First, Paramount got $65 million from Intermedia Films in Germany in exchange for distribution rights to Lara Croft: Tomb Raider for six countries: Britain, France, Germany, Italy, Spain, and Japan. These “pre-sales” left Paramount with the rights to market its film to the rest of the world.
Second, it arranged to have part of the film shot in Britain so that it would qualify for Section 48 tax relief. This allowed it to make a sale-lease-back transaction with the British Lombard Bank through which (on paper only) Lara Croft: Tomb Raider was sold to British investors, who collected a multimillion subsidy from the British government, and then sold it back to Paramount via a lease and option for less than Paramount paid (in effect, giving it a share of the tax-relief subsidy). Through this financial alchemy in Britain, Paramount netted, up front, a cool $12 million. Third, Paramount sold the copyright through Herbert Kloiber’s Tele Munchen Gruppe to a German tax shelter. Because German law did not require the movie to be shot in Germany, and the copyright transfer was only a temporary artifice, the money paid to Paramount in this complex transaction was truly, as the executive put it, “money-for-nothing.” Through this maneuver, Paramount made another $10.2 million in Germany, which paid the salaries of star Angelina Jolie ($7.5 million) and the rest of the principal cast.
Before the cameras even started rolling, then, Paramount had earned, risk-free, $87 million. For arranging this financial legerdemain Paramount paid about $1.7 million in commissions and fees to middlemen, but that left it with over $85.3 million in the bank. So, its total out-of-pocket cost for the $94-million movie was only $8.7 million.
Since Paramount could be assured of selling the pay-TV rights to its sister company, Showtime, with which it had an output deal, for $8.5 million, it had little, if any, risk. As it turned out, the movie brought into Paramount’s coffers over $100 million from theaters, DVDs, television, and other rights.
Of course, it’s not only Paramount that employs these devices. Every studio uses them to minimize risk. In the case of the Lord of the Rings trilogy, New Line covered almost the entire cost by using a combination of German tax shelters, New Zealand subsidies, British subsidies, and pre-sales. The lesson here is that things in Hollywood—and especially numbers—are not what they appear to be, proving, yet again, that in Hollywood, the real art of movies is the art of the deal.
MONEY-FOR-NOTHING FROM GERMANY
A loophole in Germany’s tax code provided a good portion of the studios’ profits at least up until Germany attempted to close it in 2007. This “money for nothing,” according to the vice presidents at Paramount responsible for arranging these deals, had been earning $70 million to $90 million annually. Best of all, there’s no risk or cost for the studio (other than legal fees).
Here’s how it works: Germany allows investors in German-owned film ventures to take an immediate tax deduction on their film investments, even if the film they’re investing in has not yet gone into production. If a German wants to defer a tax bill to a more convenient time, a good way to do it is by investing in a future movie. The beauty of the German laws as far as Hollywood is concerned is that, unlike the tax laws in other countries, they don’t require that films be shot locally or employ local personnel. German law simply requires that the film be produced by a German company that owns its copyright and shares in its future profits. This requisite presents no obstacle for studio lawyers.
The Hollywood studio starts by arranging on paper to sell the film’s copyright to a German company. Then, they immediately lease the movie back—with an option to repurchase it later. At this point, a German company appears to own the movie. The Germans then sign a “production service agreement” and a “distribution service agreement” with the studio that limits their responsibility to token and temporary ownership.
For the privilege of fake ownership, the Germans pay the studio about 10 percent more than they’ll eventually get back in lease and option payments. For the studio, that extra 10 percent is instant profit. If studio executives don’t crow in public about such coups, it’s probably out of fear that such publicity will induce governments to stiffen their rules—as, for example, Germany periodically attempts to do by amending its tax code. When you’ve got a golden goose, you don’t want to kill it while it’s still laying eggs.
HOW DOES A STUDIO MAKE A WINDFALL OUT OF BEING ON THE LOSING SIDE OF A JAPANESE FORMAT WAR?
