Tuesday, February 02, 2010

How Wall Street Hedge Funds Got Taken On A Billion Dollar Ride in Hollywood

Back in 2003, after Kirk Kerkorian 1et it by know that he was (yet again) prepared to sell MGM, Viacom, which owns Paramount, considered buying it. Although MGM no longer had sound stages, backlots or other physical facilities, and now produced only a handful of movies, it owned an incredibly valuable asset: a film libraries with 4,100 motion pictures and 10,600 television episodes. The crown jewels of this collection was its James Bond movies, which was possibly the most valuable entertainment franchise ever created. By licensing these titles over and over again to Pay-TV, cable networks, and television stations around the world, and selling DVDs from it,, this library brought in roughly $600 million a year. But that gross was an elusive number as it had to be split with others who had rights in the titles. Each title had its own contractual terms governing payments to partners, talent, guilds, and third parties.. Just making these payments entailed issuing more than 15,000 checks per quarter. Not only did titles have different pay-out requisites, but their future revenue stream depended on factors specific to each movie, such as the age of its stars, its topicality, and its genre. To figure it out, Viacom assigned a team of 50 of its most experienced specialists to estimate the how much each and every title would bring in over a decade. The Herculean job took the team two months. From this analysis, as well as considering other benefits of merging MGM with Paramount, Viacom’s executives agreed MGM was worth between $3.5 and $4 billion. But before they could arrive at a bid price, Viacom’s President, Mel Karmazin, asked them whether the value of the MGM vast library go the way of the music industry, which had been decimated by Internet down-loading. When none of the executives could rule out that possibility, Karmazin said "In that case, we are not bidding on MGM." Disney, after a similar deconstruction of MGM’s complex library, valued it at $3 billion, and also opted not to bid on the company.
Sony had a very different agenda for MGM. Since it had staked much of its corporate future on Blu-Ray as a high-definition format, it needed to get other major studios to choose it over a competing format, backed by Toshiba and Microsoft, called HD-DVD. Sony had learned from bitter past experience that format wars are often decided not by superior technology but by side payments made to studios. Toshiba and Microsoft (which had X-Box) were already offering huge cash inducements– one studio would get $136 million– to put their titles exclusively on the HD-DVD format. Such a pay-off competition could prove extremely expensive given the deep pockets of Toshiba and Microsoft, so Sony, which needed to establish Blu-Ray for its Play Station 3 as well as its movies, sought another route to victory. If it could put the huge library of MGM titles exclusively on Blu-Ray, together with its own library and the Columbia Tristar library (which it also owned), Toshiba and Microsoft, no matter how many side payments they made, would not be able to establish their rival format. To this end, Sony did not need to itself spend billions to acquire MGM, it only had get effective control of MGM’s library for a few years. So it put together a consortium that would be financed mainly by Wall Street private equity funds. And it would lead the consortium.
Even though the LBO would wind up costing $4.85 billion, Sony invested only $300 million of its own funds (and for that it got the profitable right to distribute MGM movies). Another $300 million came from the Comcast Corporation in return for the rights to put the MGM’s library on Pay Per View on its vast cable system. The rest of the equity money came from renowned Wall Street investors Providence Equity Partners, Texas Pacific Group, DLJ Merchant Banking Partners, and Steve Rattner’s Quadrangle Group. These savvy funds put in a cool billion dollars. The leverage part of the deal was organized by JP Morgan Chase, which very profitably arranged, since it also got a fee, for the consortium to borrow $3.7 billion (or up to $4.2 billion, if needed) from some 200 banks. The deal closed in September 2004.
For Sony, the gambit succeeded brilliantly. Putting some 1,400 MGM titles exclusively on Blu-ray, helped established Blu-Ray as the industry standard for high-definition, and it won the format war. It also made back a large share of its $300 million investment just on the distribution fee it earned on two new Bond movies (Casino Royale(2006) and Quantum of Solace (2008). But for the Wall Street players, it was nothing short of a disaster. To cut to the chase, they lost almost all their entire billion dollar investment. They had relied, perhaps naively, on impressive-looking projections showing that the net cash flow from the MGM movie and television library would be sufficient to pay the interest on the nearly $3.7 billion of debt over s decade. What they had not counted on was a sea change in DVD sales. In the US alone, MGM’s net receipts from DVDs fell from $140 million in its 2007 fiscal year (which ends March 31st 2008) to just $30.4 million by 2010. As a result of collapsing sales, higher pay-out for participants, increased distribution costs and other distribution problems, MGM’s crucial operating cash flow catastrophically fell from $418.4 million in 2007 to minus $54.2 million by 2010. In addition, it owed Fox Home Video $60 million for an "adjustment" in the DVD distribution contract it had taken over from Sony. By October 31, 2009 MGM, sinking in a sea of red ink, found itself unable to make its mandated interest payments on the $3.7 billion it owed banks.
Ordinarily when a company fails to make such payments, its bank creditors can seek to recover their money by forcing the company into bankruptcy. With MGM, however, the bankruptcy option presented a real problem since many of its intellectual property rights, including those to make sequels in the James Bond franchise, stipulate that in the event of bankruptcy they would automatically revert to another party. In the case of the James Bond franchise, for example. the sequel rights would revert to Danjaq, LLC. (These bankruptcy clauses are not mentioned, even in a footnote, in the 38-page "Confidential Information Memorandum" that MGM sent out to prospective buyers in the winter of 2009.) So the creditors learning that bankruptcy would destroy a significant part of the remaining value of MGM, gave it a three month "forbearance," which meant it had until January 31, 2010 to come up with the money. The idea was that MGM would sell itself to a white knight and use the proceeds to repay the banks. The deal book was sent out to a dozen or so prospective buyers calling for bids by January 15th. The replies, according to a source close to Moelis & Company, which is MGM’s financial advisor, have, as of January 22nd, have been "disappointing," with none of the serious bids coming within $1.6 billion of what MGM owes its creditors. As for the hedge funds, they have already written down 85 percent of their billion dollar investment in preparation for what may be a near total wipe-out. The lesson here for Wall Street that when a Hollywood deal seems to good to be true– it may not be.