Mining for Gold in Tinseltown
In Hollywood, financing a movie can be a tricky affair. So, too, it seems, is buying a studio. Late last year, when Sony Pictures Entertainment (SNE ) mulled buying Metro-Goldwyn-Mayer Inc., the Hollywood studio faced a simple problem: how to do a deal without taking on debt or diluting Sony stock, both no-nos for its Japanese parent. The answer: Sony sought out deep pockets, private equity firms, bringing in Providence Equity Partners and Texas Pacific Group to bankroll the deal. Now, Sony is moving with the speed of its summer hero Spider-Man. After finishing its due diligence on May 27, it could make a bid as high as $5 billion within the next few weeks.
The breakneck negotiations highlight the sudden interest of private-equity funds in the entertainment biz. Until now, most of them avoided Hollywood because of its notorious resistance to pruning lavish perks, bloated salaries, and armies of hangers-on. But fat overhead is precisely what financial buyers feed off, especially when an industry is in the doldrums and its companies cheap.
Moreover, there isn't much competition right now in movies or music from "strategics" -- private-equity slang for companies in the same industry that bid for rivals. Hobbled by its calamitous AOL merger, Time Warner (TWX ) is sticking to expanding its cable-television systems. Walt Disney (DIS ) is under attack from shareholders for alleged poor management, and Viacom (VIA ) wants to dump its problem child, Blockbuster (BBI ). Even if they could buy, many would face antitrust issues and other regulatory headaches. "Sarbanes Oxley is our silent partner," says Jonathan Nelson, CEO of Providence Equity. "It has inhibited the risk-taking on boards."
So, flush with cash, private-equity funds are swarming over Tinseltown. In the process, the firms -- which raise money from well-heeled investors looking to make large gains -- could change the economics of Hollywood. Consider what happened on Mar. 2, the day after former Seagram Co. Chief Executive Edgar Bronfman Jr. closed a $2.6 billion deal to buy Warner Music Group. Prodded by his private-equity backers -- Providence, Thomas H. Lee Partners, and Bain Capital -- Bronfman cut 1,000 employees, merged two labels, and slashed the seven-figure salaries of some top executives by up to half, taking out more than $250 million a year in overhead. "Why wait a day when you can make the change now?" says Lee Managing Director Scott M. Sperling.
STREAMS OF CASH
And perhaps make even more radical changes tomorrow. Warner has been living off the cash generated by its publishing catalog of some 1 million golden oldies. So Bronfman, nudged by his financial partners, wants to boost profits by axing lackluster acts -- the rock band Third Eye Blind is a possibility -- reevaluating how profitable ones are distributed, and revamping performance goals for the execs who spot new talent. "I think there's an opportunity to run the business differently," Bronfman told BusinessWeek after the deal.
Plenty of people agree. Last year a half dozen private-equity firms turned out to back bidders for Vivendi Universal's (V ) Hollywood and theme-park unit. They lost out to General Electric Co.'s (GE ) NBC unit, which may sell its stake in the parks. And now, the firms are focused on MGM. Lee and others have besieged Time Warner Chairman and Chief Executive Richard D. Parsons because he is said to be interested in bidding for MGM. Parsons says he won't consider a bid until Sony has decided what it's going to do.
Until recently, private-equity firms preferred to buy media outfits with hard assets, such as TV stations, movie theaters, and newspapers that produce predictable streams of cash. They're still buying them. On Apr. 20, Kohlberg Kravis Roberts & Co. beat out five other firms to buy satellite-services company PanAmSat Corp. from Rupert Murdoch's 34%-owned DirecTV Group Inc. for $4.3 billion. Providence just joined with Blackstone Group to buy Freedom Communications Inc., which owns 65 newspapers, including the Orange County Register, and eight TV stations.
By contrast, when private-equity firms have bought content providers in the past, the deals have been profitable, but difficult. Late last year, when it sold independent film studio Artisan Entertainment to Lion's Gate Entertainment for $169.5 million, Boston-based Audax Private Equity made an almost sixfold gain for investors. But it took seven years and several false starts to get there. Artisan, once a home-video company, hit it big with The Blair Witch Project movie in 1999, but then took on bigger-budget flicks that bombed and saw its overhead balloon. It eventually canceled plans for an IPO and turned the company over to industry veteran Amir Malin who cut the staff by nearly one-third, trimmed production, and prepped the company for sale. "Buyer beware," cautions Audax Managing Partner Geoffrey S. Rehnert.
Now, more private-equity outfits are cutting deals with music and movie veterans as their partners from the get-go. When Brian C. Mulligan, the former Seagram chief financial officer, put together an $18 billion bid for billionaire Marvin Davis to buy Vivendi's studio and record company, he lined up Carlyle Group, Bain, and Texas Pacific to bankroll the deal. The bid failed, but Mulligan's projections showed that the real gold mine was the cache of old movies and music that could be exploited on DVDs, online, and, eventually, wireless technologies. An initial public offering would produce the 20% annualized returns that most private funds promise investors.
With an existing studio and distribution team already operating, Sony's task at MGM, if it buys the studio, will be simpler. The game plan, say sources, is to shut down MGM's 1,000-person distribution and marketing operation and keep the 50 or so in its moviemaking operation. MGM films, including the James Bond franchise, would then be distributed by Sony. The deal's main driver: MGM's library of more than 4,000 films, which throw off an estimated $430 million a year in cash flow from DVD, cable, and other sales -- a figure that MGM says has been rising at more than 20% a year as new digital technologies and video-on-demand start to take hold. The cash flow is the key to generating handsome returns for Sony's private investors.
To appease its Japanese owners, Sony plans to operate MGM as a separate company, and would take a minority stake to keep debt off the company's books. Still, the company hasn't figured out an exit strategy for its financial partners, who want to cash in big returns for their investors. Sony could buy the partners out at some point down the road or, if the parent allows, take MGM public through an IPO. The private equity guys don't care. They just want their returns. But if they win MGM, disagreement about how to reward the money men could open the door to another Hollywood staple: a great fight scene.
By Ronald Grover in Los Angeles and Emily Thornton with Tom Lowry in New York