Although rarely, if ever, discussed outside a corporate inner sanctum, studios make so-called replication output deals in which studios get paid large amounts from Japanese and other foreign manufacturers to support their formats. Consider, for example, Paramount and Dreamworks’ win-win replication deal with Toshiba. In August 2007, in a last desperate effort to prevent its waning HD-DVD format from losing out to Sony’s Blu-ray format, Toshiba offered Paramount and Dreamworks (which Paramount distributes) $150 million to put out the high-definition versions of their movies exclusively as HD-DVD. In such deals, the DVD manufacturer pays studios up front cash for the right to make its DVDs. Supposedly, it is an advance that the manufacturer eventually gets back from selling the DVDs back to the studio’s video division in much the same way a publisher earns back the advance it gives an author. In this case, Toshiba paid Paramount and Dreamworks a cool $150 million advance even though sales of HD-DVDs were so meager in 2007 that Toshiba was unlikely to ever earn back the entire advance. The wrinkle to the deal was that the studios, Paramount and Dreamworks, agreed not to continue releasing their movies in the rival Blu-ray format.
For Paramount, it was a particularly sweet deal because the payment was booked as a “reduction in cost of goods” for its Home Video division, which meant it did not have to allocate it to any of the titles released on DVD, or share it with writers, directors, stars, other participants, or even equity partners. Then came the real windfall: in March 2008, Toshiba abandoned the HD-DVD format, so the studios got to keep almost all of the $150 million, and then re-released all their movies in the winning Blu-ray format.
Replication output deals go all the way back to the days of videos, when in 1981 Thomas McGrath, a Harvard MBA at Columbia, pioneered them. They rapidly became part of Hollywood’s invisible money-making apparatus. Paramount, for example, made a quarter billion dollars from just three deals: $50 million dollars from Toshiba for agreeing to release Titanic on DVD in time for Christmas sales, $150 million from Panasonic for agreeing to allow them take over video replication from another manufacturer (Thompson), and $50 million from the law firm of Ziffrin, Brittenham and Circuit City stores for agreeing to support the DIVX format. Since the DIVX format was never launched, Paramount got to keep the money.
The $150 million Toshiba paid Paramount and Dreamworks not to release their titles on Blu-ray was a worthy continuation of this tradition. Such windfalls, even if not visible to the public, are what assure studios a true Hollywood Ending: bottom-line profits even when their films fail at the box office.
ROMANCING THE HEDGE FUNDS
Ever since Hollywood established its powerful hold over the global imagination, its studios have sought outside investors to help pay for their movies. The list of these “civilians” stretches from William Randolph Hearst, Joe Kennedy, and Howard Hughes in the 1920s to Edgar Bronfman, Sr., Mel Simon, Paul Allen, and Philip Anschutz in more recent times. Some such super-rich investors wanted to participate in the selection, casting, and production of the movies. (Hearst, Kennedy, and Hughes, for example, all insisted that their mistresses be given choice roles.) Other civilians, such as the thousands of investors in Disney’s Silver Screen partnerships, sought only the tax-sheltering benefits, but the IRS almost entirely eliminated this loophole by the early 1980s. And some civilians, including hedge funds, actually thought they could make money by negotiating more favorable deals with the studios.
But whatever motives such civilians may have for putting money in Hollywood movies, why do studios want outside funding? When I put the question to a thirty year veteran of studio corporate f
inancing in December 2008, he shot back:
“No journalist who has ever written about movie financing has ever bothered to ask the question: why are the world’s largest and most solvent media companies raising outside capital? Journalists all seem to buy, hook, line, sinker, and press release, the line that we [studios] need money.” He noted that it was in a studio’s interest to cry poverty, if only to get stars and their agents to reduce their demands for compensation, adding, “In my thirty years in this business I have never ceased to be amazed by this gullibility.” Yes, studios can self-finance their entire slate of movies, and, unlike independent producers, they have sufficient revenues flowing from licensing of DVDs and TV rights to meet any film financing needs. The reason for recruiting outside financing is that the studios can make an “asymmetric deal” with an outsider, which means the outside investor gets a smaller share of the total earnings than does the studio on an equal investment of capital. And it is not only journalists who are gullible. Take JP Morgan Chase, which sent out a “teaser” to hedge funds, reading, “Despite compelling economic returns, major film studios are capital constrained and often must seek co-financing arrangements with other studios and other outside sources,” and offered hedge funds “a unique opportunity to participate in the most profitable segment of the motion picture industry.”
