This item goes quite a way toward giving a glimpse of the American mentality when it comes to the motion picture industry. To them its their world.

Media & New Media
October 2008

The New Screen Test

Despite a bumper summer spearheaded by a record-breaking Batman installment, the film industry might not be as recession-proof as once thought. Colin Brown reports

Among the truisms that infect film-business thinking, two have endured longer than most. First, when making movies, always spend someone else's money. And, second, cinema is as close to recession-proof as it gets: when money's tight, there is nothing quite like a darkened movie house to provide a cheap, diversionary fix.

So ingrained are these beliefs that both played a big part in the ruinous film financing binge of the last couple of years. At least $12bn of institutional capital was shovelled into the studio movie-making maw via profit-sharing structures designed to spread the risk across large portfolios of upcoming film titles. Such largesse did not come from starry-eyed US hedge funds alone; a large chunk was underwritten by such sober European investment banks as Deutsche Bank, Dresdner Kleinwort, Royal Bank of Scotland and Société Générale.

Reinforcing this rash of investment was the long-held assumption that movies were, to use Wall Street speak, "non-market directional" and "non-correlated" i.e. immune to fluctuations in the equity markets and to the economy as a whole. No matter how badly the rest of the market behaved, these investors could still count on an internal rate of return of at least 8%-9% from their movie slates.

Ever the mercenaries, Hollywood's studios happily played along with this delusion as they sought to deflect the enormous costs involved in making and marketing films. And who can fault the studios for exploiting others' money when such deals were largely tilted in their favour: most got their 12.5% distribution fees even before any box office or DVD spoils were divvied up between investors.

On paper, at least, such shared profits were all but guaranteed. After all, box office gross takings rose during five of the last seven economic downturns, including the 1970s oil crisis and the burst of the dot-com bubble. And look at the Great Depression in the US. The 1930s occasioned both America's rock-bottom low in terms of living standards but also Hollywood's high in terms of admissions as millions sought escape in Marx Brothers comedies, musicals and monster flicks.

Of course, in those days a movie ticket bought you a cartoon, a newsreel and a supporting feature - four hours of entertainment for the price of a gallon of petrol. And let's not forget that during the last recession in 2001 there was no streaming video, no iPods, no Facebook, or text message twittering and no 60-inch high-def plasma TVs bought on maxed out credit cards. There was no LoveFilm to keep us glued to those in-home cinemas, with its 58,000 film rental offerings; and no freely available love films to decimate the porn industry. There were no video games like Grand Theft Auto IV to generate first week sales of $500m; nor camera-equipped mobile phones to entertain ourselves making shoddy films for YouTube.

In hindsight, the investment community should have known better than to trust in false precedents, especially since the performance of any given slate of films directly hinges on the studio's management team and its execution of production, marketing and distribution - factors that have very little to do with any historical financial data used to rationalise film investment decisions.

When odds are so stacked against them, "co-finance equity investors are not the studios' 'partners' at all... they're prey", says Ben Waisbren, CEO of Continental Entertainment Capital (CEC) a trans-Atlantic merchant banking business that has committed some $400m in film financing. "But don't blame the scorpion; blame the frog."

With the markets long since mired in red ink, and the global consumer spooked by fears of a recession, institutional investors have wised up and are retreating from such billion-dollar slate financing deals just as quickly as they came in. In July, Deutsche Bank shut down its film-funding unit after failing to corral other investors willing to shoulder the senior debt component on a $450m fund for Paramount Pictures that would have shared the cost of making 30 films, including Tropic Thunder and a proposed sequel to Transformers. At MGM, there have been struggles to put together a $1bn "franchise fund" to help bankroll such eminently marketable properties as a two-part adaptation of Tolkien's The Hobbit, remakes of Robocop, Death Wish and Fame, and the next James Bond movie to
follow the $230m Quantum of Solace.

In the face of such adverse conditions on Wall Street and Europe's capital markets, is it any wonder that film studios are busy grooming exotic, new funding apprentices? Indian moghuls, Russian oligarchs and Middle Eastern potentates have become the latest marks.

A dwindling cadre of European film financiers are still in the game, but even the most resolutely committed are questioning whether the cinema industry can weather the economic squalls. They see in the recent worldwide box office takings of The Dark Knight, and the phenomenal success in France of the €10m Bienvenue chez les Ch'tis (€130m in revenues and counting) evidence not of a persistent appetite for cinema-going, but of growing discrimination on the part of ticket-buyers. Both films may be chasing Titanic on various lists of all-time box office champions, but there is no real reason to believe the same tide will lift other boats as well.

