Spring DealBook: Long-Read
Integration and Diversification: Risk Upside Access and Risk Downside Protection
One question I am currently examining is why, given the wealth of economic studies and commentary on film industry characteristics like Box Office results, does confusion over risk in film exist, especially in relevant finance and policy sectors?
Looking at the trade press from an outsider perspective gives a clue to this state of affairs. So, continuing my recent blog series, I review a number of recently announced deals with a consideration for the tensions and complexity of risk management approaches at play. This is to serve as a draft exercise in identifying areas of misrepresentation or opacity in literature dealing with the industry.
Examining the environmental characteristics and business logic underpinning recently announced deals for UK production companies, and the increased investment capacity of Film4 is instructive. It highlights the variety of approaches to risk across the industry and how they can be conflated.
Paradox of uncertain commerciality
Film4’s investment strategy, as far as publicly discussed (see Screen) foregrounds an increased appetite for risk, in terms of larger amounts invested per project being associated positively with anticipated increased rewards (profit participation)
This strategy, increasing the amount invested per film, is characterised as “bold” and “strong” and interestingly contrasted with investment in “riskier” projects.
At first glance, the new strategy of “bigger positions” in film finance arrangements is itself a riskier endeavour, indeed why would it be considered bold to take on if not? However, the position is concurrently being conceived as a more stable revenue generator that would allow investment in films perceived as appealing to a narrower audience.
This thinking indicates the multiplicity of interpretation of risk by Film4, which is a developer/ producer, financier and TV broadcaster and thus rights licensee. It is worth considering in more detail the levels and types of risk relevant to the company, and how risk conceptualisation may influence strategy. Reflecting on propositions from established literature in cultural economics proposes on revenue uncertainty helps to illuminate gaps in our knowledge.
The Film4 strategy is motivated by the view that the company has not fully capitalised on its past successes. It has a very strong track record of developing talent, facilitating extremely successful films, but not substantially participating in the profits.
By adopting a “broadcaster formula” Film4 received its development money back (possibly with premiums), owned a small equity stake and the TV license, but did not access the majority of revenues from top recoupment positions, presumably staked out by distribution partners like Fox (Last King of Scotland), Entertainment Film Distributors (Inbetweeners) or Universal (Ex Machina).
Quotes in the Screen article from David Kosse, the head of Film4 summarise their operational logic in relation to risk reward profiles:
“We’re choosing the projects, we’re developing the projects, we’re investing in the projects but our position in many of these projects isn’t where it should be,”
“Had we taken a bigger position in a number of those films, we would have made more money when the film was successful, and not lost much more when the film wasn’t successful. It’s making the odds better.”
A couple of points jump out immediately.
Firstly, the use of probabilistic language “making the odds better” is interesting. In this context the odds referred to, are not the odds of a film performing well financially e.g. at the Box Office, they are the odds here are the chances of Film4 benefiting significantly, should the film achieve financial success.
The choice of terminology might be confusing to traditional financiers and irregular readers of the film trade press. The issue under discussion is a structural change, it holds regardless of the outcome for the film in the marketplace. It is conceivable that some elements of profit participation may be tied to particular revenue totals e.g. bumps at certain Box Office levels, but the statement is general in its subject matter. The alteration of strategy – bigger bets – changes the odds of particular levels of financial success at the portfolio level – in stricter terms it is changing the parameters of the investment practice, as opposed to the odds of success in a specific project. Film4 is now able to access the upper echelons of returns based on its approach. This view of improved return potential – i.e. capacity for reward, as opposed to probabilistic chances of it, necessarily prompts us to consider the flip side – losses.
Secondly, the latter segment of the quote indicates that risk and return are not altering in parallel. Potential upside is increased but the downside is not affected in the same manner, why is this? Why would Film4 not stand to lose “much more” on failures but make remarkably more on successes?
