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Hollywood's hedged bets

Studios share risks, and losses, with investors. But rules may change.

February 16, 2008|Michael A. Hiltzik and Josh Friedman | Times Staff Writers

On paper, "Evan Almighty" looked like a sure thing.

A spinoff of Jim Carrey's smash hit "Bruce Almighty," the film starred Morgan Freeman, reprising his role as God, and Steve Carell, one of Hollywood's hottest comedians.

But "Evan Almighty" turned out to be a dud, with an estimated $250 million in production and marketing costs and just $173 million in box office revenue.

The film's distributor, Universal Studios, is not the only one feeling the pain. A Milwaukee hedge fund put up millions of dollars to help bankroll the movie and more than a dozen others, according to investment bankers. Hedge funds have been a major source of capital for Hollywood studios over the last three years. Drawn by projections of double-digit returns with minimal risk, they pumped $13 billion into 150 major pictures. Typically, they helped finance "slates" consisting of as many as several dozen movies. Now, the glitter is gone. Many of those deals are likely to lose money for equity investors, according to investment bankers. The toll could reach hundreds of millions of dollars.

For The Record
Los Angeles Times Wednesday, March 19, 2008 Home Edition Main News Part A Page 2 National Desk 1 inches; 63 words Type of Material: Correction
Studio financing: An article in Section A on Feb. 16 about hedge-fund financing of Hollywood movies said studio projections for films in an investment pool known as Gun Hill Road I indicated that "Doom," "The Holiday" and "Stranger Than Fiction" might lose a combined $100 million over seven to 10 years. The projected losses for those three films are actually about $84 million.
For The Record
Los Angeles Times Friday, March 21, 2008 Home Edition Main News Part A Page 2 National Desk 1 inches; 45 words Type of Material: Correction
Studio financing: An article in Section A on Feb. 16 about hedge-fund financing of Hollywood movies incorrectly identified Och-Ziff Capital Management as an investor in a slate of films known as Gun Hill Road I. Och-Ziff was not an investor in Gun Hill Road I.

In some cases, studios have restructured deals to appease angry investors. Sony Pictures, whose investors backed such flops as "All the King's Men" and "Stranger Than Fiction," agreed last year to absorb some marketing costs originally charged to them, according to three people knowledgeable about the matter.

Sony agreed to swallow $20 million in marketing expenses, one of the sources said. Another said the figure could reach $45 million.

Bob Osher, Sony's chief operating officer, confirmed the restructuring but declined to discuss the financial terms. He said the renegotiation "was never related to any specific cost element of the pictures."

New deals will carry more stringent terms so that the studios can no longer profit if their backers end up in the red, investment bankers say.

"Many of the equity investors who have gotten into the industry in the last 24 months have woken up and smelled the coffee," said Eileen Burke, a managing director at investment firm D.B. Zwirn & Co. "They're either going to say, 'I don't want to invest anymore because I don't like the misalignment of interests' or they're going to insist on better alignment."

The drama has largely played out behind the closed doors of the famously secretive hedge funds, pools of private capital that almost never disclose profits or losses.

The most prominent intermediary between Hollywood and the hedge funds is Ryan Kavanaugh, a 33-year-old former dot-com deal maker. His West Hollywood investment firm, Relativity Media, put together some of the largest and most publicized financing packages, including the one that backed "Evan Almighty."

Kavanaugh sold hedge fund managers on the idea that investing in a dozen or more films at a time would reduce the risk that a single bomb would sink the portfolio. He also touted a computerized system he said he had developed to distinguish between potential hits and misses.

"He figured out how to create a financing formula that satisfied studios and investors and banks," former Columbia Pictures Chairman Mark Canton, a friend and business associate of Kavanaugh, said in an interview.

Kavanaugh declined to comment for this article. In the fall, he told the trade paper Variety that gains from one of his funds would approach 15% to 25%. Investment bankers, media analysts and Hollywood executives expressed skepticism.

"The industry overall is generating single-digit returns, so it would seem unusual that these slate deals could do better than that," said entertainment banker John W. Miller of JPMorgan Securities.

That limitation was not so apparent in late 2004, when hedge funds got involved in Hollywood in a big way. The funds were enjoying record inflows of capital and looking for new investments. The movie business was enjoying explosive profit gains stemming largely from sales and rentals of DVDs.

Studios were looking to mitigate the financial risks of producing movies. Traditionally, they had relied on bonds and bank loans that produced dependable profit for lenders. But the studios bore all the risks of failure.

When the idea emerged to offer backers a piece of the action, rather than merely fixed interest payments, it looked like a win-win proposition. Although the studios would have to share some of the profit from hit movies, they also would shed some of the risk of losses.

The investors would collect their returns once all the films in a slate had opened and started to generate DVD and television revenue, usually five to seven years after their theatrical openings.

At meetings in studio back lots and Wall Street skyscrapers, hedge fund managers heard investment banks and promoters project annual returns of 18% or better. They were so jazzed that they agreed to forgo some of the protections that bank lenders had imposed on film companies, such as limits on marketing budgets.

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