Duds In The Water

The smart money sees slim returns from films

As risky movies go, few were more fraught this summer season than the disaster remake Poseidon. It featured no big stars, cost an estimated $160 million to produce, and had to battle the public's nostalgia for the cheesy but successful original. Few industry watchers were particularly surprised when the movie sank like, yes, an overloaded cruise ship.

Good thing Poseidon's maker, Warner Bros. Inc. (TWX ) got someone else to pay half the up-front costs -- and absorb half the potential losses. An equity fund created by Stark Investments, a $7.5 billion hedge fund based in Milwaukee, has invested about half a billion dollars in six Warner films, including Poseidon and V for Vendetta, another dud. Based on a BusinessWeek analysis, Stark has so far lost $25 million on its Poseidon misadventure, and a little less on V. There is already blood in the water: The hedgie, which declined to comment for this story, has parted ways with the former investment banker who was advising it.

The studios have been using other people's money forever, often from wannabe tycoons with only a tentative grasp of Hollywood's creative dealmaking. But recently the so-called smart money has been flooding into Tinseltown. Over the past two years, private-equity firms have ponied up nearly $5 billion, with everyone from Merrill Lynch & Co. (MER ) to Credit Suisse First Boston (CSR ) joining the stampede.

The finance pros figured they had moviemaking all figured out. But several megaflops have some Hollywood insiders wondering if the private-equity guys are in way over their heads. "It's tough to be an investor when the studio gets to pick the films and you stand behind them in line to get paid," says leading Hollywood banker John W. Miller of JPMorgan Securities. "It's hard to see how you can get more than single-digit returns -- if you're lucky."

The Wall Streeters arrived in Hollywood armed with sophisticated models that they say will protect them from losses. Essentially they project film profits based on the records of directors, stars, genres, and even distribution dates. "You can never take the risk out of investing in a film," says Ryan Kavanaugh, head of Relativity Media, which has a pretty good record. It raised a $600 million fund with Deutsche Bank (DB ) to provide financing for Paramount Pictures (VIA ) and Universal Studios films. "But you can mitigate it by choosing those that meet rigorous criteria." And to minimize the downside of any one film that may bomb, private investors often put money into 20 or more flicks.

It's not exactly bulletproof. Ask Legendary Partners. A $500 million fund set up by two Hollywood veterans and backed by ABRY Partners, AIG Direct Investments (AIG ), and Banc of America Capital Investors (BAC ), Legendary plans to invest in 25 Warner films. It backed Lady in the Water, the animated Ant Bully, and Batman Begins. While a fund spokeswoman says it's too early to judge its performance, the first two films were flops, so Legendary will be lucky to break even on them.

Making a hit movie doesn't guarantee a rich payday, either. Superman Returns falls into that category. Since its June release, the Warner film has grossed a very respectable $337 million-plus worldwide. Yet according to an investment banker who crunched the numbers, Superman will earn a paltry $25 million for Legendary, which teamed up with the Honeywell International pension fund for this deal. That's barely a 7% return over 10 years, or the time it will take for profits to roll in from the box-office take, DVD sales, and TV showings.


Why is it so hard for outsiders to make money in Hollywood? Ballooning budgets and skyrocketing marketing costs don't help. But the studios game the system, too. They insist on distribution fees of 10% to 15% before sharing profits with investors. And backers often have to stand in line with stars and directors, who tend to want a piece of the action. Besides, the studios make investors take the riskiest movies while keeping likely hits for themselves. Credit Suisse First Boston invested $505 million in Walt Disney Co. (DIS ) films, but the studio didn't let the firm in on two big summer moneymakers, Pirates of the Caribbean: Dead Man's Chest and the animated smash Cars.

Maybe the private-equity guys should follow Merrill Lynch, which launched one of the first funds with Paramount, but has since switched to financing film directors like Ivan Reitman, where it gets better terms. Or they could talk to Amir J. Malin. The former chief of studio Artisan Entertainment Inc. now co-manages Qualia Capital, which focuses on media and entertainment assets. Malin has turned down several production deals. What's he investing in? Film libraries. With them, the risky creative part is over.

By Ronald Grover

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