties and local labor withholding tax liabilities. Another play particularly under co-productions, is applying for equity investment from government bodies in deals where the most lucrative territories are already fractionalized. The equity from the film bodies is usually structured as bottom-tier equity that rarely gets repaid. The rationale for this new limited source of money is that it does get paid back indirectly by the economic activity generated in the respective countries that self-finance the loss. However, governments will examine their programs if they consistently receive little or no direct payback from the films they invest in. The soft money game is now played in a way that sees local tax collected on foreign actors and/or crew, along with local direct and indirect taxes (e.g. VAT and GST) on total economic activity, self finance the payment of the incentive

upfront. Most new programs pay incentives upon the completion of production after having collected the taxes along the way. The downside of this trend for independent producers is that this throws up yet another cost and another core finance problem as the soft money needs to be monetized upfront. Investor contributions via tax shelters were usually paid upfront to a producer. This monetization comes at price and also the challenge of limiting any security required to that of the potential incentive only without impacting on the remaining collateral package available for other purposes. The amounts of money now coming from soft money have on the surface, on a single nation basis, appear to be on the increase. Yet this is of little comfort or real help, as the intra-national rules limit how one can stack the deal and does not match the old money available in a double-dip or co-production world. The previous 50% tax free equity contribution to a film deal is now less than half that and is often taxable and no longer paid upfront. Worse is that off-balance sheet tax shelter equity had many favorable impacts in the financial accounts of Hollywood players as the new hedge fund investors are about to discover. An off balance sheet equity partner does not get accounted for as revenue or may not be split with other deal participants. In the brave new world of soft money revenue, it may not only be taxable but also accountable to other deal participants.


The cost to Hollywood of this first wave of intra-nationalism was devastating and mostly the real impact of these hits went unreported in their true impact on the financing game. The loss of free money reduced much of the core current Studio production slates. For a split second it had to contemplate the unthinkable and actually invest in its own product. However along came the Hedge Fund players (discussed in the 3rd wave of change later) to fill the void but as they will find out intra-nationalism has changed the amount of free money available in deals forever. The Present Ulla shows exactly why you have to put it all on display no matter what the context of the seduction. Dialogue from The Producers “If you got it flaunt it, step right and do it! Flaunt it! You gotta step right up and strut your stuff… people will tell you modesty is a virtue but in the theatre it can hurt you. If you got it, flaunt it….!” Ulla describes why the casting couch of foreign tax incentives works as well for all Producers as it does for Max and Leo. Both deserve a standing ovation even when one is sitting down. Post the wave of intra-nationalism, countries everywhere (new to the game and past masters) are offering incentives to lure Hollywood to their shores via high percentage based rebates, tax credits and cash handouts and zero interest production loans. Key US States like Louisiana, New Mexico and Hawaii keep upping the ante while they are pursued by new entrants such as New York. The new double dip within US

borders for smaller budget films ($15-$20m), comes in the ability to mix the State incentives with the new Federal incentive – Section 181 of the American Jobs Creation Act. There are teething problems under Section 181, due to the unclear status of residuals/variable deferments being included as part of the maximum threshold qualification requirements and its interaction with some of the US’ general tax laws i.e. active vs. passive investor definitions and Capital Gains Tax. Also, unlike some other international revenue authorities, the IRS understands the concept of leverage abuse and the application of their “at risk” laws. This will reduce the ambitions of some who plan to bring Sale and Leaseback style structures to the US. Mixing a federal tax shelter and a tax subsidy within one country is also possible in other jurisdictions such as South Africa and New Zealand. Canada recently increased its labor based incentives and Australia is reviewing its current programs and daily new nations come to the soft money party. Sadly while these are all positive outcomes the intra-national nature of such new programs is not enough to fill the hole left from the demise of the double dip market pre the demise of UK and Germany.


Dialogue from: The Producers Leo and Max Sing… “We can do it. We can do it…. We can do it we can make our dreams come true…. Beautiful Girls wearing nothing but ermine and pearls! We can do it! We can do it! Say good bye to petty clerk! Say hello Mr. Producer! Yes, I mean you, Sir! We can do it! We can do it! Find me a chance to be a Producer! Find me away to make my dreams come true Sir! You see Rio, I see jail! We can do it… we can make our dreams come true…!” Leo and Max dream in song of a better way of doing things even if it is risky. The industry likewise finds external change means many will no longer be petty clerks but increasingly the Producer’s they always dreamed of being.


SECOND WAVE

Global Corporate De-verticalization

Disaggregating Core Functionality/ New Capital Structure

Many in the film business, like much of America in 2004-2006, are becoming aware of a fundamental business process change that has been taking place across the globe. A new industrial revolution lead by the decline in business interaction costs, has seen the widespread de-verticalization of corporate business structure. De-verticalization is a process characterized by the process of separating functions and services from the internal workings of vertically integrated companies. Companies undergo such changes to operate more efficiently and create improved results by using partners to perform key functions. The use of partners who over time create new economies of scale based on an industry rather than a company only model. The automotive industry has seen Ford and GM become victims of the inability to become early adapters to such change. The US auto industry, stuck in vertically integrated mode performing all functions in-house, lost its competitive advantage with other cutting edge competitors. Companies who out-source and off-shore most of their functions enjoy lower cost structures and greater operating efficiency than vertically integrated competitors.

The major players in the film business are in many cases, owned by multi-national companies who in all their other activities, are deep into de-verticalization mode to survive in a global economy. The film business was not slow to follow suit and to off-shore /out-source functionality, lower production cost structures and obtain off balance sheet capital. Runaway production and the SAG counter move of Global Rule One were evidence that Hollywood had moved to do so. The wrist length web of house keeping deals exported producer talent to the Studio Lot within easy reach and control. Yet these processes did not change the core functionality or the operative business structure or culture of the film business. Inflated negative costs and salaries and 1st dollar gross participations were still the order of the day. Rather than saving money the Studios were using de-verticalization savings to afford the price of the cab fare to the theatre. The real problem was that the First Wave only added to a fundamental business process change that was already over due. The corporate masters of the Studios want to see higher levels of business savings garnered from the export of functionality and capital market investment strategies.


The core functionality model of the studios has to change to meet the reality of global market economics. Studios do not need the production lot and could better invest elsewhere. The demise of the lot is inevitable as in a global market place studio production space can be found everywhere. The Hollywood entry barrier of Tinsel Town production expertise is now a dead letter. Once upon a time, Hollywood had a core production advantage due to the legacy of years of hands-on experience. This entry barrier no longer exists in a world where talent is available everywhere and due to computer driven communications can seamlessly move borders. The runaway production bubble has seen many other nations such as Canada, Australia, UK and New Zealand develop cutting edge production skills. The reality is that in a global market, a key aspect of exporting function is the ability to source supply partners who can deliver services at “best in class” levels. In the film industry, Tinsel Town no longer has an edge in “best in class” production skill. The problem for workers in Hollywood and the rest of the US, is that increasingly other nations can provide “best in class” services at a lower cost and with better tax enclave benefits. The Studios then no longer need the production lot, nor want to be tied to one supply area or supply partner for production skill. The savings in out-sourcing and off-shoring production skill are considerable. The potential removal of SAG rates, pension benefit obligations and more importantly, residuals is a critical financial difference. Residuals come off the top of a film’s video revenue stream, in the post 2006 market place this may be the only significant revenue due to a total lack of

theatrical income after P&A recovery, and so is an unwarranted tax on the equity participants who finance a film. The production model that sees such residuals paid when investors lose their shirt would not survive in any other business, other than the film industry. SAG and Global Rule One depend on the scarcity and value of its US resident cast and crew contributions to the production process. However at a crew level this no longer exists and at a talent level as seen in our Fourth Wave, the decline of star power will see this final weapon become almost a dead letter. The new movie business model will see a total disaggregated production function with all production handled outside the studio system. Studios will hire production manufacturers to make films and they will go where, when and to who is the cheapest “best in class” provider. The Studio system will no longer run high overhead structures. On the lot house keeping arrangements will not be needed. All parts of the development, production and marketing processes may be exported. The only issue is how to maintain control and how to find new suppliers to create the cost savings. The advent of co-financing and collaborative marketing campaigns in relation to tent pole projects are pointers to a functionally co-operative business.


Studios will be solely distributors of product who control only the channels for delivery of filmed entertainment product. While they may assist in financing production they will not own the means of production or perform the production function itself. The impact is already hitting home as the amount of money “on the books” available for in-house production is already in decline.The risk of loss and need to lower systemic risk by cutting fixed cost structures will see further reductions to the levels of production capital being made available. The industry is going to see lower cost structures for crew and talent. The price tag of not doing so will be a further decline in US made films and loss of jobs, as seen in the auto industry. New, off the lot players not even based in Hollywood will be the real employers, not the corporate multi-national with a thick wallet. The final act of this play will see downward pressure on revenues paid to film producers through a more television driven style economic model. Studios in return for mitigation of production capital risk will offer deals that keep the upside in their economic control. The trade off will instead be a soft landing and minimal upside for new production supply partners. MGM is the best example of a no frills economic model to date. The acquisition of Dream Works SKG, is a pointer to the fact that the immediate past industry operating model needed to be adjusted. Ultimately there will be perhaps only 3 x Studio players who control a number of creative brands. The writing is on the wall and the demise of some existing players is already only a deal or two away from reality. Who will survive will depend on who are the best adapters, who best uses their operating capital base by protecting it and achieving real returns. The studios will increasingly attempt to export production capital market risk off-balance sheet by way of sourcing soft money and courting hard equity. The availability of soft money has declined as mentioned in the First Wave. The availability of Hard Equity which is about to be burned as we discuss in the Third Wave will also decline. The future depends on how heavy a toll these waves take on the industry. The industry will de-verticalize and move to a more normal manufacturing model. Revenue will move to more of a television model with less up side in trade for less downside. New “best in class” supply chain partners will be created and all will have their own capital base. All that survive will create better economies of scale through being industry rather than specific company focused. Many players may spin off key functions and these separate new independently owned operating entities will then service the wider film industry. In many foreign countries, having 3 or 4 x US controlled production service entities makes little economic sense when they seldom handle more than a limited amount of business. Long term production may be facilitated by clusters of supply partners who each add to the value chain. Crew may come through one company, location and facilities provision through another, CGI services from brands such as ILM and so on. The spread of capital market investment in production infrastructure across niche suppliers will ensure Hollywood no longer has to keep funding this core cost.


“The niche savings from economies of scale, out-sourcing and off-shoring will drive a better economic profile for Hollywood, ensuring lower negative production costs.”

Lower production investment means lower risk and with a new financial model, production may once again become a profitable business albeit one outside the direct ownership of the Studio system. Today the reality is that the system has changed but the wave of change has not yet hit home with full force. The next few years will see all this change occur at an increasing pace. If not for the Third Wave of hard equity investment this would have happened already. Many industry players report private equity as a new long term positive impact. The reality is that will only be so if the money invested in production capital is returned intact plus an attractive profit. This result, luck aside, cannot happen while the industry clings to the non de-verticalized high cost business structures which ensure that private investor money will always lose its shirt. The industry attitude

grounded in a lack of care as long as it is not my shirt is the reason behind why private equity will run from Tinsel Town’s allure. When it does the scene is set for a major melt down and only the prepared will be left standing. Private money is not a solution to the coming drought of industry production investment. The reality is that just like gap, short fall insurance and soft money before it, hedge fund private equity may die a similar death. Unless key industry business structures and revenue profiles change the Hollywood dream will burn production money as it always does. The current wave of hedge fund private equity investment is merely plugging leaks in a sinking ship. Only true recognition of the de-verticalization process by early adapters who move to make changes happen can ensure survival of the Perfect Storm one long overdue and one already on its way.


Dialogue from: The Producers Max looks into an empty safe and apprises Leo of what must be done and the cardinal law that still dominates Hollywood film finance thinking even now. Max “What do you see?” Leo “Nothing!” Max “Exactly but now we have a sure fire flop It’s our job to fill that safe with two million dollars!” Leo “Gee Max, how much do we put in? Max “Bloom! The two cardinal rules of being a Broadway Producer are… One never put your own money in the show And Two NEVER PUT YOUR OWN MONEY IN THE SHOW! GET IT! Leo “Got it!”