This comes down to two things. One is the absolute scale of Film4’s investment, and the other is a core characteristic of film revenue distributions. It is also very important how these two elements stand in comparison. De Vany (2004) and much of the film economics literature recognises the unbounded nature of film returns, films are information i.e. not used up upon consumption and hits explode in non-linear patterns as crowds share their appreciation, cinemas book and rebook the film and revenues soar. Once costs are paid back, profits accrue at dramatic rates and over a long life profile. In contrast, an investor can (assuming insurance provisions etc.) only lose as much as they put into the film. So if we consider an example, The Last King of Scotland cost £5m to make and generated roughly £47m purely from global theatrical and US DVD (according to The Numbers.com). Considering Film4 still only has £25m to invest pa, spread over approximately 10 features, the potential losses per project pale in comparison with possible returns. The issue is accessing such returns when hits occur, and acknowledging within business strategy that such hits are extremely uncertain.
The integrated nature of risk management strategies: practitioners consider some approaches to give both access to high returns and cushion against extreme failure. However the detail of industrial-structural approaches is often obscured.
Upside Access: As noted in Screen, Film4s’ approach is to engage in upfront co-financing deals, as opposed to potentially being stuck behind continuing distributors fees, a separate corridor to distributor expenses, then to sales agents fees, expenses, then to harder-finance equity participants etc. in the recoupment chart.
The details of the deals disclosed are sparse, but indicate a variety of approached to managing the risks derived from uncertainty over audience reception. A 50/50 co-financing of Martin McDonagh’s next film with Fox Searchlight gives Film4 access to “success of a worldwide rollout” which we may take to mean a share of some kind from global territories exploited by Fox. Taking on substantial risk upfront differs greatly from stereotypical broadcaster / public funder models of: development funding, small amounts of equity to jump start market finance and then filling in any gaps, yet remaining lower down the recoupment waterfall.
Downside Protection: Film4 will consider their risk mitigated by the track record of McDonagh (In Bruges) and producer Peter Czernin (Marigold Hotels), and the guaranteed market access and support from global Fox Searchlight distribution, with the incentive to keep connected to talent for future projects. In addition, the track record of the producers in a particular genre is understood to bring a reassurance as to future performance.
A different but complementary strategy to territorial aggregation of revenue streams is to maximise access to revenue from multiple types of rights exploitation. The Film4 deal with Entertainment Film Distributors and FP Films is for all rights. It also provides a degree of stability over cash-flow with 4 films being secured over four years.
Part of the vision set out for Film4 is based on the assumption that past performance is a strong guide to future results. I.E. To grossly oversimplify: If we had invested heavily in X’s last film, which was a hit, we would have made a lot of money, therefore we should invest heavily in X’s next film. Whilst that is an over-the-top characterisation for effect, the core concept is absolutely crucial to how the independent industry operates. As I will explain in following sections, the salient differences between applications of past consumer demand and past demand from market actors (investors, sales agents, distributors, TV buyers) are rarely articulated.
However, at the same time that inferences from past performance is embedded in ongoing activity, that very process is the subject of strict legal advice to investors that stipulates past performance is not a guide to future performance and may not be repeated. This understanding also forms the basis of a wealth of academic research that indicates forecasting future revenues from the past is unreliable, and a part cause of managerial problems such as the “sure thing fallacy”. To paraphrase De Vany (ibid): the film business encourages selective learning based on extreme, rare events. It is a high skill industry, good films are very hard to make, but this fact fosters an illusion of greater control. In a complex and uncertain system where there are many interacting parts and complicated stochastic dynamics, there is no simple form of causality from which to reliably predict returns at the investment stage. Films are unique products entering unique market environments.
However, despite a sure understanding of these industry characteristics, professionals still operate placing faith in previous endeavours. This can be considered, in part, as a recognition of the overwhelming uncertainty of future revenues, and must also be contextualised by the fact that research based on Box Office revenues does not tell the whole story, a fact often ignored by research claiming to offer management implications from econometric studies.