Hedge funds brimming with excess capital—at least up until the crash in 2008—made perfect civilian recruits for Hollywood, except that hedge fund managers had neither the expertise nor time to evaluate the prospects of individual films. In 2003, Isaac Palmer, then a young senior vice president at Paramount, came up with a brilliant solution. Studios could offer hedge funds a cut of their internal rate of return. This internal rate of return is not limited to so-called “current production,” or the theatrical releases, on which studios almost always lose money. Rather, the rate subsumes every penny the studio makes from every source including pay-TV, DVDs, licensing to cable and network television, in-flight entertainment, foreign pre-sales, product placement, and toy licensing. So, even in a bad year, such as 2003, when Paramount released enough bombs to get the studio head fired, its internal rate of return was around 15 percent. This return also included the profits from the company’s copyright lease-back sales to foreign tax shelters. (Palmer himself had structured one such deal that netted Paramount $130 million.) Plus, if the studio has a single big breakout movie, as it did in 1999–2000 with Titanic, the internal rate of return could leap to as high as 23 to 28 percent.
A safe 15 percent return, with a possible kicker in the event of a hit, proved very attractive to Wall Street. Palmer and his associates at Paramount worked out a deal with Merrill Lynch through which the hedge funds put up 18 percent of the capital for twenty-six consecutive Paramount movies in 2004 and 2005 through a vehicle called Melrose Investors, which then was extended through 2007. What makes this deal asymmetric is that Paramount also took a 10 percent distribution fee off the top on all the revenues, money which the hedge funds do not share. Since this cut comes from the gross, it makes Paramount, but not the hedge fund, a dollar-one gross player in its own movies.
Other studios had even sweeter or more asymmetric deals with hedge funds. Legendary Pictures, for example, was organized as a vehicle through which hedge funds, such as AIG Direct Investments and Bank of America Capital Investors, could sink a half-billion dollars into Warner Bros. movies. But, unlike the Melrose Partners deal, the Legendary Pictures investors do not participate in the entire slate of Warner Bros. movies, which means that they do not really participate in the internal rate of return.
In its asymmetric deals with Wall Street studios enhance their own returns by getting a distribution fee on their investors’ share of the revenues. And remain true to the Hollywood tradition of giving civilian investors the short end of the stick.
ENDING UP ON THE WRONG END OF THE DEAL
Back in 2003, after Kirk Kerkorian let it by know that he was (yet again) prepared to sell MGM, Viacom, which owns Paramount, considered buying it. Although MGM no longer had sound stages, backlots, or other physical facilities, and now produced only a handful of movies, it owned an incredibly valuable asset: a film library with 4,100 motion pictures and 10,600 television episodes. The crown jewels of this collection were its James Bond movies, possibly the most valuable entertainment franchise ever created. By licensing these titles over and over again to pay-TV, cable networks, and television stations around the world, this library brought in roughly $600 million a year. But that gross was an elusive number as it had to be split with others who had rights in the titles. Each title had its own contractual terms governing payments to partners, talent, guilds, and third parties. Just making these payments entailed issuing more than 15,000 checks per quarter. Not only did titles have different pay-out requisites, but their future revenue stream depended on factors specific to each movie, such as the age of its stars, its topicality, and its genre. To evaluate the library, Viacom assigned a team of fifty of its most experienced specialists to estimate how much each and every title would bring in over a decade. The Herculean job took the team two months. From this analysis, as well as considering other benefits of merging MGM with Paramount, Viacom’s executives agreed MGM was worth between $3.5 and $4 billion. But before they could arrive at a bid price, Viacom’s president, Mel Karmazin, asked his team whether the value of MGM’s vast library would go the way of the music industry, which had been decimated by Internet downloading. When none of the executives could rule out that possibility, Karmazin said “In that case, we are not bidding on MGM.” Disney, after a similar deconstruction of MGM’s complex library, valued it at $3 billion, and also opted not to bid on the company.