THIRD WAVE Hedge Fund Equity Players Enter the Game Capital Market- Off Balance- Sheet Private Equity Finance The Holy Grail of film finance “risk equity” appears to be washing its way through Tinsel Town absolving all the usual suspects from the sins of the recent past. At a time when Hollywood was caught short, yet another hit of new money came to the rescue. The last 2 years has seen a stream of well resourced private players attempt to enter the fray and beat the house. The jury is still out on such players, as if they ever had chance. For now the focus is on the $3 billion in Hedge Fund money that has poured into Hollywood during 2005/2006 to replace the demise of soft money tax shelter plays. The industry war chest of $3 billion came in quicker than a pirate’s flag raising and from a relatively small number of deals: Paramount started the trend with $230m raised through Melrose Partners 1 through 2004/2005 followed by Melrose Partners 2 which runs through 2007. They provide 18% of the capital for the whole slate in return for 18% of all revenue sources. It was stated by some in the business in 2004 to run at a 15% internal rate of return.

Legendary Pictures signed a 25 picture deal over 5 years with Warner Bros for $500m over a limited slate of pictures that included Batman Begins and Superman Returns as well as financing some of the investors own slate. The partners mutually agree what films to finance but some of Warner’s key product is not on the table. Warner followed this with another $500m deal with Virtual Studios pertaining to investment in 6 films including Posiden Adventure and V for Vendetta. Virtual Studios is connected to executives of Relativity Media who feature in the Sony/ Universal deal below. Disney through Kingdom Partners raised $505m in the form of $135m equity and a $370m credit line with the funds being invested in a slate of 32 Disney films. The Weinstein’s new company raised $490 m in equity and secured a credit line of $500m to make and distribute films giving it a $1 billion war chest.

H HOLLYWOOD BANKER.COM

Universal and Sony used Relativity Media through Gun Hill Road, an investment subsidiary to raise $600m for the production of 7 x Universal films over two years at a 50% level of investment and 11 x Sony Pictures films via a part financing model.

Fox via Dune Capital Management raised $328m for production financing over a slate of 28 films. The same entity was a co-partner in the $900m buyout of the Dreamworks library from Paramount with George Soros.

Most of the deals above were created and secured from the Hedge Fund pot of gold and all used the economic rationale of slate portfolio finance as their deal model. The central theme was to spread risk over a number of projects using an odds approach to subsume risk. The winners over losers mentality was bolstered by rhetoric that since such deals covered all revenue streams, the Wall Street Investor was tapping into the high internal rate of return enjoyed at a studio level. The pitch was that the investors are partners of the house and cannot lose. If the slate performs at just normal levels, then a 15% level of return would be achieved with much higher levels if they were involved in high performing slates. All is not what it seemed and the surface logic while no doubt attractive may not exist in reality for very long.

Hedge funds are the dark side of the Wall Street investment community, enjoying greater latitude in the inherent lack of investment limitations. Unlike mutual funds they do not have to report daily, the new wild west type of investment frontier. The SEC attempted to rein them in during 2006 but failed initially. New laws to tighten them up are on their way. One industry estimate is that some 35% of all Hedge Funds fail. Originally these were high risk high return exotic investments that specialized in financial arbitrage play. For example, buying a company’s convertible notes at

a price that would at the current stock price generate the certainty of a profit at the date of the note conversion, assuming the stock price held up. Over time, the types of arbitrage and financial instruments upon which they invest in as a class widened. The more players and more money seeking such returns meant less opportunity to find such arbitrage plays on the market. Given a market hungry for returns that can no longer be found in real estate etc the focus has turned to exotic investments such as film. Hedge Funds are highly volatile and with the prospect of new laws, face only a short life span before real answers have to be given to investors. The risk of rapid implosion in the Hedge Fund market generically will if and when it happens, have a ripple impact on film finance options. Specifically the performance of the film deals done by Hedge Funds may kill this investment source before any regulator does.


Enter the Studio suits, who over the previous 5 years they had made a killing not from their movies, but from the soft money tax shelter deals related to them. Audience driven revenue is always fickle but equity investor money once taken is always faithful. Jack Sparrow would warm to “dumb” tax driven equity investment money chests, as like dead men such money can tell no tales and will ask no questions. The Hollywood euphuism “civilian investor” was coined to describe deep pocketed money not versed in the film game and more terminally not playing on the House side of the table. The seduction inherent in the Hedge Fund play comes from the illusion that Wall Street is now a House investor and cannot lose. An investment illusion that had only 6 years previously cost gullible bankers and insurers millions. The soft money profits generated from the UK and German Tax Shelter equity investments, made the books look good. First, the books showed revenues based on production slates sourced with predominantly off-balance sheet capital.

Second, the money was treated as a subsidy so it was not really off the books capital, but off the books revenue. Third, was the once in a decade boom in DVD revenue at its peak growth period which also created a positive spin. Many industry pundits talked up the internal rate of return enjoyed by the Studios across all revenue sources. The business not only appeared more profitable than it really was but worse more predictable than it really is. Wall Street failed to see this and used the pas t to project a future world that could never come to pass. Michael Eisner once put the Disney internal rate of return on capital at 4%, but since 2004 some figures of 12%-14% and 15%-20% have been quoted, depending on who is pushing the dream. The industry talk was that these were the real inside numbers one could invest directly into by becoming partner of the House. Wall Street analysis determined they had cracked the Studio Holy Grail and code of numbers that even Da Vinci himself would have found un


Paramount in 2003 released such bombs as The Core, Time Line, Dickie Roberts and Pay Check and allegedly still generated a 15% internal rate of return. The rate if there was a massive hit could be as high as 28%-32%. According to JP Morgan analysis, the cash on cash return on the cost of $100m + films is 32%, on $75m to $100m films only 2% and on $50m to $75m films, 5%. The real truth is something we will never really know. The problem with all of the hype is that it failed to address one key issue which was if the Studios are generating 15%-20% plus internal rates of return, why do they need to source outside capital at all? Dialogue from: The Producers Leo “As a kid I went to Ballyhoos 42…. Here I still have the ticket stub and ever since then I have had a secret desire to be a Broadway Producer….” Max “A secret desire Huh….. Let me give you a little advice kid….. keep it a secret….! Now do the books! Top draw on the left….” Max explains why many would be fund gurus should have stayed accountants and sublimated their desires to become players. The Hedge Fund money is supposed to rank with the Studio House in the cash flow stakes. If this were in fact so then this capital would unless it was lower than the blended cost of Studio equity and debt finance combined, become even more expensive. Worse all equity if it is equal would in a studio leverage position have a diluting impact which is the opposite of what this money is

supposed to bring to the table. The only way the Studio can be better off is if in it enjoys a better branch position further up the tree than its new partners. Hence the hedge fund money that was supposedly seen to rank with the House, cannot do so. The House would not raise it in the first place. Civilian equity will always come second and no matter who perfects the talk that is the film business code of honor. The only question is how far second place is behind and whether the whole bet gets eaten or if some return is in fact paid to keep such equity in the game. Whatever the outcome one can rest assured that no one on Wall Street has yet found a way to beat the House at is own game. The most fantastic part of the Hedge Fund story appears to have been missed by must industry pundits. The genius behind this latest plays comes not from the sophistry surrounding them but from the fact they masked old tricks re-worked. The short fall insurance demise of 1999-2000 was founded upon the misuse of risk mitigation strategies tied to the idea that one could use insurance based mathematical risk aversion tactics and apply them to the film industry. The key players such as banks like Chase Manhattan and insurers such as AXA saw this whole drama unfold in the courts.


The films in issue in that litigation were the Mirror Has Two Faces and The People v Larry Flynt. The case makes interesting reading. The distributor Tri Star, sold to a bank a revenue participation agreement to share in projected film revenues which was then unwritten by the insurance pool. When the inevitable happened the truth about the real financing facts came to the fore and lead to the insurers seeking to escape liability. What is interesting is that the identical logic used to tout the rise of short fall insurance as an answer to industry capital market woe, is identical to that being used to justify hedge fund investment strategy in 2006. The mathematical basis was flawed in the insurance model and is still flawed today as the only difference in the paperwork behind the models is the name and the date.

Dialogue from The Da Vinci Code Dr Robert Langdon speaking to the conference on Religious Symbols-: Robert “Symbols are the

language that can help us understand our past… a picture is worth a 1000 words but which words…??? Understanding our past determines our ability to understand the present.

So how do we shift truth for belief? How do we write our own histories personally or culturally and therefore define ourselves? How do we penetrate centuries of historical distortion to find original truth? This will be our quest…..”

This speech explains why the past may help one to understand the present but equally why it may not necessarily be of help in predicting the future. What is Hollywood Banker on about now? Simply this, the insurance industry lives or dies by the correct application of actuary generated mathematical perceptions of risk. In the case of life insurance for example a company has no idea if you or I will die tomorrow.


Yet if you obtain a large enough group of policy holders, say 10,000,000, then each year the statistical average of the number of those who will die will stay about the same. The company does not know which individuals may die only that with relative mathematical certainty that no more than 8 per thousand will die. Armed with that relative certainty which is sourced in a mathematical principal known as the law of large numbers, an insurer can take and price life premiums sufficient to pay out those who die and make a profit. The key to the law of large numbers lies in the ability to create a sufficiently large pool of data, large enough to provide a finite variance. Knowing the variability is finite over a large population of events allows insurers to take risks and come out ahead as they can create mathematical certainty sufficient to assess average risk. The insurance industry mentality only works over large populations of transactions where there is a bell curve distribution that trends toward finite variances. The short fall insurance attempts at risk management application of these principles to the film business had already revealed the lack of application of the law. The mathematical basis for such risk assessment simply does not exist at an actuarial level. Movies do not comply wit h the law of large numbers for two reasons. First, the population of movies that one can invest in is too small to be useful. A leading industry actuary conducted a study of 2000 films over many years and produced inconclusive results. Second and more importantly is the fact that the revenue streams of movies are not finite variances.

In fact they are infinite. There is no pattern, only wild spikes. Less than 5% of films in any given year account for 80-90% of Studio revenue. There is at math level, no average box office number that can be used to determine a finite set outcome that converges to create stable predictable risk management decision making. The average revenue rises and falls randomly and more often than not the average falls as the size of the pool increases. The variance is unstable and an opposite mathematical paradigm exists where the more data one adds to the pool the greater the volatility of the results and the less predictable they become. The risk perception tools in the film business operate more in common with the unpredictable world of Chaos Theory as it defined by mathematicians. Random chance drives the movie business as much as anything else. The law of large numbers does not apply due to the business characteristics intrinsic to the movie business. The reality is that the slate portfolio finance strategy of the Hedge Funds is mathematically only a magnifying glass whose intrinsic design flaws increase their risk profile and add to the unpredictable outcomes.


The Art De Vany book Hollywood Economics and published articles in support show the following terminal propositions that come from the inherent probabilities that affect the movie business. First, the falseness in the belief that any mathematical model is an accurate predictor of box office or any other linear revenue outcome. Second, the falseness in the belief that a large portfolio offers protection because of the law of large numbers. The law plainly does not hold true in this type of probability field over a narrow unstable population base. Third, the false belief that the average return is a predictor of the mean return as it is in fact the opposite. Fourth, the falseness in the idea that there is precision in such forecast techniques. These ideas lead to the stark conclusion that most likely outcome for any movie investment is not an average return but more likely a minimal return. Few movies succeed the most likely result is failure. According to Dr De Vany, the movie business is a stable Paretian model. The rationale behind his conclusion is that in such Paretian models the average return is dominated by large scale events that move all over the place with infinite var iance. According to Dr De Vany, the movie business is a stable Paretian model. Such random variable

distributions are not stable in relation to the law of large numbers. The range of outcomes remains infinite and too wild to ever predict. His work illustrated graphically, shows huge random spikes as high as they are be low, rather than a bell curve shape of normal distribution of average outcomes. The pictorials capture poignantly the fact that where there is high risk there is also a high risk of loss. The mathematics show a low probability of success depicted against the massive impact of big wins that dominate the profit picture of Hollywood. Films such as Titanic with a standard deviation 20 times the mean and Forest Gump at 10 times the standard deviation relative to the mean, underpin the Chaos Theory application to the probabilities in play. Such deviations may not happen ever again or could happen tomorrow. No one knows and with respect no one can ever know. The graphed works show that most industry profits come from what are known in math circles as Fat Tail distributions that happen at the upper end of the probability scale. In short the huge size of the spikes that represent a big win and take earnings many times over the standard deviation to the mean, are what the studios live off. The game is to invest low risk money in fat tail potential and this is what the current Studio model does.