Organisational Structure and Derived Demand
The independent film industry has developed to insulate itself, as far as possible from consumer demand uncertainty – the risk of whether an audience will pay for a ticket/DVD/stream or not. Thus financiers are more likely back a film if they believe it can be sold to distributors around the world, or VOD services, prior to being released to the public market. Thus in making decisions investors are not solely considering audience demand, but rather, derived demand – the demand from TV stations, distributors, VOD services for content. These market actors are more predictable than theatrical audiences. They may operate on a basis that cannot be accounted for by rational probabilistic risk analyses of their final market, however, so long as there are common understandings of evaluations between market buyers and sellers, the conventions hold up. Taken from the perspective of inter-subjective rationality, i.e. if something is rational to transacting parties it need not be objectively rational, then operating strategically per project, according to track record and accessible relationships is advisable.
It is also important to recognise different levels of risk mitigation at play in the complex processes of the film industry. Although consumer demand risk outcomes determine final returns to investors like Film4, there are many necessary steps before that even becomes a possibility. For instance assuring access to final consumer markets is a significant stage, hence deals with Fox and Entertainment – both producers having previous market success, this manages the risk of whether all rights are fully exploited and thereby ensure investors access maximum capacity for ROI. In order to get to that stage, films must successfully get into production, i.e. be greenlit and thereby recoup development expenses. Again investing in projects where partners have strong track records in converting scripts into feature films is logical. These strategies in risk management are of a different order to the evaluation of risk regarding Box Office performance. We might label them defensive, or B2B market oriented.
These market-centric (not consumer) approaches deal with creative risk to an extent, in that by reprising relationships with known talent, the style or genre is a stable characteristic. From a different point of view, these approaches can be considered to be dealing with operational risk, the risks of being in business, rather than specifically dealing with consumer demand maximisation strategies.
The two deals mentioned secure a supply of high quality content and route to consumers, with appropriate resources and skilled expertise for market delivery. In attempting to optimise the necessary conditions for success, practitioners rarely calculate future performance results in terms of probability. Estimated levels of performance based on past results and models are commonplace, and the better information memoranda for film investment schemes base their forecasting on probability distributions, but few companies maintain explicit records of chances of particular levels of success, and many use manipulated averages of historical returns. Yet, it is common for practitioners to use the language of chance “improving the odds” outside of strict application of relevant quantitative techniques.
This is not to criticise the professionalism of practitioners, the most accurate Artificial Neural Network models in current research provide probabilities for returns in certain band levels of box office, rather than quantitative point estimates (Ghiassi et al. 2015). Rather, it is important to point out the gap between general self-description of practical operations of the film industry, and strict conceptions of chance and risk that are held in other fields e.g. finance.
Portfolio Approaches to Uncertainty
Following on from this disjunction between the different uses of probability for thinking about managing uncertainty, is the assumption in Film4’s strategy that films deemed more commercially attractive, in which greater investment will be placed, can be relied upon to deliver overages for recycling into more niche titles.
The contention put forward in Screen is that the ability to take larger stakes in films with track record talent, will “help fund the riskier, more remit driven projects.” Certainly at the absolute level of facilitating the model as a possibility, the increased stakes achieve this, i.e. without the potential to earn more income from hits, any increased reinvestment would be impossible.
But in terms of measurably addressing the chances of particular financial hits – which require Box Office success (not solely smart deal structures and offsetting downside) – each unique project is susceptible to the enduring market conditions of radical uncertainty. I.E. Box Office cannot be reliably predicted.
From De Vany (2004, p98): The probability that a movie will reach an extreme outcome, which is required for it to be profitable, is small. But the outcomes associated with extremes dominate total and average revenues and profits. So, risk is not only unavoidable, it is desirable. One wants to choose movies that have a large upside variance. Star movies have that kind of variance, but by virtue of that fact they also have unpredictable outcomes.
Given these widely accepted dynamics, there seems to be a disconnect between particular elements of strategy and anticipated outcomes described. In the article a sense of certainty in future hit-level revenues is indicated as the expectation stemming from agreements with producers with successful track records. This is a problematic simplification, which conflates ultimate consumer demand (the audience) with derived demand (that of co-financiers, sales agents, distributors, exhibitors). Although both contribute to the total success or failure of a film, each pertains to distinct types, or layers of risk.
