Credit crunch hits Hollywood

As Deutsche Bank closes its film financing unit and walks away from a $450m investment in Paramount, Wall Street is wondering whether movies have lost their magic

By Stephen Foley
Wednesday, 16 July 2008

Think of it as the same sort of alchemy that briefly turned sub-prime mortgages into investment grade bonds (before they turned back again into the financial equivalent of toxic waste).

Those oversize brains inside Wall Street's top investment banks, hedge funds and private equity firms have, for the past half-decade, been doing the same sort of mathematical magic trick with Hollywood films, perhaps the most notoriously unpredictable investment opportunity of them all.

Only now the credit crisis has upended everything in the exotic world of high finance, and Hollywood faces a $5bn (£2.5bn) annual hole.

Will a movie be a sleeper hit? A blockbuster, even? Oh my, perhaps it will be so big it will become a "franchise", the start of a trilogy, a TV-syndication and DVD-sales cash cow that spawns enough merchandising to take up a whole wall of Toys R Us?

Or maybe it will be a turkey.

Such breathless gambling is not the way Wall Street works. And yet, in the past three or four years, some $10bn has been wired across the US to the major studios operating under that Hollywood sign in the mountains of California. Almost half of that came in the early part of last year, as investors sought ever-cleverer ways to put money into "non-correlated assets", investment opportunities that guaranteed decent returns whatever happened to stock markets.

By investing in a slate of likely hit movies being made by one of the six major Hollywood studios, Wall Street's oversize brains calculated that they could suffer the odd turkey and still make money. By channelling their investment through a specially created company given a funny name and loaded up with debt, they could multiply the profits. Even after paying the studios a fee for distributing the movies they were getting help to fund, and paying interest to the debt-holders, the vehicle could turn a decent profit – at least according to the complex mathematical algorithms with names such as the Monte Carlo model.

Most of the major Wall Street banks set up lucrative film financing arms to co-ordinate talks with the major studios, create the special-purpose vehicles and sell the equity and debt investments to hedge fund and private equity clients. Financiers such as Ryan Kavanaugh, still in his early 30s, have built fortunes by bringing investors and movie bosses together in these deals.

The studios loved it too. Guaranteed bankers such as sequels and the finales to trilogies, for example Superman 3, were kept entirely on the studios' own books, but they have used these private equity deals to reduce their financial exposure to risky new films, and help defray the spiralling costs of bagging big-name stars. Increasingly, even mid-budget films were being added to the slates alongside the likely blockbusters, and Hollywood appeared to have found a sustainable source of new funds.

But there is gathering anecdotal evidence on both coasts that the first wave of investment vehicles have suffered decidedly miserable returns, and some gossip that the equity holders in a handful of those vehicles may have been entirely wiped out.

And yesterday, the bombshell news that Deutsche Bank is closing its film financing unit entirely and walking away from plans for a $450m investment in a slate of up to 30 new films being made by Paramount, the giant studio controlled by media conglomerate Viacom. The films could have included a new Star Trek movie, the next Ben Stiller comedy, Tropic Thunder, and GI Joe, another toy-themed summer blockbuster. They will all still be made, but Viacom may be on the hook for more of the production costs, and that could lead to a little parent-company pressure to keep budgets in check.

Sources said Deutsche had simply found it impossible to find buyers for the debt portion of the proposed financing vehicle, now that the credit crisis has made investors suspicious of exotic debt instruments and effectively shut down the markets for all but the most gold-plated bonds. The terms that bondholders demand this July are a world away from the covenant-light, low-interest terms that prevailed before the credit crisis hit a year ago.

Paramount, for its part, was said to have decided that the terms Deutsche was demanding to do the deal were simply too onerous. Neither side would comment yesterday.

Roger Smith, of the research company Global Media Intelligence, said there had been a dramatic drop-off in movie investment by Wall Street since the summer and it would not return on the old terms.

Indeed, he said that GMI's own calculations suggested that Wall Street's mathematical models were faulty, having plugged in expectations for DVD sales that simply won't materialise. "The easy way out is to blame credit conditions, but that is a partial answer," Mr Smith said. "The basic deal structure has to be revised substantially in favour of investors and less in favour of studios... If there had been no credit crunch, and if we had never heard of sub-prime mortgages, studios would not be able to obtain money on the same terms as before."