The failed portfolio model used in the short fall insurance bubble is not going to work today in the Hedge fund bubble. The actuaries are seldom wrong and here the numbers despite the hubris of investment bankers does not match the likely outcome, but anything is possible. The Studio deal models in most of the private equity plays mentioned insure the wheel remains fixed. D istribution fees and marketing costs come out first and the internal hedge of studio overhead remains. The control of the worldwide revenue streams does not remove the moral hazard of non-accounting as creative Hollywood numbers apply as much to gross revenue as they do to net profits, as any television investor will tell you. That is not to say that some private equity may not have neutralized the Studio hand. The first cracks in the system are already surfacing as the Virtual Studio Fund that invested approximately ½ the production cost of $160m-$200m in Poseidon is a sign of things to come. Warner Bros under the deal, still got a 12.5% distribution fee, recouped marketing costs, earned revenue from overhead recapture in the budget and perhaps on some other production inputs as well. The Virtual Fund ranked behind all this and contingent payments to Talent out of gross distribution revenue .The estimated loss is expected to be in the order of $50m on its $125m. The real killer is the loss of the project’s 15% earn over the time horizon on the whole $125m. The real deal book loss over another form of exotic investment would be after accounting for lost earnings, north of $100m. The jury is still out the other box office bomb V for Vendetta which may well also be an apt title when the Hedge Fund has to finally report to its core investors. None of this is a surprise as Village Road Show had a similar venture with Warner Bros. It knows the business better than anyone and it has a natural hedge in its ownership of exhibition channels in many foreign markets. This deal due to the underlying economic realities of production investment had to be redone and is now partially off Village’s books and now with Crescent Entertainment. One would have to ask if Village, an experience player with a hedge in its own business model, found the production business hard going then why could a civilian ever think they could do better? The Hedge Fund wave may survive if the deals have been done to ensure some money comes back and some returns follow. Yet that is not the nature of the Hollywood money pit. The glamour and the risk are all elements sold with the seduction of the high returns. The likely outcome of this Third Wave is that Hedge funds themselves may implode under new laws outside the film industry. The aftermath of such a demise, will mean Hollywood will have to find new ways to finance its capital markets. Recently burnt investors may not be so easy to con a 3rd time but then the industry is founded on the suspension of disbelief. The Hedge deals could in fact work, there may be big wins or they may have hidden underwrites that protect them. If this is so then this capital may exist for a while but at some point the need to find a different way will present itself. The downward pressure on production costs is one and the development of new innovative investment ideas is another.


Dialogue from: The Producers Carmen Ghia answers her/his star employer’s home phone……. “Hello Welcome to the elegant upper east side townhouse of world renowned theater director Rodger De Bris on this lovely sunny afternoon in July….. How may I be of assistance…..!!” Carmen answers the telephone of Rodger De Bris in a manner not too far removed from how some who still haunt the Hollywood Hills today are accustomed to be being treated. In the new Hollywood of 2006, the Studio system no longer calls, nor pays for the phone lines of even the brightest world star.


FOURTH WAVE The Demise of Star Power The New Rules of Talent Acquisition Strategy The rise of reality TV and the acquisition of U Tube by Google, are both leading indicators of the Andy Warhol 15 minutes of fame philosophy that is changing the marketplace for star power. The very public statements of Summer Redstone and all the ensuing debated analysis over Paramount not renewing Tom Cruise’s lucrative deal missed the point. The general demise in star power and with it the growing inability to hold Hollywood to ransom, is already hitting Tinsel Town. The Cruise/Wagner house-keeping deal reportedly worth $10m a year was not the real reason for the demise of the deal relationship. No, the deeper reason with wider implications, lay in the part of the deal that saw Tom reportedly take 25% of first dollar gross. On Mission Impossible III this amounted to $50m on top of a guaranteed $20m salary on a film that was expected to do better. The reality of such star deals is that even when a film takes substantial world revenues, that such a kicker can add 30-40% on top of an already bloated production investment. A $150m film would then soar to $200m and the real break even point to cover marketing and production investment could lie north of $500m.

The Studios, after being hit by the decline in free soft money, withdrawal of core operating capital and faced with courting new equity they might actually have to pay for, are running scared of deals they can no longer afford. Star power had finally out-priced the ability and the desire of the client to pay. In the weeks that followed, Cruise naively ran around other Studios seeking a new deal but no one could or would play. The rumored personal life issues were not the reason for Paramount cutting him loose. The underlying reality was no one else in town was going to pay either and with all due respect, nor could they given the same financial hurdles. The personal life drama public relations storm of stars and of Cruise in particular, now are key marketing tools to draw heat to a film. Hollywood in its last attempt to market movies has had to forget film product and sensationalizes the life of the star to get people to go see the art. No the Cruise treatment is emblematic of how all talent will be treated in the future when it comes to overly bloated deals.


Why did this happen to Tom Cruise? He was a symbol and at the end of day he like many others had not realized that a major financial change in how Hollywood does business had already happened. Hollywood did not change out of choice. Hollywood due to animation product has become less and less star dependent than in the past. However, at a deeper level there are other reasons . Recent industry studies of financial performance related to star power have revealed an interesting paradox. While great films make great stars the reverse is not necessarily true. Increasingly the financial performance of film with stars in it has not reflected returns equal to the cost inclusive of contingent kickers paid to stars. So stars do not it seems, make films good and therefore bad films cannot be saved by stars. These economic truths are hitting home in relation to the pricing of stars as one would find in any services market. Star salary pressure grew out of a short supply and more critically the key to the banking that star power held. No longer can talent be paid irrespective of actual economic outcome and ahead of the real risk investors who employ them. In a fast world that is driven by the Andy Warhol Mantra of 15 minutes of Fame, stars do not have as much brand power as they did in the past. Old Hollywood built flawless reputation capital over decades and ensured star brand values were life long economic drivers they could leverage to recover their investment. Now in the age of instant celebrity irrespective of talent or discipline, world fame and star power can be fleeting. The brand values of talent today do not enjoy the same lead time that needs to go into establishing them for a life time. The number of stars that can open a movie that you can take to the bank is declining

rapidly and if full truth in financial terms was disclosed, is already almost a dead letter. This is due to the aging of older stars with established brand values declining and no new talent carrying the same economic weight in the green light game coming to replace them. The new crop of actors and actresses are also not necessarily American nor do they live in Hollywood. The Studio system is we contend very happy with this result as it makes it easier to walk from ransom demands. One spin was that Cruise left because with private equity backing he could make more money. This was pure financial fantasy as nothing can beat the weight of a Studio behind you with 1st dollar gross participations. Hedge fund private equity investors backing Cruise now face the Summer Redstone problem unless they have managed to get rid of the 1st dollar gross fee corridor. If they accept such a deal as outsiders without the natural hedge of a Studio distribution fee cushion, they face a higher hurdle than the studio did and with respect the absolute certainty of loss. If they did not, then that reality is confirmation that Hollywood has changed its operational structure toward sanity. The irony is that while Tom was saying Hedge Funds would be better partners, his gross point equity kicker of some $50m taken on Mission Impossible III comes straight out of the pocket of the Melrose Partners 1 hedge fund.


The Cruise problem was only the tip of a bigger ice berg - an Inconvenient Truth of melt down proportions that has centered around talent/crew costs generally. The power of SAG over the last 5 years and its ability to use ransom by threat of strike to enforce Global Rule One and high pension benefits and residuals, was and is a major hand brake on Hollywood’s core viability as a production center. The ability to out-source and off-shore the means of production allows films to be made anywhere with access to low labor rates and tailored production incentives from soft money. The only arrow left in the SAG armory is the critical value of a few stars that remain bankable. The trend at the moment appears to be that many new stars while living in the US are from other nations. The depth of a star brand is not what it used to be. If stars are too costly they just will not work and if they do payment may well depend on economic outcome and not before the hard equity.

Dialogue from The Producers Carmen “You are going out there as a hysterical raging queen but are coming back passing for a straight great big Broadway star!” Rodger “I will do it! I will do it! I I will even put on my Gloria Swanson lucky mole!” Carmen seduces the director into being a star in his own show and like all Vanity labels, action comes from sensibility and not often common sense. Some Stars today also enjoy the ego value of a Vanity label in the form of a self-owned production company. They use their own star value as a co-financing tool if they are appearing in their productions. However, in another unique spin in these scenarios the talent is often forced to work for less when it is working for itself. In the past if they really wanted you they would pay but today and increasingly tomorrow if the

demands are too high then players like Redstone will walk. The price of doing “dumb” deals where to make even modest money they have to be a big hit, is just too high and savvy players would rather do more modest and less risky deals. In the modern world ever to have the same run as older stars did. In the past, there were more concentrated media outlets that reported and spun PR and the world turned more slowly. Now in a global market, with fast pace multip le media delivery systems, nobody has an ability to craft reputation driven brand value in the way of the past. Stars are increasingly becoming short lived and interchangeable. A vacuum of star brand value now exists, with many older high brand value stars retiring and also enjoying less traction in a younger market place.


The late baby boomer stars of the Cruise generation still enjoy brand value from the Hollywood of old, but generations to come do not and more darkly in the future will not. This reality will increase as it is in the systems interest that it should. If fame is to become a more fleeting commodity, then the ransom can be reversed as the system can hold the star to ransom. The Tom Cruise matter was the first attempt of the system to do just that as the message was clear . If you do not play by the rules you are dead and what is more we can and will replace you instantly. These new substantive realities will limit in the future bloated salaries, end 1st dollar gross participation corridors and make talent perhaps a little easier commodity to deal with. Evidence of these new trends can already be seen in television where former high branded movie stars whose careers have waned, have been reborn. The short life of television other than for long running series , has already placed downward pressure on the salaries of past stars as people simply just want to work. The real impact will be on SAG as the Studios seek to disarm their trump card. Investors in the production area make employment possible and deals struck with the studios by SAG two decades ago do not reflect the current reality of the business. Theatrical Box office, other than for tent pole or hit films barely covers P&A. Video through the DVD boom, is now the only major source of investment return. The burden of residuals is from another time and another century. In a newly risk averse production capital poor world, Hollywood can no longer afford to pay. The current wave of Hedge Fund money is being taxed and it may well be the last equity production

investment money to have to face this imposition. The issue in Hollywood or Detroit is whether or not the product will even be made in the USA. SAG has resisted the winds of change for a long time but now the global reality is coming home to roost as Hollywood’s core production capital base is in for a long term decline. Re-inventing the 25% Team In the long term reduced star salaries means only one thing - less money for agents, managers and lawyers! Unthinkable we know! The 25% team have probably done too good a job in the past garnering salaries and gross participations for clients. These deals could only be paid for via the support of money for nothing free capital from outside the entertainment industry’s real economic plane. Now the 25% team, like the stars they represent face declining revenues unless they can re-invent their client and how they both get paid. The future may hold the reality of salary re-investment as a production funding source but for more than monkey point participation. New ways to make money from deals involving the packaging of private equity with talent and selected territory participations have already started. Further, new business models may well see agents, managers and lawyers combined via casting style loan-out companies.


