Dan Borkin
Although film-specific risk is reduced through the diversification achieved with slate financing, slate finance in its current form is an unfavorable vehicle for investors due to the revenue recoupment practices of film studios. I will use Sony Pictures and Relativity Media’s ’07 Beverly Slate agreement to demonstrate that equal investment does not lead to equal returns, and that a film studio, due to its role as a distributor, is advantaged in the revenue recoupment process.
Background
Slate finance is a popular method of risk-diversification in film finance. Slate financing is when a film studio solicits investors to co-finance multiple films (a ‘slate’ of films) instead of one film. This investment vehicle allows studios to decrease its cash expenditure on production costs and enables a third-party to gain investment exposure to a diverse slate of films. The value proposition is that investing in one film is risky, but with an investment spread across films of many genres, types, and sizes, that risk can be diversified.
The mechanics of slate financing are relatively simple. In its basic form, a fund is created by a third-party partner that acts as a co-investor in a studios’ films. The third-party raises money for the fund through its own capital or by issuing bonds, which are either underwritten by a bank or sold piecemeal to various interested parties. The money raised is used to satisfy the funds’ co-financing obligation with the studio, and in exchange the fund is entitled to a portion of the cash flow generated by the films produced.
Shared recoupment of a film’s cash flow is the relevant element in this analysis, specifically the fund’s entitlement to a portion of each film’s cash flow. If a studio and a fund split a film’s budget down the middle, with each investing an amount equal to half of the film’s budget (50/50 partners), one might think that both the studio and the fund will be entitled to half of the film’s cash flow. Rather, the fund will receive much less than half of the film’s cash flow, and this difference will be compounded over each film in a slate.
The ’07 Beverly Slate: An Analysis
The Beverly Fund was established by Relativity Media in 2007 to satisfy a $500 million slate finance agreement with Sony Pictures. [1]. Sony agreed to commit $500 million of its own capital, which meant that the Beverly Slate would consist of $1 billion in spending power for up to 45 films over a 5-year period, solely for production costs. [2].
The cash recoupment provisions agreed upon in the co-financing slate agreement follows the current industry standard. It was agreed that when money was earned from the exploitation of co-financed films, Sony would first receive a distribution fee and then recoup its expenses. The remaining balance, per film, would then be split evenly between the Beverly Fund and Sony. [3].
Herein lies why equal investment does not entail equal returns. It is unknown what distribution fee Sony took for this deal, but the average distribution fee in the industry is 30%. [4]. The expenses it can recoup, before the Beverly fund is entitled to any money, is referred to as the “Prints and Advertising” (“P&A”) expenses, which is essentially the advertising budget of a film. [5].
The average cost of producing a major studio movie is $65 million dollars, with the average P&A expense being $35 million dollars. [6]. Suppose this ‘average movie’ is a real movie that will be released under the terms of the Beverly Slate agreement and has the same attributes: a $65 million budget and a P&A expense of $35 million. As per the agreement, the Beverly Fund will pay half the production cost and Sony will pay half, both paying $32.5 million dollars. Let’s assume that Sony agreed to take a 20% distribution fee on each Beverly Slate movie, lower than the industry average, in order to attract investors into the Beverly Fund.
If this film makes $100 million dollars, Sony will first take $20 million (20%) as a distribution fee. Then it will recoup its $35 million P&A expense. What’s left of the $100 million is now $45 million, to be split equally between the Beverly Fund and Sony. Sony will receive $22.5 million and the Beverly Fund will also receive $22.5 million. [7].
The end result is that Sony spent $32.5 million on the production budget and $35 million in advertising, for a total spend of $67.5 million. Sony ultimately will receive $77.5 million, resulting in a gain of $10 million. The Beverly Fund spent $32.5 million and will receive $22.5 million, a loss of $10 million.
This is how the industry standard revenue recoupment works in the film industry. The ‘slate’ aspect of film financing does not diversify this risk because this recoupment schedule exists for every film invested in the slate. Distributors’ (the film studios) priority in the recoupment waterfall creates a situation where in order for a financier to recognize a return on their investment, a movie has to perform exceedingly well. Investors commonly think that slate financing also remedies this aspect of risk, that over the course of the many films released in the slate, the “hits” will make up for losses. But the hits need to make up for the losses and the average performing films, because on an average performing film, like the one above, the investor also loses money.
Slate finance, a tool for diversification, is less risky than an investment in a singular film, but even with that diversification, the metric for success does not change. Films still need to make multiples of their budgets before a co-financier sees a return on their investment. Due to the way revenue recoupment functions, it becomes imperative that a slate fund has agency in which of a studio’s films the slate will consist of, because although the film industry has become financialized, the game remains the same. [9]. You have to pick the hits.
[2] Id.
[3] Id. See also: https://stephenfollows.com/how-a-cinemas-box-office-income-is-distributed/.
[4] https://stephenfollows.com/average-film-distribution-fees/.
[6] https://www.investopedia.com/financial-edge/0611/why-movies-cost-so-much-to-make.aspx.
[7] It should be noted that the $100 million that this hypothetical film earned is not true a $100 million. In order for $100 million to be recognized as the top-line revenue by the studio (to be then broken down and distributed) various other distributors and virtual storefronts (theaters, iTunes, Amazon Prime, etc.) have already taken a percentage in the amounts of anywhere from 10% to 40%.
[8] Note that the breakeven point for the Beverly Fund on its $35 million dollar investment in this hypothetical film occurs when the film earns $125 million dollars.
[9] The ’07 Beverly Slate sets precedent for this. It was the first slate finance agreement where the investing party had the right to choose which of the studios films the fund would co-finance. See https://1.next.westlaw.com/Document/I22c15f60548411e1b71fa7764cbfcb47/View/FullText.html?originationContext=typeAhead&transitionType=Default&contextData=(sc.Default), Paragraph 17.