Entrants to Private Equity Finance for Independent Feature Film Funding

Thoughts on the opportunities and potential returns  for a new private equity film fund .

I would suggest a focus be on three areas namely: 1. Interim financing (aka”Bridge Financing”) required by the producers of a film at the point when a project is “financed” by virtue of legally binding offers from acceptable parties and the finalization of long form documentation on which such offers are conditional. 2. The cash flowing of (“Tax Break Funding”) available to film productions in various jurisdictions. 3. Mezzanine finance (“Gap Funding”) secured against the unsold rights of individual films.

My comments on these investment opportunities are as follows:

BRIDGE FINANCING Financing of independent films is a complex and fragmented process, involving numerous parties. The finance for many pictures often does not ‘close’, and funds are not available for drawdown in time to commence principal photography. A typical film requires as much as 10% of its funding up to 8 weeks prior to the start of filming means that without a source of cash flow from Bridge Financing, a production can be seriously compromised. An unfortunate fact is this problem is never greater than when a bank is involved in the financing and this applies to the majority of independent films; a conservative estimate is that films with budgets equating to 50% of the sectors’ aggregate production value* have a bridging requirement. Bridge Financing is an extremely specialized market and can only be managed properly individuals with knowledge of all aspects of film finance.  The bridging requirement is typically 20% of a film’s budget and the market affords repayment plus a 15% fee on closing of finance. The bank’s lawyers typically finalize documentation in two months, i.e this is the Bridge Fund loan period and, again conservatively, it is reasonable to assume that a Bridge Fund will turn over three times each year. A Bridge Financing proposal could not be recommended without legally binding offer letters in place, subject to the completion of long form documentation. These should support the need for an amount totaling a “strike price” endorsed by an acceptable completion bonding entity. In the case of media lending banks and state bodies providing subsidies or spend related tax breaks then once their offer letters, lawyers instructions and first drafts of key documents are in place, you would deem this sufficient to proceed with the Bridge Financing. However other financiers would be required to place their funds on an escrow account, pending financial close, in advance of drawdown of bridging funds. Similarly, legally binding pre-sale contracts being discounted by the bank in question, a letter of intent from an acceptable completion bond company confirming that the strike price would be met from the sum total of the conditional financing offers, contracts with key talent and a legal opinion with regard to chain of title would all need to have been executed prior to drawdown.

TAX BREAK FUNDING In today’s market it is almost inconceivable that an independent film will be financed without the aid of tax breaks. In truth production companies gravitate to such jurisdictions to avail themselves of what is effectively non-recoupable finance. It is reasonable to assume that such tax breaks would account for at least 15% of a film’s budget. The downside of state tax schemes to producers is that, being spend related, the benefit in cash terms only becomes available after audited proof that the associated expenditure has been incurred. At its worst this can mean waiting until completion of the film although many schemes, most notably those in the US, pay out within three months. Given this time lag there is undoubtedly a huge demand for a fund to cash flow against future tax revenues as the cash flowed amount is typically required to complete the financing for strike price purpose. Although the credit risk to a fund offering Tax Break Funding is more than acceptable, given that it lies with the public sector, the competition to supply this type of finance is, at the moment, limited. Fees payable on such finance are typically 10% of funds advanced but, not unlike bridging funding, annual returns are enhanced by the fact that investment could easily be turned over twice a year. Any Tax Break Funding proposal would be conditional on a local auditor confirming in advance the value of the tax break based upon the legislation then in place and the budgeted spend. The costs of such audit would be charged to the budget of the film in question. Funding would also be conditional, inter alia, on the completion bond company providing comfort that the actual spend in the relevant jurisdiction will be in line with the budgeted spend.

GAP FUNDING The term “gap finance”, an element of which appears in just about all independent film finance plans, relates to the provision of funding secured against future revenues generated from the sale of those rights unsold at the time of the initial financing of the film.  The key remaining private sector providers of gap finance are the traditional media banks who are currently providing a maximum of 15% of the budget. It is my belief that there is a fundamental flaw in the media banks’ lending strategy in that their analysis focuses too greatly on the ratio of the value of unsold rights to the amount of gap finance provided and places insufficient emphasis on what total sales as a percentage of budget need to be in order to recoup. In short, all other things being equal, a 25% gap finance provision with 90% of worldwide rights unsold by value represents a safer financing opportunity than a 15% gap investment with only 30% of worldwide rights still available for sale. Given the above, and the competitive edge that a private equity fund has over a bank in terms of its ability to commit more quickly, my recommendation would be to compete with the media banks’ gap funding rather than provide so called “super-gap” finance alongside but subordinated to them. A 25% gap provision would undoubtedly secure a significant, say 20%, share of the total, bank and non-bank, market today. Such a percentage would attract an executive producer fee at a minimum of 3% of a film’s total budget plus a 20% premium on investment recoupable together with the principal in first position. In terms of timing the typical production cycle extends to ten months. Allowing four months to deliver and collect under sales contracts I would estimate funds to be turned over within fourteen months. There is the option to discount these contracts with a bank as and when they are fully documented, thereby expediting the timing of availability of funds for reinvestment, but this would need to be weighed up against the cost of lending. Aside from executive producer fees and investment premiums the private equity fund may be entitled to a real profit share, namely one that is triggered immediately on repayment of all recoupable sums (often as little as 80% of budget) and sales commissions. The premiums on investment detailed above are, by the favorable nature of their place in the revenue “food chain”, to a large extent a trade off for a profit participation. Accordingly, even though a small profit share should be achievable, I have not provided for this in the return on equity calculation detailed below. The key to Gap Funding is undoubtedly the identity of the sales agent and charged with selling the rights to a film. Accordingly such funding will be conditional, on the sales estimates, against which it is secured, originating from an acceptable party and in an amount, net of commission, to provide sufficient cover for the principal amount and the associated premium to be recouped. An offer of Gap Funding at 25% of a film’s budget will be sufficient.

Jonathan C. Rayos

CEO | President | Executive Producer

FilmEmerge | FilmEmerge Foundation | FilmEmerge Productions

www.filmemerge.com

ANY INVESTMENT IN FILMED ENTERTAINMENT IS SPECULATIVE AND INVOLVES SIGNIFICANT RISKS INCLUDING, BUT NOT LIMITED TO, THE POTENTIAL FOR LOSS OF SOME OR ALL OF THE INVESTED CAPITAL, A FILM’S LACK OF AN OPERATING HISTORY, LIMITED REGULATION OF A FILM’S ACTIVITIES, THE RISKS OF THE TYPES OF INVESTMENTS TO BE MADE BY A FILM, A FILM’S POTENTIAL USE OF LEVERAGE, NO OR LIMITED LIQUIDITY OF THE INVESTOR’S INTEREST IN A FILM, LACK OF DIVERSIFICATION OF THE FUND’S INVESTMENTS, POSSIBLE NEED FOR FOLLOW-UP INVESTMENTS, MANAGER CONFLICTS OF INTEREST, POTENTIAL FOR REDUCED PERFORMANCE DUE TO SIGNIFICANT FEES AND EXPENSES AND MANAGER’S PERFORMANCE BASED COMPENSATION. INVESTORS WHICH HAVE A PRELIMINARY INTEREST IN THE FILM SHOULD UNDERSTAND ALL SUCH RISKS AND HAVE THE FINANCIAL ABILITY AND WILLINGNESS TO ACCEPT SUCH RISK FOR AN EXTENDED PERIOD OF TIME BEFORE CONSIDERING MAKING AN INVESTMENT IN A FILM.