Enterprises that are one stop wrap around shops that cut star acquisition cost and star overhead by Studio demand from the side line. In such a new world order it will be the former 25% team’s job to reduce salaries to keep a profit margin in-house from money obtained from the new lean Studio. In essence, HB contends we will go back to the past to resume the star system function in the show business world of early Hollywood, acting as a principals rather than agents. The studio game has despite

appearances to the contrary already gone. MGM stands as a precursor of what is to come for all of the companies in the production arena. The new employers will come from production deals sourced outside the Studio whose function is to act global strategic production manufacturers. No longer will the deep pocketed players be tempted to seduce talent with unsustainable offers. The game is too far gone for that now and the rubber must meet the road.


FIFTH WAVE

Innovative Capital Market Production Finance Tools

New Business Process Structural Models

Approach Thinking in the Fifth Wave will be characterized by:

WACCO: SPAMS: LIPS: SPF: SPF: SPV: PODS

New Deal Techniques; in the Fifth Wave will be characterized by:

POD: RPA: SINS: MAS: FEOM INNOVATIONS

The first 4 waves of intra-nationalism, de-verticalization, hedge fund equity and star power demise have set the scene for a new operating climate. The impact of the first wave is now being fully felt as the old money for nothing soft/hard equity play sinks into decline. They can only be found currently in the government film funding bodies of some countries but this money is becoming scarce as it is rarely returned to them. The second wave is only just starting to impact the game and has been partially masked by the third wave . The impact of the third wave has been felt in that it has filled the holes in production finance that the entertainment businesses capital markets would have otherwise faced. The fourth wave is in train and despite Hollywood being awash with temporary cash the cost structures in relation to talent will face downward pressure. The fifth wave is already here but will begin in earnest once the future of private equity from the Hedge Funds pans out. The only way to prevent the demise of private equity funding sources and/or to prepare for life past a potential demise is through innovative capital market production finance techniques. Strategies sourced from the rules and dictates of new business processes post de-verticalization of the movie business into new core disaggregate enterprises that become the new production and distribution hub, are now in a transformation process.


The new models will see studios acting as pure distribution channels which co-finance production from the sidelines. The future world will see no studio overhead and most of the current systems core functionality exported. The production will be all out-sourced and where appropriate off-shored. Distribution will become more and more seamless as the sophistication of the core technologies and their penetration rates take the film audience to different channels of consumption. Statistically these new audiences may have more stable bases similar to television and the financial models may become more non linear revenue driven. The internet system does provide new direct billing to create pure linear revenue models. It will be interesting to see how those who control distribution create a balance between these two realities. The fifth wave will be characterized by the development of a whole new wave of economic security interests that truly are reflective of the operative reality of the movie business. The following highlight new approach thinking philosophies and new “best in class” techniques to create deal strategy practice structures as a way forward to create a stable capital market for the finance of filmed entertainment product. The cost of production relative to total revenue must change and create greater margins in operating profit. WACCO Dialogue from The Producers Leo finds the Holy Grail key to WACCO thinking and MAX gets it in a New York minute. Leo “Amazing! Absolutely amazing, under the right circumstances a Producer

could make more money with a flop than he could with a hit. It is quite possible if he were certain that a show would fail, A man could make a fortune…….”

Max “Yes you were saying you keep saying it but you do not say how” Leo “Well it is simply a matter of creative accounting……”

The Weighted Average Cost of Corporate Opportunism is an acronym the Hollywood Banker first used in an article some 5 years ago referring to the financial ratios used to determine the weighted average cost of corporate capital. In a WACCO world approach we assume that Studio corporate executive thinking (like the balancing of the cost of debt to equity finance in the weighed average cost of capital analysis) is also extremely calculated in an opportunistic way. In other words, WACCO thinkers will push the financial envelope to the fullest extent as long as it benefits the Studio bottom line short term, without account of the long term cost of impact.


The wholesale adoption of trends with limited long term economic shelf life such as gap, short fall insurance and tax she lter “soft” equity and lately, private hedge funds, are prime examples of WACCO at work. All portended long term capital market finance potential and all except the last, where the jury is still out, failed and further damaged the industry in the eyes of the investment community. A stable capital market has to abandon WACCO thinking and move to a more long term view point where sources of finance are paid their due. A market which ensures investor capital is preserved, stable returns generated and where appropriate, some real potential blue sky if a film really hits. New forms of equity and debt need to mature in the market place that can monetize soft money and hard equity in ways that make them easy to access. For investors, real security lies in instruments with principal guarantees, tax leverage optimization, financial planning utility, interest and exchange rate mitigation, liquidity and low exit cost strategies . Many strategies and structures to date were high risk paper deals that did not cover the prospect for and/or the high probability of the total loss of investor principal and/or tax equity. Nor did they account for the investor’s opportunity cost in some other alternate economic arena outside the film industry. The artificial tax benefits were too often put at undue risk due to poor substance issues relating to deal economics or created debt or equity instruments that were too complex to fit easily across a wide investor pool. Long term, new deals require the creation of capital market friendly film investment products, that meet the needs of a global financial market place. The use of off-balance sheet finance that came at little cost to profitability has masked the reality of Hollywood’s results. When the soft money around the world disappeared, Hollywood was left to fund the whole production slate alone – enter the hedge funds. New capital market techniques must at a macro economic level if they are to work long term, redress this market distortion. The industry production slate investment of the major Studios needs to reflect the whole picture and create long term stable capital market strategies on and off balance sheet. The real weighted average cost of capital of each deal and each player needs to be clearly appreciated. HB contends that more and more money will come on balance sheet but in ways that do not impact the financial picture adversely. By this we mean that the leverage of debt to equity will reflect not just pure debt and equity instruments but shades of soft or hard characteristics within them. A switch to low cost debt or equity is critical component in any economic strategy solution to the future capital market structure of the film industry. The use of new hybrids that reflect debt and equity characteristics also will further blend the mix as the old distinctions between equity and debt, principal and interest give way to new operative concepts such as defined revenue corridors, split capital recovery rights and back stop capital guarantees.


SPAMM Studio Picture Asset Management Model or SPAMM for short, is a thinking approach to the capital markets of the not to distant future. Studios and all other players alike need to adopt specific asset management approach models to every deal and to slate financing needs in general. SPAMM deal approach thinking is characterized by the following:

A) monopoly deal approach B) wrap around securitization/credit enhancements C) studio structure self funding D) external collateral E) deal rights enhancement

The above assessments can be used inside the Studio or by those producers outside wishing to sell a deal to the finance division. If properly applied it will solve any film finance problem providing the underlying economic deal substance exists. SPAMM thinking will create the optimal low cost and most risk adverse deal structure out of all the available capital resources. It reflects a merchant banking mentality which results in the lowest financial risk profile of loss to the Studio, lowest cost of interest and/or profit share payments to 3rd parties (with a calculated deal money tree that reflects to the deal and the player the real average weighted cost of capital) and creates self-financing deal components with the appropriate use of on and off-balance sheet capital capabilities. A) Monopoly Deal Approach

The Studio is always a monopoly player, who can green light any deal due to the strength of its balance sheet and distribution capabilities. The ability to sign on to a project knowing up front the deal can happen if the right risk position is attained is a powerful tool. The Studio has to merchant bank its way out of the risk position in the deal and will only do so by signing on when it knows it has a deal exit strategy that will export deal risk to an acceptable level. The process optimally requires the Studio to look at the balance between on and off balance sheet money to fund production and distribution. Distribution money carries the lowest risk exposure as it is first out of the deal and carries substantial cross collateralization risk mitigation protection. The production money is most at risk and the degree of that risk comes from how many other soft and hard money claims for recovery from a deal’s revenue corridors rank equal to or ahead of the Studio money.


Normally not much ranks ahead of even Studio production advances or co-finance equity but in a tight future capital market this may not be the case. The deal has to then from a financial risk reward analysis point of view, determine the real weighted average cost of capital. This is determined by deal equity and debt from both on and off balance sheet sources to obtain the real financial position after hard interest returns, pre-set revenue corridors and profit sharing. Interest, profit sharing and revenue corridors foregone are all part of the deal’s real weighted average cost of capital. The deal’s money tree needs to from a capital market analysis viewpoint, be reflective of all these money sources and the prices to the deal out of the waterfall. Risk analysis is with respect to many, often a misunderstood part of this process. Determining the likelihood of future linear and non liner revenue streams in this industry is very difficult. The only real certainties lie in the mathematical depiction of the entitlements as structured on paper. Where a player is placed in the money tree determines where their money faces risk relative to others, even in a zero revenue assumption driven world. The real risk management by the player is achieved as per most casino operators – while they cannot set the wheel they can determine the best probability position for winning. Why the house wins is not because it can predict winners or losers. It is because whether or not something is a winner or loser affects them more positively than other players at the table. The monopoly players prior to the last four waves did not really care about containing negative cost until capital became

scarce. Monopoly players now want to cash flow deal parts in ways where the intrinsic deal risk of the cards they hold are better placed to obtain winnings or mitigate losses than every other player at the table. The recent past of tax shelter driven soft money equity is a prime example of this risk setting in action. B) Wrap Around Securitization/Credit Enhancements The real power of a multinational owned studio with gilt edge credit lies in the ability to export that credit status into deals both on and off balance sheet. The ability to use size and strength to securitize de-facto debt and equity products is where the future of film finance lies. The neat trick is to use it to create wrap around products that use this credit status to infuse new capital market products with investor credibility. The best trick of all will be to do so in ways that lever the core corporate equity to high ratios of equity to credit exposures as per banks and governments. Banks operate effectively at 1:10, but in the film finance market the future survivors in the studio game will depend on who can raise the ratio the highest while attaining the lowest core deal risk exposure. High leverage with high risk exposure is terminal so is the opposite.


“The real studio game will be determined not on the screen but on the calculator as to who used leverage to move their money the fastest while creating the lowest risk profile for the money on the table at any one time.”

New tools for such analysis and new approaches to investment banking theory and practice lie at the heart of such work. At a micro level the independent players in the game as the new industry partners who make product will also have to understand this thinking and its impact on them. C) Overhead Structure Self Funding In any Studio deal, the overhead of 10-20% routinely assigned to many film budgets is the ultimate self financing tool. The new world will see a lean and mean studio economic model with overhead exported to new players at lower core costs. The Studio in any deal model can always self finance this cost as even without the film in production, it still is a fixed cost not a variable one. The rationale lies in the fact that only a small part of the production’s overhead charge, relates to variable deal overhead. In many of the German multi nation co-production deals with pre-sale components, the overhead represented the only studio exposure in the arrangement. This meant that the Studio’s exposure was limited to its P&A commitment. If the film was poor, this P&A commitment was curtailed and recovered through the DVD revenue. D) Outside Collateral

The real risk capital that gets a marginal deal across the line is bottom tier production equity. Given that Studios have only a desire to be distributors not creators of product, this fact takes on greater and greater market significance. The pipeline needs product and has fixed overhead costs to meet. The need for product is voracious and only growing. Therefore the distribution fee and the gross operating margin is a real deal hedge. Bottom tier equity of 10-20% in highly exposed films means these projects are still able to be self-financed from the prospective margin of the earnings stream from distributing the product. Any money not covered by this internal hedge is pure risk equity. This capital can be used as collateral that lies outside the pure deal economics of the film. The art then is to use this collateral to best effect to green light the project and then to get that money back as soon as possible, immune from loss and more importantly ready to reinvest in the next deal.


E) Deal Rights Enhancement The fact a Studio player and its distribution channel is behind a film is a critical value added enhancer. In an independent film it may well be the only key in the current market for gap and super gap that gives the money the comfort they need to invest. In co-finance deals the studio-to-studio deal gives the other partner comfort that another industry player can see what they see in the project and this alone enhances that value add of both. Private equity investors may also seek comfort from the involvement of a Studio distributor if revenue corridors can be negotiated. The hedge fund money now seeks revenue corridors across their slates. Direct studio involvement adds value to their portfolio approach. LIP DEALS

Dialogue from The Producers Leo “I have spent my life counting other peoples money. People I am

smarter than. When am I going to get my share? When is it going to be Bloom’s day? I want everything I have seen in the movies…..?”