"The recession-proof nature of cinema is a myth that the industry likes to perpetuate," says Andrew Hildebrand, a London film-financing specialist. "Most of Europe's independent film industry is dependent on television underpinning its funding. Over the last few years, with broadcasters suffering acute market share fragmentation due to new competitors, TV licence fees have dropped. Worse still, many non-studio, non-quota films simply don't get bought. With a recession hitting TV advertising, these problems will only be exacerbated. So traditional sources of indie film financing will likely be hit even harder. What gives the myth some credence, however, is that film is cheaper than other forms of entertainment including videogames and restaurants. If you look at supermarkets, special offers are doing well and so are the luxury items. Sales of beef fillet have gone up exponentially since it beats dining out - it's the middle that suffers in recessions."

And it is that middle that is of concern right now for a conflicted French film industry. A group of industry professionals led by filmmaker Pascale Ferran, director of Lady Chatterley, published a damning 194-page report earlier this year that decried the disappearance of mid-budget films by experienced filmmakers. These so-called "films du milieu" are being squeezed out by a combination of public funding preferences and commercial pressures. The report's title said it all: "the middle is no longer a bridge, but a fault line."

The undue influence of big multiplex chains and TV broadcasters that subsidise so much of French cinema has led to a demand for simplistic, big-budget, star-driven, formulaic fare geared for prime-time viewing. Meanwhile, the state support mechanisms favour experimental films by novices. More than half the 227 films made last year in France were first or second time efforts by their directors. The problem is that few bother to see such avant-garde visions: 150 of the films made in France were watched by fewer than 100,000 people last year; their box office grosses covering a pitiful 2% of their production costs.

In so many ways, France is a perfect example of the contradictions that beset the industry across Europe. On the one hand, the country has never seen such success. Marion Cotillard won this year's Academy Award for Best Actress for La Vie en Rose. In May, The Class won the Palme d'Or at the Cannes Film Festival, the first time a French film had won the top prize in 21 years. For the first five months of this year, French-made films accounted for a remarkable 59% of the national box office take. And investment in French films reached a record-breaking €1.2bn in 2007.

And yet, if current trends continue, France is in danger of stubbing out the kinds of artistically adventurous, commercially accessible films that made its cinema among the most exportable in the world. Were he still alive and making films, François Truffaut would no longer be certain of finding French backing - unless he signed on to direct a Ch'tis sequel, or, better still, its American remake.

"We are seeing a polarisation in the types of films being made" agrees Yann Le Quellec, the Paris-based chief of CEC's European operation. "There are fewer €5m-€10m films that have the ability to draw in audiences. Traditionally, Europe derived its international appeal from these kinds of films. Now they are disappearing for financial reasons."

This is not just a French problem: there seems to be a general acknowledgment that, without a plausible shot at a Best Actor/Actress Oscar nomination, films in the €5m-€10m budget range are operating in a dead zone and are harder to recoup.

All this is happening at a time when a strong euro has made European films harder to sell around the world - and when Hollywood cost-cutting has seen the closure of two potential US distribution homes for European films: Warner Independent Pictures (which released March of the Penguins) and Picturehouse (La Vie en Rose; Pan's Labyrinth).

Both fell victim to an unsustainable glut of pseudo-indie movies that have been churned out by Hollywood studio offshoots chasing the next Juno. Fierce competition among these speciality labels - many of them involved in European cinema either as financiers or distributors of films shot on the continent - has seen them all spend more on production and distribution, further eroding their profitability and cannibalising the adult marketplace. With a finite supply of time and eyeballs to fight over, more casualties are expected.

So brutal is the US marketplace now that international players are turning their back on what was once the world's most coveted film territory. Among them is Canada's Entertainment One (E1). Instead of being tempted south of the border, its fixation is Europe and building a distribution network that already encompasses releasing operations in the UK (Contender) and the Benelux countries (RCV). "We still have very strong intentions to do more in Europe," says E1 president Patrice Theroux. "I will be disappointed if we are not in two more territories soon."

Fortunately, such overseas interest has not translated into the same wanton gold rush that has left the US film industry reeling from the after-effects of Wall Street's irrational exuberance. For that, paradoxically enough, Europe has the current credit crisis to thank.

Le Quellec recalls a 2007 London film finance conference in which Europe was trumpeted as the next great opportunity now that institutional investors had tapped out Hollywood. "Ninety per cent of those in the room were American. They saw Europe as the new Holy Grail, particularly since the break-even point for European films is lower than in the US. What worried me is that they were talking about Europe as if it were the US. It is more an aggregation of markets; a fragile landscape with many different forms of support. Any influx of money at that point would have created even greater inflationary pressures than in the US and resulted in a catastrophe. All the institutions were in the starting blocks - and then the sub-prime crisis happened and practically no one came in except us."

Le Quellec also sees a Darwinian upside to this thinning of the herd. "Some very good deals are being dropped as a result. This is an opportune time to consolidate market share through good long-term partnerships. Cash-on-cash returns from European films can be significant for revenue sharing partners. Even though distribution costs are increasing (the cost of prints and advertising in France has risen 300% in the last 12 years), we think European film is still a sound investment. The good news is the best independent producers will be left even stronger than before and in a better position to access the capital markets. Europe's cinema industry will be financially healthier as a result."