The announced agreements with McDonagh/Fox and FP Films/Entertainment operate at the most basic level to secure access to talent, well-developed creative material, and to a pipeline to market. These strategies mitigate the risk of conversion – that a film will not be put into production and the risk of a film being produced but not exploited. Avoiding these downsides of being in the film business are common requirements.
Trust in creative talent and management acumen that has already secured international market representation, or which, based on in-house data is empirically judged more likely to do so, is a strategy somewhat divorced from the vagaries of final Box Office receipts.
Investors are negotiating the derived demand from other market participants. In these reported cases some such partners have come on board early (distributors). This process can result in financial structures that protects an investor in the position of Film4 from losing significant sums according to final consumer demand, e.g. if Entertainment or Fox were to have put up have put up MGs per territory.
These partnerships are certainly engineered substantially because of expected Box Office performance, but they are not solely subject to that risk of consumer appeal, the initiators have protected themselves to a degree through market contracts in advance. These relationships are of an entirely different kind than the networks of information flows which dictate revenue distribution upon release. Deals are negotiated over extended periods, across multiple parameters and on the basis of personal relationships related to extremely few market interactions (2 or 3 films), upon which a significant amount of importance is placed because filmmaking is so difficult and so expensive.
The implications of the interrelation of these risk management techniques is often an opacity when they are presented in the press, based on understandably few non-confidential details. There is a blurring of concepts due to the use of similar language across the board, which may only suit certain specific practices when considered from other industries or disciplines.
Consider the commentary provided in the Screen article that the recent increase in Film4 investment capacity is driven by an attempt to head off demands for “safer” bets should the channel be privatized. I.E. By demonstrating a self-sufficiency for generating revenue from commercial films for reinvestment into riskier creative projects, Film4 will be protected from interference.
This illustrates a lack of clarity over what might characterize safety, either within general discourse or at least from the imagined perspective of Channel 4 shareholders. And this issue is worth unpacking.
Safety is not reliably secured in advance at the Box Office, no matter the talent track record involved or overt commerciality of the project.
It is to the theatrical market place that the terms and methods of probability distributions strictly apply, but Film4 is not known to be an adopter of tools that apply such methods scientifically e.g. Epagogix, or claim to e.g. Relativity.
Rather, it is in the access and deal terms Film4 is able to leverage that elements of safety, i.e. downside protection, may be secured. However, there is almost no academic research of scale on this segment of the business as the details of deal terms are private and confidential. Hence wider understanding of components of “safety” is undeveloped.
As a result of the availability of large datasets and identifiable film variables (genre etc.) the dynamics of the Box Office are regularly quantitatively expressed and can be inputted to outsiders’ calculations. Yet the vast availability of information does not allow for product optimization as it might in most other industries. Just investing in conservative shareholder approved “safe bets” according to some formula derived from histories of theatrical performance would not achieve the desired goals.
Indeed, this strategy would deprive Film4 of significant possibilities to achieve outsize hits. The underwriting of creative risks i.e. the development of Danny Boyle or Steve McQueen, is what facilitates the potential for the very hit films that Film4 are disappointed to have fully capitalized upon. The consumer market demands diversity and originality, but the particular unique product that will be a success is highly uncertain.
The notion of a path to safety, assumed to exist in reverse engineering Box Office hits, is a substantial contributor to a lack of coherence in the understanding of risk management in the film industry. Risk is necessary and desirable in the launching of each film. The steps taken to minimise risk elsewhere are enabled by access to financial and market resources, and as can be seen by putting Film4’s plans in context with other recent deals, the majority of such resources are concentrated outside the UK.
Scale and non-UK ownership: buying access and exporting profits
The revenues Film4 regret missing out on, due to their position in previous hit films, will likely have been apportioned to major distributors. It is these same market actors with whom Film4 are in competition to access the most preferential positions in prime projects.