Here we see the thinking that drives Leo and so many would be players. Leading Independent Producer deals refer to those production arrangements sourced totally off the Studio balance sheet aka Jigsaw deals. Jigsaw deals are those arrangements where the producer must assemble all the deal chips independently to obtain full financing of the project. While a few LIP producers do however underwrite their own deals, the reality is they have outside the studio system substantial but limited risk production slate capital. The savvy do not believe the dream and protect their core capital base jealously and merchant bank their way out of every deal to attain a zero risk profile. Economic failure of LIP companies can be traced solely to those who, when big enough do believe the dream by starting to apply a portfolio approach by investing core operating capital. The new age of film finance will see the emergence of more LIP companies where more and more of the total finance package will be moved on their shoulders.

The new models in LIP financing will have to create greater deal certainty so that these companies can survive. The cost of such downside mitigation will come at the loss of the upside to those providing the risk underwriting. The new production reality that will see the demise of the Studio Lot and the Studio as an owner of hard core production assets, will create opportunities for LIP film makers. The stability of hard assets invested in production capacity, combined with a flow of production-to-order work from the studio system will create better economies of scale for LIP’s and for the studio system per se.


The need to source work and keep production flow will see reinvestment of production cost margins into deals and this will become a new de-facto source of industry capital. The jigsaw rules of LIP production deals will create a new economic discipline on the system through the use of off-shoring and out-sourcing. How to contain costs while maintaining production value on the screen will be the challenge and those that attain this will be rewarded. A partner service model that will see LIP companies working as value chain suppliers to the Studio. The Studio may as MGM does now, act as a finance packager and broker for the LIP deals of the future providing one or more pieces of a film finance puzzle. The discipline of jigsaw film finance lies in the deal by deal approach. The risks are sign on and off on a deal by deal basis. LIP deals require sufficient development capital to move the deal from bare property status to a project with sufficient attached elements to attract piece meal finance. The LIP type deal market is less stable than a the SPAMM monopoly style deal market as there is no ability to sign on up front, knowing that down stream deal risk will be mitigated. Yet this may improve as over time more and more SPAMM deals will flow down to become LIP deals and/or combinations of both. SPF - SINGLE PICTURE FINANCE The industry will begin to adopt the approach of a single picture financing thinking model. The portfolio approach magnifies and intensifies losses and will as long as it survives, lead to a loss of industry production capital. The reality is that every deal that is managed on a SPF basis with high discipline to a point of zero risk, will allow the player moving the deal to live another day. SPF thinking is the way of life for savvy players but the temptation to take risks on a slate basis is always present. Only SPF thinking provides the solution to the financial quagmire of slate financing as one can use SPF models to properly create risk analysis. Revenue analysis is at best from a probability viewpoint, only helpful to discern trends but not enough to create deal by deal or even slate by slate comfort. The degree of helpfulness depends whether or not revenue sources are linear or non-linear in nature. In other words they may help if they show more predictable outcomes tending toward finite variances in the case of non-linear revenues.


SPA - SLATE PORTFOLIO APPROACH This approach thinking is the operating mantra behind the current hedge fund wave. The new money at the Hollywood table eschews single picture financing as too high risk. This of course is the fundamental flaw in the slate approach as it is currently mandated as detailed earlier in this article. The slate portfolio approach can only work where the risk of loss due to SPF thinking lies as close as possible to a zero risk environment. The industry creative imperative often green light’s a film when the risk analysis is still not at the desired minimum posit ion. If a film deal is not at that point it should for the slate portfolio approach to work, never be green lit. The investment horizon is important in the venture capital world as 5 times your risk back Year 3 or 10 times your risk money back in Year 5 is the standard. The portfolio approach has to pick up significant losses and attain this result if it is to compete with other opportunities. Risk mitigation comes not from probability of revenue but from the lack of statistical exposure to risk in the first place. Risk aversion comes in the deal plan not in the deal’s hopes and dreams. The real task of private equity is to create investment models that reflect more stable mathematical risk and reward relationships than exist currently. The ability to use the slate approach correctly, depends on mitigation of loss in exchange for certainty of limited reward. Slate portfolio approach thinking that does not in its execution contain the discipline of single picture financing is doomed to fail. The real trend in the fifth wave will see investors seeking a bias to risk that ignores whether or not the slate approach exists, but will depend on the deal model not on the spread of the subject matter. SPV – SPECIAL PURPOSE VEHICLES The wrist length use of newly formed entitles to attain the benefits of out-sourcing and off-shoring is now an industry pandemic. The formation of “business in a box entities” that carry on defined deal functions such as production activity in legal form but not real substantive continuity of business, is how Hollywood does business today. The goals mostly are to avoid the application of SAG’s Global Rule One where possible, access exchange and labor rate savings, but more importantly to tap directly into international soft and hard money finance options, both on and off the balance sheet.


The wave of foreign tax shelter money and foreign soft money incentive programs drove this. In a related article in this issue, we explain why the bare formation of entities without the alignment of underlying substance, inevitably fails as a business model. The HB contains that legally such form driven attempts to tap into the benefits of off-shoring and out-sourcing are now more than ever problematic. The coming wave in a de-verticalized market place will see the market place differentiation of entities in relation to operative deal parts become the substantive deal reality. The demise of this trend will come when new substance driven entities arise fully capitalized as independent production partners, who are “best in class” value add partners to the supply chain. The reality of these new film collaborators is that they will be industry partners acting as arms length business providers to the industry at large and not one company. POD – PEACE OF MIND, OFF BALANCE SHEET, DE-VERTICALIZERS This HB coined acronym is the lexicon of the new way of deal thinking and of deal structuring in general. The patent vulnerability of form driven SPV thinking has and will increasingly be seen for what is, fundamentally flawed at a substance level. POD’s will be increasingly created as real substance entities. The need to create industry partners who actually supply production elements and invest in production capability assets is about to explode. POD structures may even invest in the production process itself and will cause a fundamental change in how the business of film is carried out. The POD process will create the glue to ensure that international tax incentives, whether by way of tax shelter equ ity or subsidy are safe from local authority attack. Better yet, if they are attacked the POD is the ultimate legal containment devic e to stop domino claims against other deal participants. A luxury not enjoyed by participants under SPV deals where there is a wrist length relationship. As Hollywood seeks to secure new equity, a major comfort issue for such investors will be protection from 3rd party claims. Critical to the sanctuary that must exist, is the ability to break the link between the ultimate deal motivator and its investors. The only way to do this is ensure that the ultimate deal motivator never has a wrist length relationship with any other deal participants. The POD rationale is as per the name implies - peace of mind, due to creating a legal barrier to confine deal damage to the POD and not other deal participants. Off-Balance Sheet creates real off-balance sheet finance that is compliant for legal and accounting purposes. De-verticalizer refers to real not just book entry cost savings from running fully capitalized businesses that lower the cost of production by off-shoring, out-sourcing and lowering the need for studio overhead.


New industry economies of scale not related to one master are a critical part of this paradigm shift. The combination of law suit free, genuinely off the books investment money and savings from a new business model is a triple win for the movie business. So beware the POD entities are coming fast and they will change every aspect of the business for ever…!

NEW DEAL TECHNIQUES

Dialogue from Strictly Ballroom

“There are no new steps. There are no new steps...” The mantra from Strictly Ballroom aptly describes the reality of film industry business thinking. In a world of change the core industry culture may be resistant to those who want to teach new steps.

Film industry capital market structuring techniques have changed markedly over the last decade. Gap finance, shortfall insurance, soft money, tax shelter equity and now hedge fund players evidence the flow of surface change. Yet the core business model upon which the business feeds remains the same. The approach thinking methods outlined in the Fifth Wave collectively provide a new design threshold for capital market product creation. However , they face the immutable reality of the in-house industry culture. The Opus Dei zeal of profit at any cost mentality of the Studio is not about to change, as legally this is the mission in modern corporate America. The industry structure despite all the sophistry to the contrary is still driven by a devout Silas like thinking, a mania directed toward preserving the industry’s status quo. A major flaw in many theoretical models that one can postulate to be new potential re-distributors of capital risk, lies not in their weakness but rather in the fact they work too well. If a model does spread risk fairly and creates a real economic possibility for investors to predict risk via statistical modeling tools, then the solutions no matter how clever may never be accepted by the system. Creators of new securities face an industry cultural paradox where the more stable a new capital market product is, the less likely any real player is to consider offering it. The current industry business model thrives on the priority of pole position of the Studios at the top of the money tree. The problem many investment bankers fail to appreciate is that if higher risk money is available at lower cost it will always to be sought over more expensive but arguably better long term capital market sources.


The real future lies in a financial analysis approach that accounts for all on and off the books capital in play, on a deal by deal basis through to the overall slate perspective. The real weighted average cost of capital needs to be figured in the cost and risk of all financial resources employed in a project, from sources including subsidies, tax shelter equity, pure risk equity and creative capital paid via participations. The reassignment of financial risks and the pricing of the process, is critical to any new deal technique. The fundamental flaw in the industry’s capital market process to date, lies in the failure to appreciate the true cost of capital. RISE OF THE POD’s Dialogue from The Da Vinci Code Robert explains why even the most complex problems may have simple solutions. Sophie “You solved the Grail…” Robert “There was every orb but one, the one that fell to earth and inspired Sir

Isaac Newton’s works, discovering gravity until his dying day, the apple….. The code was APPLE!”

The one page production budget is coming to a store near you as the industry adopts a POD mentality. The Rise of the Machines in Terminator 3 saw a new future world model come to the fore to replace human kind and so it is in the film business in 2006. The operative industry culture needs to change and the rise of the PODs caused by the de-verticalization of the business is here and it is inevitable. Long term industry partners must be developed as entities with strategic value that can be maintained to ensure long term production viability. The system needs product and if production moves off the lot to new industry partners then a new economic model must ensure they can do more than just survive. The new movie industry value chain needs partner

suppliers able to supply product at “best in class” standards at a lower long term economic cost. The POD business model has much to offer and the new supply chain will see the growth of the following industry production cells as key POD business concepts. The final outcome of the POD approach may be the development of the 1 page production budget, filled with cost inputs from the cells that form each of the industry’s major supply PODs.


Global Crew Pod The critical resource of a skilled production crew in 2006 is no longer a Hollywood centric production asset. A global crew POD business opportunity exists for players who supply top crews drawn from a global market place. The ways in which this economic reality plays into the soft money market place is becoming more defined as new games evolve. The ability to move key crew elements globally to obtain cost and tax savings is now already under way as many major players move to out-sourced and off-shored business models. The next wave will see the business process of the function moved completely outside the in-house production system. The economic sense of 1 line in the production budget saying “crew cost” is compelling and the benefits of “not on my books” protection is how business will be done. Crew POD approaches will see one payment go to the POD crew supplier who is more than just the employer of record. The crew POD will be the employer in fact, responsible for all taxes, union liabilities, record keeping, soft money compliance and human resource consulting. A global employer capable of putting a hit team together of the best skill sets drawn from crew sourced from many places. A one-stop-shop source for obtaining skilled crew minimizing costs and while maximizing benefits. The ultimate loan out company that bills for labor supply in relation to production crew needs who takes for a fee total risk and responsibility of the crew production risk. A valuable new business barrier that solves all the problems in one house, keeps all problems

contained and lowers production cost of crew. The skill levels of a global market and economies of scale inherent in such a model are obvious and cannot be resisted. Global Talent Pod The logical extension of the Crew POD concept is the Global Talent POD. The reality is as fewer talent become the key to a film’s bank ability and are not US based, the more likely Talent based POD’s will emerge. The cost of production must fall. There is no other choice in a world market. The reality is talent must become a contingent cost whose payment is related to a project’s success and recognizes that it takes little or no risk. What has to change is where talent gets excessively paid irrespective of result. The advent of star vanity labels are a pre-cursor of this coming trend. The new talent POD concept may well see agents, lawyers and managers involved in the POD as it becomes not a servant but a talent master. The POD approach may supply all the above line talent on a wrap around basis, responsible for casting, direct employment, taxes and soft money record keeping. The cost savings from partially deferred contingent payments tied to gross box office or DVD gross revenues, may well become a new model.