Sony had a very different agenda for MGM. Since it had staked much of its corporate future on Blu-ray as a high-definition format, it needed to get other major studios to choose it over HD-DVD. Sony had learned from bitter past experience that format wars are often decided not by superior technology but by side payments made to studios. Toshiba and Microsoft (which had Xbox) were already offering huge cash inducements to put their titles exclusively on the HD-DVD format. Such pay-off competition could prove extremely expensive given the deep pockets of Toshiba and Microsoft, so Sony, which needed to establish Blu-ray for its PlayStation 3 as well as its movies, saw another route to victory. If it could put the huge library of MGM titles exclusively on Blu-ray, together with its own library and the Columbia Tristar library (which it also owned), Toshiba and Microsoft, no matter how many side payments they made, would not be able to establish their rival format. To this end, Sony did not need to itself spend billions to acquire MGM, it only had get effective control of MGM’s library for a few years. So it put together a consortium that would be financed mainly by Wall Street private equity funds. And it would lead the consortium.
Even though the LBO would wind up costing $4.85 billion, Sony invested only $300 million of its own funds (and for that it got the profitable right to distribute MGM movies). Another $300 million came from the Comcast Corporation in return for the rights to put MGM’s library on Pay Per View on its vast cable system. The rest of the equity money came from renowned Wall Street investors Providence Equity Partners, Texas Pacific Group, DLJ Merchant Banking Partners, and Steve Rattner’s Quadrangle Group. These savvy funds put in a cool billion dollars. The leverage part of the deal was organized by JP Morgan Chase, which very profitably arranged, since it also got a fee, for the consortium to borrow $3.7 billion (or up to $4.2 billion, if needed) from some 200 banks. The deal closed in September 2004.
For Sony, the gambit succeeded brilliantly. Putting some 1,400 MGM titles exclusively on Blu-ray, helped established Blu-ray as the industry standard for high-definition, and it won the format war. It also made back a large share of its $300 million investment just on the distribution fee it earned on two new Bond movies, Casino Royale (2006) and Quantum of Solace (2008). But for the Wall Street players, it was nothing short of a disaster. To cut to the chase, they los
t almost all their entire billion dollar investment. They had relied, perhaps naively, on impressive-looking projections showing that the net cash flow from the MGM movie and television library would be sufficient to pay the interest over a decade on the nearly $3.7 billion of debt. What they had not counted on was a sea change in DVD sales. In the US alone, MGM’s net receipts from DVDs fell from $140 million in its 2007 fiscal year (which ended March 31, 2008) to just $30.4 million by 2010. As a result of collapsing sales, higher pay-out for participants, increased distribution costs and other distribution problems, MGM’s crucial operating cash flow catastrophically fell from $418.4 million in 2007 to minus $54.2 million by 2010. In addition, it owed Fox Home Video $60 million for an “adjustment” in the DVD distribution contract it had taken over from Sony. By October 31, 2009 MGM, sinking in a sea of red ink, found itself unable to make its mandated interest payments on the $3.7 billion it owed banks.
Ordinarily when a company fails to make such payments, its bank creditors can seek to recover their money by forcing the company into bankruptcy. With MGM, however, the bankruptcy option presented a real problem since many of its intellectual property rights, including those to make sequels in the James Bond franchise, stipulate that in the event of bankruptcy they would automatically revert to another party. In the case of the James Bond franchise, for example. the sequel rights would revert to Danjaq, LLC. (These bankruptcy clauses are not mentioned, even in a footnote, in the 38-page “Confidential Information Memorandum” that MGM sent out to prospective buyers in the winter of 2009.) So the creditors, learning that bankruptcy would destroy a significant part of the remaining value of MGM, gave it a three month “forbearance,” which meant it had until January 31, 2010 to come up with the money. The idea was that MGM would sell itself to a white knight and use the proceeds to repay the banks. The deal book was sent out to a dozen or so prospective buyers calling for bids by January 15. The replies, however, were disappointing, with none of the serious bids coming within $1.6 billion of what MGM owed its creditors. The hedge funds wrote down 85 percent of their billion dollar investment. The lesson here for Wall Street is that when a Hollywood deal seems to good to be true—it may not be.
The Hollywood Economist 2.0 Page 6