To compete, instead of offering distribution and P&A as well as investment, which the studios can. Film4 are to make greater investment amounts available to producers and improved terms of trade. Producers are then more able to pick and choose other partners and terms, thus potentially seeing greater proportions of returns themselves, should a hit result. This is the project-by-project offer Film4 can make. However, this is one of many means by which production companies consider risk management.
In addition to diversifying revenue streams, production companies look to minimise risk by securing capital for overhead costs and access to markets for stable, defined periods. Many companies produce TV as well as film, and/or combinations of games, commercials, branded entertainment, music videos, or act as talent agencies. This spread of income improves cashflow, lessens the reliance on feature film development conversion, and insulates a company further from film consumer demand. It can also make the company more attractive to acquisitive companies looking to secure access to content.
UK market actors do not match the scale of market access or resources offered by major international companies. Therefore access to revenue from IP created in the UK and equity in related companies is regularly appropriated by US and EU majors. For example recently, Vice Media has acquired a majority stake in Pulse Films; Fox Searchlight Pictures has deals with Damian Jones / DJ Films (Ab Fab) and Joe Wright / Shoebox Films (Atonement); Sony Pictures TV acquired a minority stake in Fable Pictures – Faye Ward (Suffragette); StudioCanal have bought into (20%) Bennedict Cumberbatch’s company SunnyMarch, and Urban Myth Films, which produces major series for BBC. At an individual level too UK companies struggle to keep hold of talent. The CEO of Film4 quoted in the new strategy article is joining US studio STX, re-emphasising the draw of international scale in the global marketplace.
This industry characteristic, increased returns to scale, is further illustrated by the problems of UK independent distributors and consolidation in that sector. Metrodome announced it was seeking a buyer in March: “The distribution business model is changing. We need more vertical integration and scale and a partner or two on the production side. Owning IP and partnerships are increasingly important.” Recent years’ dealbooks support that commentary. Revolver (with Gunslinger production) shut in 2013, Icon has gone through a series of changes: bought by Access Industries in 2009, moving into production in 2011, re-launched in 2013 after acquisition by New Sparta. The M&A activity of Studiocanal, LionsGate and Eone (HE combined with Fox) points to the impact of collapsing DVD revenue and hence falling library evaluations (Metrodome’s DVD income was 90% of the total 5 years ago, now it is less than 45%) as leading to a concentration in capacity (which has been mirrored in the sales sector).
Diversity of Content
Metrodome commented that the environment driving consolidation will likely have a detrimental impact on the variety of films available to audiences: “If we are to protect the independent film business in the UK the sector needs support otherwise programming diversity will really take a hit”. Certainly this reading of concentration and scale in terms of resources and global territories fits with current SVOD expansion and major studios strategies e.g. as explained by Elberse. If we consider the idea a bit more the depth of implications for the current question of UK film companies value comes forward.
At the level of theatrical availability we can consider that a trend of fewer distributors, following the major’s trend of a fewer, bigger bets strategy, articulated by Elberse, would reduce the provision of a variety of content to UK audiences. Yet, there are increasing numbers of films being made and released, especially via new digitally facilitated distribution models. So will the UK audience really suffer from a lack of choice? Probably not at a fundamental level of absolute ability to see different films, however, an environment of extremes with more or less mega-tentpoles, and many, very low budget indies on miniscule releases, means that the chances of a theatrical break out from a non mainstream film are low.
The path to profitability for lower budget films is less difficult in total budgetary terms, but increasingly unlikely as typical alternative releases (6-screens and VOD) do not provide sufficient opportunity for a hit. The knock on effect would be negative for UK film companies, with major UK productions made by multi-nationals having revenues appropriated overseas, and the low-budget formula providing insufficient opportunities for substantial returns for UK producers or, indeed, the exchequer.
What is most telling for the question addressed in this post, is the continued diversity of understanding of risk in film and a need to address the complexity often glossed over in reporting.
Photo credits: Front Page, Matt Adams, this page, Kit Chan. Both under Creative Commons via Flickr