The POD gets paid similar to a SAG residuals model and then splits it to the talent as negotiated. Talent becomes a production reinvestment entity in the final result and a complete reversal of the cost plus mentality of the last decade.


Production Lot Facilities Pod In a global market, production facilities are everywhere you want to go. The cost of LA real estate and high overhead make out-sourcing production space and facilities on a deal by deal basis highly attractive. The world economies of scale have caught up with the Hollywood dream factory whose capital assets are now too expensive and whose utilization comes with the price structures of SAG labor. New production facilities will be created so that such companies can keep production at capacity by sourcing work from all the Studios not just one. The provision of such costs will also enable profits to be invested into production copyright ownership by way of margin reinvestment. The system then has to play fair with that equity as if it does not it destroys the hand that feeds it directly. The price of this model is much better than that which the industry faces today and provides for the real prospect of production equity investment at some level. Production Management Pod The most critical deal resource will increasingly be the “best in class” skill levels of the producers. Leading independent producers and former on-the-lot favorites will be the new production POD managers who are the principals engaged to make films on a manufacturing basis. Key relationships will remain but there will and has to be

flexibility for such producers to make product from any source. The ability to make films, on time and on budget with the highest level of screen production value is a strategic industry goal. The Producer POD will wrap all the production accounting, financial management and core film production expertise in one place. This means real production skill levels will increase while actual cost profiles decline due to no longer supporting a plethora of on-the-lot housekeeping deals. Post Production Pod The advent and pace of new technology has seen the effective out-sourcing of post production skills particularly in CGI, animation and VFX. The Pixar acquisition aside, the trend is to out-source such services. The trend will accelerate and the profit margins inherent in the work make such POD service provides new potential equity investors. The high margins lend themselves to some form of quid pro quo reinvestment in high end projects and payment forms that reflect the audience acceptance of the work quality. The high cost hardware and huge costs of soft ware development need to be spread on an industry basis and increasingly this will be the preferred operating model. Marketing Pod The provision of prints and advertising together with the whole product marketing function demands change. The reality is that major players are attempting to do deals where for minimal production cost exposure and just prints and ads money, they recover marketing capital plus earn distribution fees at little to no risk.


Downward pressure in the US domestic market has seen such players able to cover all risk by limited theatrical release cost spending exposure while making healthy claw backs from the cross collateral of DVD rights revenue. The latest market trend is the development of direct to video deals that pay no minimum guarantees and hence carry no deal risk. The model is all profit with no risk and long term the hidden cost is the burn faced by the production investors. The ability for producer via a POD to tap into these marketing functions, including direct media placement through advertising agency expertise and PR skills, will result in lower costs to the overall deal. Distribution fees could well be split off to these new marketing POD service providers if they are also advancing releasing cost capital investment. Hollywood Banker has for some time in past articles suggested P&A swaps that see marketing money investors flipped into pari-pasu production investors and vice-versa. Development Pod The limited number of films actually under the direct control of the major players in their current and future slates after one takes out remakes, sequels and franchise product, leads to the conclusion that development could be a service POD. A POD where development costs are externalized to companies who invest in rights, spend initial development seed capital and then on-sell the concept to the Studio system. Already several wealthy players have started such models whose economic rationale lies in the fact that key rights investment in core creative product is a viable enterprise. The tax treatment of expenditure in many jurisdictions is a problematic hand brake, but the development (pun intended) of new capital markets in this part of the industry process with viable exit strategies is on the way. The latest entrant in this vein is Wind Dancer Films, which has sourced private equity to develop projects that will then be financed externally to move into production mode. The company, owned by Matt Williams from What Women Want and the television show Roseanne, was backed by some Merrill Lynch private equity funds. Library Owner Pod The purchase and re-sale of copyright interests such as the Dream Works library buyout by Paramount to 2 wealthy players is a sign of a coming wave. The new wave of high definition DVD, 3rd screen downloads to phone and ITUNe type models and the coming explosion of VOD make long term content more and more viable. How viable depends on the art and its longevity, but seminal films may have substantial long term values akin to syndication models seen in the television market.


The idea of POD investors acting as a take out model for the production process investment under some new capital market structure is very appealing. DreamWorks tried to be innovative by creating credit line collateral secured by library values as determined by future box office values. Such efforts aided by other new capital market financing techniques will be the hall mark of the library owner POD players. Players that own significant industry cash flows from prior product have a capital base upon which to base investment in future product. New models may well use a cash flow type swap to fund current production copyright acquisition. The Cellular Approach of the POD Thinkers The selective use of a number of POD entities to out-source production skills and capital will see each POD acting as a unique cell containing its own cost of capital and business risk. The collective weight of this approach will see films made in a “best in class” way at the lowest cost. The POD thinkers will as the approach works become even more aggressive in assuming the old development, production and marketing roles that were formerly kept in house. The system will get comfortable with how to finance and control new business models. Studios due to the runaway production boom during the soft money bubble are already used to such ways of thinking. The rise of the POD creates more fat from lowered production costs and those savings can be split. First, into a lower industry risk profile and second, as seed money for new partners to become real production investors. The realignment of risk and return with suppliers of services and/or capital sharing is part of a production investment paradigm shift and a key feature in any new capital market. The industry money tree will have to change to compensate for new ways of thinking because if it burns key suppliers it will bite the very hand that feeds it.


SOFT MONEY CAPITAL MARKET STRATEGY

Dialogue from The Producers Max “Do me a favor and move a few decimal points around. You’re an accountant

and part of a noble profession. The word count is part of your title…” Leo “It’s cheating….” Max “Its not cheating its charity….. Bloom you’ve got to save me don’t send me to

prison help meeee!!!!” Leo “Yes, alright I will do it $2,000 is not so much…. I am sure I can hide it

somewhere after all the IRS is not interested in a show that flopped….” Leo demonstrates why Soft Money is never ever what it seems. Monetization The wave of intra-nationalism that personifies the world of soft money finance in 2006 has created a new business reality. The new incentives around the globe are increasingly not self-financing like the old tax shelter investment plays of the past. Most incentives sadly are paid on the completion of production and this means that there is an upfront need to finance an incentive. “Monetization i s a new film business necessity” The value of the incentive that forms the collateral core is the critical issue for lenders and for completion bonders alike. Estimates of incentives must be accurate as to the amount and more importantly certainty. Problems occur is there are changes in the production spend which devalue the incentive or put it at risk of default. An analysis of the incentive value needs to be done by both the production accountants and an independent party. In some programs the only issue is the value and if the program is straight forward the risk of non-qualification taking the incentive down can be relatively well covered. The real problems come where the spend criteria are so picky that a non-compliance issue endangers the whole incentive payment. Banks will lend against incentives but they are conservative and often require further collateral security against the possibility of non-payment. The provision of extra security may not be possible. In many jigsaw plays by independents there is simply no spare collateral. Another problem is a savvy outside lender will probably only agree to make an advance late in the production cash flow cycle. The idea is that the loan will be conditional on the production spend from other sources being used first to evidence the qualifications for the incentive being met.


Enter a new breed of entrepreneur who either lends or invests against it or in the collateral of the security to be found in the payment of a future incentive only. The comfort level of such lenders and availability of loans depends on the rules relating to an incentive program. The track record of the country or state in making payments of such money is also a key factor. An player who can lend, monitor and actually do the accounting for the incentive under the same web of expertise is a real insider edge. New lenders who specialize in this sort of money depend on know how and input into the incentive process as a hedge against the risk of program non-compliance leading to a loan default. The lenders who monetize incentives in risky compliance situations will want interest and perhaps a back-end kicker. The justification for such incentive rewards and security is that while soft money lending appears to be a debt transaction, it is in essence an equity one. What is really happening is that if the collateral pool against deal resources is not being impacted then the loan is against a contingent revenue stream. The risk is really reflective of a non-recourse loan in such a context and therefore more like a bottom tier equity play. Equity On-Sale Methodology Some incentive programs can be on-sold by the initial applicant (producer) to an end user (investor) upfront normally at a discount. Louisiana for example even provided for this in its initial legislation and allows a state tax credit to be on-sold up to 3 times. The cost is the face value of the discount the investor enjoys for early purchase of the credit. This, over a short time horizon can be expensive but the technique at least allows producers to monetize the credit up front, with no further security over the remaining collateral package of rights that will be required for other financing purposes. Self Monetization Programs Many Monopoly studio players carry their own deal incentive monetization risks in-house by simply financing the incentive up front and waiting for a post production payout. This often requires them to set up their own wrist length SPV entities in the foreign countries or states to claim the incentive. The upside is this may not represent a direct cash exposure as the studio overhead in a budget is a self financing tool used to underwrite it. However, most soft money programs do not allow foreign overhead as qualifying spend. Outside monetization follows the law of Hollywood. Never use your own money even where it is only your own future profit. Outside monetization ensures benefit to the deal regardless of result where as self-financing can be a direct cost as it may result in the loss of cash that the house could have kept itself. Another downside of this approach is that it may lead to a high risk of incentive loss and/or exposure to other taxes. The use of POD approaches to self finance incentives is a safer approach and will see Monopoly players monetize a POD player who makes the claim.


The use of POD players or other deal participants to monetize incentives can also be done if they invest in the film and tie payment contingent on the incentive receipts. Some programs prevent this others allow it. Most require that incentives can only be paid against spend actually incurred or accrued not on deferred or contingent spend payments. Bonders and other lenders are often not happy with such self financing plays preferring to see actual cash monetization not simply a round robin book keeping exercise between participants. However as monetization becomes more the rage many deal participants or investor interests may move to self-finance the incentive payments. Interestingly this type of investment is the kind of classic arbitrage that a hedge fund should be involved in. An investment in equity via money paid late in the production cycle against an incentive with a high yield and low risk threshold. A hidden time bomb in any loan or equity swap of soft money as part of the monetization process comes from the fact that it may be taxable or denied via some unrelated tax matter. Tax credit driven programs depend for payment on the SPV applicant, not having other tax obligations that detract from the payment. If an entity is hit with any unexpected tax bills (VAT/GST/Income Tax etc) then the soft money payment may disappear. Yet another risk in the new soft money game and yet another hidden price to potentially contend with if you want to monetize soft money.


INCENTIVE MAXIMIZATION - 2006 STYLE

Dialogue from The Da Vinci Code In scene where Silas the devout albino killer monk explains to the mysterious Teacher how he got the location of the Key Stone and how he motivated the Keepers of the secret to talk. Silas “Teacher, I have the location I have had independently confirmed by all.” Teacher “I had feared the Priory’s penchant for secrecy might prevail”. Silas “The prospect of death is a strong motivation….” Dying in the movie business is a strong motivation and it is such fear that drives the quest for the Holy Grail of free soft money for nothing production finance incentives. At the zenith of the soft money bubble, it was not uncommon to see not just double, but triple dip plays tapping soft money from three or more countries inside of the one deal. The UK/Germany co-production models with another nation, being the most common. The credits at the end of such films were often more interesting than the movie itself to those of us who dabble in the science behind the art of such deal structures. In 2006, most incentive programs are so specific in relation to activity and/or status requirements that they make it very tough to double dip let alone triple dip. Nature however always finds a way and 2006 is no exception, so we present the latest curve balls. The reality is that it is very hard to go from a game where some 35%-50% of the production cost was sourced from essentially “free” deal incentives, to a mere 10%-20%.

The New Double Dips in play in 2006 are:

A) Shelter to Shelter B) Shelter to Subsidy C) Subsidy to Subsidy D) Internal Subsidy on Subsidy

A) Shelter to Shelter Tax Shelter to Tax shelter deals are still possible, but only in limited circumstances as most countries are aware of the UK and German deal models previously used and ultimately rejected by the respective authorities. Some promoters from the Sale and Leaseback world have tried to move the dream to other countries. However the days of using films as risk free money go-rounds to generate tax savings to be split between producers and investors are over.


Many nations have film specific tax provisions that allow 100% write offs in Year 1, such as the US, Australia, New Zealand and South Africa. In order to use these provisions, the investor equity must be real and place the investor in a risk position where their ultimate net position from the investment is contingent to some degree on the financial performance of the film. Where the deals created are real, it will be possible to source private equity from 2 or more countries on the same film under a co-production style model, whether treaty based or not. It may be important to match the level of tax shelter equity sourced and the production activity from each country to avoid the imbalances and ultimately the increased scrutiny as seen in the UK. The high art of incentive stacking now is only for the real sophisticated players and then only for deals that fit the particular territory, as forcing the pieces to fit is a recipe for attack. The future will see less use of an SPV approach and more of a POD approach to affect such deals. Only such a substance driven approach will survive the karma of the recent past. B) Shelter to Subsidy There are many opportunities around the world to mix a Tax shelter with a Tax subsidy on the 1 film, particularly within the one country which is positive in this intra-national incentive environment we now operate in.

The old days saw this double dip occur between 2 different countries. The UK was the prime example of the country used to provide the tax shelter with say Canada providing the activity based tax subsidy. The imbalances this created have been well documented and future attempts to consistently push the envelope in this regard between other nations will lead to predictable outcomes. Ironically, the UK is now best positioned to provide the activity based tax subsidy portion of co-production deals with its wide treaty partner base. The USA is a prime example where the Federal tax shelter under Section 181 can be utilized with the various state based subsidies and rebates. In New Zealand and South Africa the laws also allow for this double dip strategy. The nature of such deals will become clearer but they will mean that some part of the finance plan is off the books equity and some will be taxable revenue and potentially accountable to all deal participants. Monetization of the subsidy component of such deals may be problematic, although this may be solved as part of the tax shelter equity arrangement.


How these fit together commercially is evolving. The net benefit seems to indicate a 20% to 40% net of tax equity contribution. This style of mixed intra-national play has a great future because the fit together is a natural one. However they may not stay long if they are abused. The net trade off assessment tax position also needs to be monitored, as many state incentives in the USA for example, require talent and crew to pay local taxes for their spend to be qualifying. New Mexico has set up a way for local loan-out corporations to qualify interstate talent for such purposes, but there may be a tax trade off negotiation between the producers and their agents! C) Subsidy to Subsidy Most soft money program criteria of countries, due to their intra-national focus make double dipping 2 or more tax subsidies very difficult. However there are examples where this is possible. There are some countries or states that have subsidies based on the residency of their cast and crew and not the location of where their services are performed e.g. South Africa and Hungary. Some territories also have a minimum threshold of local activity that must be passed, then the incentive may be calculated on a wider definition of qualifying spend e.g. Louisiana and Iceland. Be warned, these incentives change regularly and also have other sub-requirements that make shadow plays and multi-territory subsidy claims very tricky.

There are further subtle benefits available to a production in cases where for example, crew from one country are being exported to work in another country under such incentive stacking arrangements above. They lie in the favorable taxation treatment that most countries implement on foreign income derived by their residents. The interplay of the applicable double taxation treaties is very important to utilize these benefits, but depending on the countries in play, this concessionary tax treatment can be factored into the deals when hiring the crew initially. This is not to forget the potential fringe savings that may also be achieved. The Crew POD model suggested previously is looking more attractive. The other soft money double dip play is where under official co-productions, the respective government film bodies are both approached to provide bottom tier equity into a film. Much like the Shelter to subsidy deals of the past outlined above, if the minority partners are consistently the same countries, then an imbalance will occur particularly if the equity is never returned, killing off a valuable deal chip for producers. Public money comes with public scrutiny!


D) Internal Subsidy on the Subsidy Play The ultimate intra-national double dip is the subsidy on the subsidy play. The new trick is to make every dollar count twice. Many countries pay soft money at a Federal level and at the State Level. The prime example is that of Canada with its labor based rebates. Other examples are found in Australia where some states offer labor based incentives that are not deducted from the federal 12.5% incentive. Also certain parts of the production process are so highly valued by some territories that they offer additional incentive kickers to entice the work to their region e.g. specific VFX rebates or subjective post production grants on top of the generic labor or other activity based programs. These small kickers can quickly add up in the hands of a soft money expert. Care has to be taken to ensure within a country that best efforts are used to maximize the qualification for these double dip programs. Some governments will convert the anticipated incentives to be claimed into discounted equity provided upfront – a valuable deal tool for the jigsaw player. I NEVER KNEW WHAT I COULD NOT KNOW DEAL COST

Dialogue from The Da Vinci Code In the scene where the police surround Sir Leigh Teabit’s plane, failing to notice that Robert and friends are hiding in the back of the limo beside them. Robert “Did they notice?” Leigh “People barely notice what is in front of their eyes, don’t you find” In soft money structuring many people fail to see what is right in front of them. Such blindness in this game costs millions of dollars in unclaimed opportunity costs. The new rules of the soft money world have created a different operative reality. Explosions of global soft money incentive programs, combined with their intra-national focus, has closed down much of the abusive conduct in this area. However much is still possible and it is critical for any player to obtain access to the high art applications of soft money incentive attraction. Most players even the largest however can fall victim to not knowing what they never knew thinking. Such thinking flows from being victim to what appears to be the normative logic of the known world. The earth was initially considered flat until someone fell off the edge. In this area, hiring the best will protect deals from falling victim to “I never knew what I did not know thinking” deal costs. Not tapping into the best or right way to tap soft dollars cost millions of dollars in opportunity costs. The following deal analysis decision matrix will help remind readers of the questions they must ask

themselves on their next project. HOLLYWOOD BANKER.COM

Deal Analysis Decision Matrix

1. Soft Money – is it tax credit, exemption, rebate, subsidy or shelter? 2. Is it taxable or tax free and if so when and to whom? 3. How can it be monetized and what is the resource impact on deal collateral? 4. Can it be double dipped? What are the trade offs with regards to activity and status criteria?

What are the economic prices to the film budget from off-shoring? Are these extra costs or savings? Do they create currency hedges or more problems?

5. Can it be funded by a local film investment body? 6. Who is its accountable to and where does it fit in the deal money tree? 7. What if any are the shadow play potentials after considering the impact of net trade off

assessment on the deal model? 8. Where is the due diligence and independent audit? Is the soft money really at arms length if

an SPV gets attacked? 9. What is the high art play? Have all the play book options been tapped in the target nations?

Are there any other nations offering a better deal? Is the deal shelter to shelter, shelter to subsidy, subsidy to subsidy or internal subsidy on subsidy driven?

The mix of answers to these deal soft money questions are a crucial antidote to the unstated fear of falling victim to I didn’t know thinking. The real high art lies in seeing the whole picture (pun intended) and then adjusting the parts, soft money included, for maximum leverage. In this respect optimal outcomes will never be found in accepting vanilla perceptions of tick the box book keeping as they hide the nature of risk and accountability that lie dormant in every deal in a global market. Who is entitled to soft money and how it pla ys into profit sharing on the back end and down through the revenue waterfall as it rains on the privileged few is also a far from settled matter. HB in a future piece explores the complex deal issues that surround such thinking. Future soft money plays and much litigation may flow from the lack of appreciation of how the free money crumbled into the deal. Finally, many have lost millions and millions of dollars by obtusely not appreciating what is possible. The fee for high art is a fraction of the saving. Money for nothing does not come free in this game only the ignorant pay the true price in opportunity cost foregone. To borrow a line from the recently departed Wild life hero, Steve Irwin, you have to be a passionate Soft Money Warrior to keep up with all the potential deals that could be done.


HARD EQUITY MEETS FINANCIAL INNOVATION

THE LAKE: FEOMS: RPA : SINS: INNOVATION

Dialogue from The Producers

Leo “Lets assume for a moment that you are a dishonest man” Max “Assume away” Leo “When you produced your last show Funny Boy, you raised $2,000 more than

you needed but you could have raised $1m and put on your $100,000 flop and kept the rest……”

Max “What if it were a hit?” Leo “Then you would go to jail. You see, rather than selling 100% of the show you

would have sold more than 1,000%. If the show was a success there would be no way to pay off the backers…..”

Max “So for the scheme to work, we would have to find a sure fire flop…” Leo “Our scheme? I merely posed a little accounting theory It was merely a

thought.” Max “Dear Bloom, Glorious Bloom the world is turned on such thoughts.” Indeed the world is turned on such thoughts the real problem is not creating innovative film finance techniques but in accepting them. CAN THE REVENUE WATERFALL BECOME A LAKE UNDER A NEW AGE BUSINESS MODEL? The film industry has at an operational level created a Studio driven economic mantra, commonly known as the revenue

waterfall. The Opus Dei zeal of the system to inflict this upon talent and civilian investors alike, is a masterful use of the hypnotic power of an established false belief becoming an unsustainable financial illusion. The Priory Sion composed of independent


players and talent, have many times tried to find a better way to prey. Over time, Star Power invented Gross Point deals and SAG tagged distributor level revenues to grab residuals, as these 2 priority claims changed the free fall flow of money down the waterfall. However, minor talent and civilian investors remained at the bottom stuck in a perpetual drought. The Lake In this fifth wave of financial change the proceeding four waves have made way for a new market concept known as the Lake. Under the revenue waterfall only a privileged few are blessed with the Holy water of actual deal revenue. Under a Lake model the streams of all revenue flow into a common pond that pools to form a lake of money. Water from many revenue streams flows into the lake and touch many different shores at the same time ensuring that all life in the film business gets sustained. While major players in priority positions get to enjoy most of the lake water some of the smaller creatures will get to live again and to perhaps re-invest. The thematic of the Lake replacing the waterfall as an industry model is the coming reality. The number of star and private equity and/or gap deals that carve out exclusive revenue corridors, is already a deal reality in 2006. As the lack of future private equity, new soft money rules and de-verticalization changes hit the business, the Lake model will come to be the operative industry model. The ability to feed all parts of the deal in a

lower cost environment will be a critical deal price one that Hollywood can and must pay to get the benefits. New industry partners need to be viable business models with long term ability to provide high quality product and production values. In a leaner and meaner operating model there will be no option but to pay and the market place will take care of this aspect. The problem is the House will still want to stack the odds as this is the only way the House can remain viable in a stable Paretan Distribution model. Surviving comes by making money off people lower down the food chain at no cost and at little risk. The stable nature of this core economic risk mitigation is what underwrites the Studio plays on the big table. The film industry is in many ways a zero sum game. If I win at the box office you lose unless the market grows at a fundament level. The John Nash insight of co-operative game theory explored in A Beautiful Mind is now at stake. The studio model is in flux and only those who adopt a co-operative game theory approach to talent, crew and civilian money will survive. Survival will come by application of the Lake principle. The Lake model will no doubt like all religious advances be denounced by the system, but the water is already pooling.


The Lake metaphor as a perception tool may also lead to some deal participants to construct economic deal models that do conform to the law of large numbers and to have normatively stable bell shaped distribution curves. For example in the area of soft money monetization and the packaging of gap loans against pre-sales and sales estimates. Other revenue niches that are marked for specific deal participants may also be capable of such packaging. The Lake shape means that participants that are normally not able to enjoy any prospect of revenue nor able to calculate any outcome due to the system, now can. Under a Lake model, some revenue touches each shore and depending on the source and its predictability, it may be relatively stable enabling it to be packaged and on-sold. The Lake approach is then an attractive way of re-thinking the industry financial picture. Many new ways of financing and packaging industry revenue streams will come from such a focus shift and add to the capital markets available. FEOM - Fractionalized Equity Ownership Models This comes straight from Lake approach thinking. The waterfall thinkers see only those at the top able to secure money for the dream while those at the bottom find it hard to find new followers. Under the Lake approach deals can be seen through the prism of FEOM thinking. FEOM occurs when parts of the deal are fractionalized into various different

ownership interests and related cost centers all of which have access to general as well as dedicated revenue corridors. The ability to reconstruct the rules of the game in this eclectic way means that the sum of the finance parts is greater than the value of the former whole. At present, vanilla deal ownership models are constructed on a bottom tier equity game model akin to the biggest loser. Plays that always see the same players stuck in the same old place and getting burned as they are yet again the biggest losers. FEOM thinking looks at each deal piece and then re-orders its risk relative to general and specific revenue corridors that are peculiar to it. Such deal making can create FEOM interests that are highly stable and have finite variances that will allow the laws of large numbers to apply. The new film finance architect has to ask not how much a deal participant is getting in terms of back end or priority rank in the waterfall revenue illusion? Rather the issue is what does this deal piece entitle me to that is actually mine, what is that worth and what is the variance likely to be? In a co-production example the right to home territory revenues and/or local soft money incentives may change instantly the risk profile of a bottom tier deal participant’s investment prospects. The ownership of copyright and/or back end can be an illusion. High investment risk to a production investor may be cut substantially if that party has def ined or


guaranteed revenue corridors to recover the investment from. FEOM breaks a films revenue resources and the order of the waterfall down into a deal mosaic of various parts. FEOM capital from co-production partner A may look totally different from that in relation to co-production Partner B. These deal interests may then look totally different from the distributor who is merchant banking upfront for later down sale, a package of foreign territory revenue. The point of FEOM thinking is that it adopts a flexible business posture towards every deal participant. The old days of fixed copyright and/or back end interest under such an approach method are now a dead letter. There is no point in owning 100% copyright in a film that had been stripped bare upfront in perpetuity. The FEOM creation of distinct new legal interests carved from a central core of revenue stream entitlements over various places, times and rights is a new wave film finance strategy. The smart player is first interested in the risk profile of their FEOM and then equally interested to ensure other deal participants know the risk related to their bit of the pie. The hidden gain in reconstructing all deal pieces is that if the models work they add more to the finance package than a vanilla financing route ever could at often a lower collective risk. RPA – Revenue Participation Agreement This idea is not new as it last made its appearance in the short fall insurance era when in the CHASE v AXA case it was famously documented. In that case the investor’s SPV purchased from the film distributor, an RPA rather than a direct interest in

the underlying copyright or specific territorial licensing rights. The RPA denotes a new rights packaging tool that bundles revenue streams from licensing rights together for sale to investors. The investor group owns nothing in the copyright of the core intellectual property rights but merely an entity generated right to participate in film revenues as defined in the RPA itself. This tool provides for the possibility of bundling and packaging different revenue streams to create a new asset class that may appeal to investors. The ability to create equity or debt interests from packaging contingent deal revenues from one player in the waterfall revenue to another is a unique investment product. The ability to play with the risk curve and to structure returns relative to it over a film or a slate using this technique has resurfaced. Hollywood Banker in 2004 developed a new way of film deal analysis by creating a perception tool called hydra modeling. Under this way of thinking the waterfall model was deconstructed in the soft money, hard equity era to account for linear and non linear revenue and cost components. The idea behind this concept was to allow deal participants to see where they stood in the money tree and at what risk.


The Hydra Model approach of defining revenue and cost components into linear and non-linear categories, coincides with the mathematical approach of Dr De Vany. The linear aspects carried into the deal mix infinite variance probability and the non- linear carried more finite probability characteristics The RPA tool creates a way of bundling linear and non- linear revenues to generate a new asset class for investors to have faith in. In the Chase v Axa case, the RPA was general and covered multiple revenue streams but in a bottom equity position. The future lies in using this technique with the FEOM to create equity positions where the risk profile is more than that of a bottom tier equity player . Soft Money and split rights thinking will see new RPA products that come from a FEOM point of view that ensure some return to the participant is obtained from general or unique specific deal revenue corridors. This type of deal making is already in play as many Hedge Funds have secured general revenue corridors similar to gross point positions enjoyed by stars. There is no limitation on what and when this type of thinking may apply. RPA investments create unique tax impacts in relation to write offs and revenue assessment and these form part of the attraction to sellers and buyers alike.

SINS – Synthetic Investment Notional Securities

Dialogue from The Da Vinci Code Robert Langdon first unravels the anagram that leads him to the Mona Lisa painting that is the start of his quest. Robert “Draconian Devil The

Only Named Saint…. The phrase is meaningless unless you assume the letters are out of order…”

Sophie “An Anagram?” Robert “Yes, look it becomes Leonardo Da Vinci’s Mona Lisa” Hidden in many sins is the seed of virtue as our analysis portends. Given the many SINS of past film finance players this is more than an appropriate acronym. The future of film finance requires as per the RPA example above the creation of a whole new bunch of security interests that meet capital market needs but which are in essence synthetic instruments used to repackage risk and reward relationships.


The current flawed hedge fund and private equity approaches under the waterfall system using a portfolio risk aversion mentality are bound to fail. A bottom tier equity player or even first tier one playing behind the studio distributor and their fees and marketing costs simply cannot win. However, SINS are a way to save the day as even in a Chaos Theory driven world there are approach methods that can be used to re-distribute risk and return effectively. The use of futures, currency swaps and options are examples of the wider finance industry’s ability to repackage risk through the use of synthetic thinking. The futures contract invested in orange juice does not require an investor to have a direct interest in the orange. Equally in the film business real capital market viability lies in creating investment grade securities that bear no direct ownership interest in a film’s underlying property rights or indeed any related specific licensing rights per se. The Hollywood Banker over the years has described various models either as debt, equity or hybrid structures that could do the job. The key to designing an effective and appealing product for capital market investors lies in understanding what sells. The design must address principle risk, interest rate risk, moral hazard risk, tax risk, liquidity and/or salability issues. Not all problems or issues need to be resolved but any design if it is to create a new asset class must consider these market related issues. In past work we have looked at Tax Shelter Equity Investment models as SINS type instruments.

The ideas like RPA structuring and FEOM style thinking will drive the creation of new products. The Lake conceptual approach frees deal makers to create new kinds of products with new risk reward relationships not tainted by the waterfall priority skewing of outcomes to ensure civilian participants always lose. Those at the top of the deal tree will in a stream lined POD driven production environment, enjoy improved reward to risk ratios as they have less core production and marketing capital on the line yet get to retain distribution fee earnings. Parceling of risk is a function of all financial markets and the entertainment industry can create products that are acceptable. The real issue is will they move to this point as many financial products that could be created suffer from the fact that it is cheaper to finance in-house. Exporting risk and reward comes at a cost. When using debt it is interest and when using equity it is profit. The science behind the art of new money raising comes in balancing the cost of off the books money so that it is cheaper to go outside than finance internally. Dr De Vany in his mathematical analysis has given voice and credence to a number of financial matters that in relation to both tax and securities law applications, confirm what Hollywood


Banker has always written about. Namely that the infinite variance of some linear revenue streams such a box office or DVD sales can only be mitigated by zero risk deal models or some other form of synthetic financial mit igation. The cost of pre-selling territories may if there is no upside protection in case of big hit rob all the deal participants of a major win. The position of a gap financier and 1st tier equity finance, leaves bottom equity exposed without any revenue corridor and therefore most likely to result in loss. Investors, whether they be equity or tax driven, need to be apprised of these statistical realities in any prospectus or private placement memorandum. Any investor would trade the certainty of loss for some other synthetically derived outcome. A low risk asset class with limited return potential plus a limited kicker may well prove attractive to those seeking exotic investment returns, while being covered for some down side risk. The ability to create synthetic instruments that meet market design standards and are securitized as well as negotiable has arrived.


INNOVATION 2006 In a post Hedge Fund market place the following equity investment trends will come to the fore:

1. Pure tax shelter deal models that do not split tax savings but rather include them as part of the investment product structure will come to the fore. Such models will never see money kicked back from savings to investors up front as one off de-facto subsidy deals did in the past. The use of Section 181 under the American Jobs Creation Act 2004 along with other accelerated write off provisions available globally will expand the role of gap equity.

2. Bottom equity plays will die off as private and institutional money learn the hard way.

Securities law will increasingly demand that “dumb” money gets told the realities of the deal. Saying it is a high risk investment is not meeting this obligation.

3. Gap funding via debt or equity models that use asset class securitization over very strict

criteria may grow as a financing tool.

4. New industry partners will invest POD money from taxes and profit margins back into production models to secure business. Many post production houses are already in this model.

5. Soft Money Monetization will be the new hot game in town. This will result in new asset

classes packaged as loans that may be capable of being pooled.

6. Soft money double dips via new uses of incentive programs will seek to create core equity finance post taxes that will form the new real bottom equity in deals.

7. New players in P&A funding may be able to create production funding so that the revenue

corridors from 1st dollar gross flow back to the joint capital pool of blended marketing and production resources.

8. Talent and crew and how they are used, where and how they are taxed is a new financing

tool in a global market. New models of contingent payment and reinvestment via revenue corridors will change the nature of above the line costs.

9. Lower cost structures that reduce the average cost of production will create new fat to

reinvest. The Studios will act as merchant banks and less as production entities or even distributors.

10. New forms of equity or debt instruments or hybrid securitized instruments will use RPA

techniques and FEOM thinking approaches to generate SINS type investment products for public or private sale.


11. Capital will be divested from the Studio systems equity base and flow into the POD

suppliers. Capital released will lower Studio overhead and create new economies of scale that generate better returns on all industry assets.

12.Studio capital that remains as finance coin needs to evolve into new models and be used

intelligently to lever production and marketing while cutting the average cost of capital. New ways of doing this will flow from all the changes mentioned.

POSTSCRIPT Dialogue from The Da Vinci Code Robert “So dark the Con of Man…. Another anagram – Rocks Omen, Madonna,

Codes Demons…… got it, Madonna Rocks is a painting by Da Vinci” The dark con of man that fears seminal change is what holds the film industry back. The coming Lake approach to revenue sharing over the current Waterfall model is already upon us. As real risk equity gets hit out of the ball park, Lake driven approach thinking will be the only way to do deals. The finance implications of the four waves discussed will come home fast and hard. The new lean industry model that will be co-dependent on industry partners will be forced into revenue sharing not revenue grabbing. The Studio system will become more and more bank and less and less a production and/or distribution business. The growth in new ways to structure FEOM deals so that deal participants can self monetize their piece will be of great benefit to those seeking bankable money. Soft money may well remain the only true bottom tier equity under a defunct waterfall approach. Other investor money will need to calculate a deal form and a deal model that is legally reflective of the real mathematical bias of the system. Promoters who make offers to investors who are kept in the dark about the pre-set odds will find it harder and harder to find money. The HOLY GRAIL of stable enduring long term sustainable capital market for film finance is possible if you are one of the faithful. The growth of new soft money, better tax structuring and new infrastructural change sets the climate for a better way. While the system devours its young it cannot expect to grow creatively or financially as it lacks both the moral and the financial imperative to do so. The future is bright for independents as they are the new system. Hollywood past is no longer Hollywood present. Hollywood future is already knocking at the Hedge Fund door and the final curtain is going down. Only a new Max and Leo can save us now or will the old mentality die and real creative capital come to the fore?


Dialogue from: The Producers Film and Broadway success is always only a few steps away. Max “Step One, find the worse screenplay ever written! Step Two, hire the worse director in town! Step Three, raise $2m, one for me and one for you…..There are a lot of little old ladies out there! Step Four, hire the worse actor that ever worked and before you can take Step Five, we have a flop and take $2m and go to Rio...”. Leo “That would never work!” Max “Ye of little faith....” Max restates the ultimate industry formula but within it there is the kernel of hope that new thinking will one day change the film finance game. THE END

“The Movie Industry” even a meaningless phrase such as this can when unraveled, reveal the deepest coded message of all. Watch as the word salad of anagram divination spits out chilling words that form mysteriously into very timely industry prediction. On More Money Trust Dies More The Men To Street In Dust Moves Onus Try Into Must End Tree Their Invite Is Time Industry “Trust in Movie Money men Dies on the Street” “The onus is on the Industry to try more moves to invite money into the movie money tree or their time must end in dust” THE HOLY GRAIL OF FILM FINANCE KNOW HOW HOLLYWOOD BANKER .COM

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