PRODUCTION,NOTE BULLETS

By JASON BOOTH

Staff Reporter

Bankers have been very good to Hollywood in recent years, pouring billions of dollars into film and television production on the assumption that the global thirst for entertainment would assure repayment of their loans.

But that assumption is now being tested.

Just as real estate lenders ran into problems in the early ’90s when the local market went into recession, Hollywood lenders are now experiencing similar although less severe problems as the entertainment industry cools off a bit.

Asia, a key overseas market for Hollywood, is in economic turmoil, while domestic film distribution is only growing moderately. The video market, once a financial safety net for film producers, actually shrank last year.

As a result, there is concern that U.S. filmmakers have overextended themselves, a situation that threatens the profitability of Hollywood’s bankers.

“As more banks jumped on the bandwagon, more films were being made than truly should have been made, that truly were not commercial,” said Lewis Horwitz, president of the Lewis Horwitz Organization, a division of Imperial Bancorp that specializes in lending to independent filmmakers.

The relationship between banks and Hollywood is a long-running, complicated one that underlies every movie and TV deal.

The most basic Hollywood banking deal involves a producer, a distributor, a bank and a completion bond company.

? The producer and distributor sign a contract stipulating the amount of money the distributor will pay the producer to deliver the completed movie.

? The producer then uses the distribution contract as collateral to get a bank loan, using the loan proceeds to make the movie.

? The bank requires the producer to buy a “completion bond,” an insurance policy that requires the completion bond company to repay the bank loan if the movie is not completed.

? Upon successfully completing the film, the producer delivers it to the distributor, is paid by the distributor, and uses that money to repay the bank loan.

In reality, the deal is almost always far more complicated, often involving 10 or more distributors, with each distributor handling a specific market U.S. theaters, European cable TV, Asian pay-per-view and so forth. Many deals involve multiple lenders, which often come together to form a syndicate.

As for producers, major studios routinely bundle several movies together into a “package,” which is spun off into a shell company. Commercial paper is then issued against the package, with the proceeds to finance future movies.

In short, many movie finance deals are far more creative than the movie script. And as deals have gotten more creative, they have also become riskier, leading to problems in a glutted market.

When Hollywood produces more product than its customers (distributors) are willing to buy, a glut occurs. Unable to get enough distribution deals to satisfy a bank’s requirements, producers try to get loans with less-than-full collateral, promising that more distribution deals are imminent. Bankers, still optimistic based on past results, agree to make the riskier loans, at higher interest rates.

Then problems start to surface. Either the anticipated distribution deals never materialize, or they do but then the distributor fails to pay the contracted amount, citing a change in marketplace conditions (e.g., a foreign currency devaluation). Then the producer defaults, and the bank must write off the loan.

A look at the numbers suggests that Hollywood may be in the early stages of such a scenario.

There were 458 new films released in 1997, according to the Motion Picture Association of America the highest since 1988 and up from 370 in 1995. As that supply has jumped, demand from distributors appears to be slumping.

Attendance by film distributors at the American Film Market in Santa Monica last February, the largest U.S. sales event for independent films, was 9 percent below the 1997 level, according to the American Film Marketing Association, which puts on the event. And many of the films that distributors bought were sold at steep discounts, said several industry sources who attended the event.

Even the Cannes Film Festival suffered as much as a 25 percent drop in attendance this May, according to local bankers.

While the list of Hollywood’s bankers remains short, more institutions have tried to get into the market: There are 20 registered with the American Film Marketing Association, up from 15 in 1995.

Said Ken Whiting, who heads up the recently formed entertainment division of Sanwa Bank California, “It doesn’t make much sense to be the largest bank headquartered in L.A. and not have a presence in entertainment. Entertainment is the fastest-growing industry in the U.S.”

Whether newcomers or even veterans can make a profit by lending to Hollywood is questionable, said industry veterans.

“It’s our feeling that the market is over-banked, high-priced and high-risk,” said Dudley Mendenhall, managing director of the Entertainment and Media Group at Bank of America.

But if banks are worried about the oversupply of independent films, they have only themselves to blame. They were the ones, after all, who dreamed up “gap” financing for films.

Traditionally, most bank loans for film production have been made on the basis of pre-sold distribution rights.

Once a producer had a script and cast, he would “pre-sell” the film to one or more distribution companies. The bank would then lend the producer money based on the value of those contracts. Once the film was completed, the distributors would pay the producer and the producer would repay the bank.

But there is growing demand for films made domestically in local languages, rather than imported from the United States. In response to these changes, distributors have become more selective about the U.S. films they would agree to buy up front, making it increasingly difficult for producers to borrow money from banks back in Hollywood.

“There used to be a time when independents could get their film fully pre-sold. Now it is almost impossible,” said Martha Henderson, head of the entertainment division at City National Bank.

Rather than make fewer loans, the banks responded by lowering their lending requirements.

Instead of requiring distribution contracts whose value equaled 100 percent of the loan amount, bankers are willing to accept estimated values of yet unsold distribution rights. Such loans became known as “gap financing” because they are made despite a gap existing between the loan amount and the value of actual distribution contracts in hand.

Let’s say a producer wants to make a $100 million movie, but has only $75 million in distribution contracts. He convinces the bank that additional future distribution deals will be worth at least $25 million, and based on that estimated value, the bank issues $100 million in gap financing for the producer to make the movie.

The practice was first employed by Banque Paribas of France and Lewis Horwitz. Their lead was followed by Imperial Bancorp’s Entertainment Group and a slew of other players.

“People saw that we and Lewis Horwitz could make money out of gap and they all thought they could do it,” said Michael Mendelsohn, who runs the local entertainment lending operation for Banque Paribas.

Gap financing has many advantages. Producers find it easier to get their films financed, while banks are able to charge higher interest rates on the unsecured portion of the loan. Its use has been a key factor behind the recent surge in film production, bankers say.

But gap financing has a fundamental problem, which is now coming back to haunt local bankers.

“If gap has not already backfired, it will,” said Mendenhall. “It is very risky to make a $10 million film with significant uncovered costs at a time when there is a lack of shelf space for new products.”

The Asian economic crisis, which has reduced the region’s appetite for U.S. films by an estimated 15 percent, is putting many gap loans in jeopardy. Even loans that were based on 100 percent pre-sold distribution contracts are running into trouble as overseas distributors struggle with devaluations of their local currencies.

As a result, there is widespread belief that banks with heavy exposure to the independent film industry are getting hurt, causing a tightening of lending requirements.

Imperial Entertainment, which made the largest number of film project finance loans in 1997, is said to be particularly impacted by the downturn in business.

Morgan Rector, president of Imperial Entertainment, acknowledged that his group is dealing with a number of troubled loans, but said he has not yet been forced to make any charge-offs.

“Certainly some are struggling, but we still classify them as digestible. At the end of the day I think there will be few, if any, write offs,” he said.

While the Asian malaise has had its greatest impact on independent film producers and banks that finance them, it has also affected the major studios and their banks. But due to their size, they have proved better able to withstand the downturn.

The formation of “debt syndication groups” also has lowered risk. Twentieth Century Fox Film Corp., Warner Bros. and Universal Studios Inc., along with a number of production houses owned or affiliated with the major studios, have raised vast amounts of money through such groups.

Typically they involve a studio creating a shell company and giving it the rights to a package of the films the studio has already produced. The shell company then issues commercial paper to a syndicate of banks based on the underlying value of those films. The shell then transfers that money back to the studio, which uses it to finance future film projects.

So will the current level of overproduction and the troubles in Asia lead to a major consolidation in Hollywood? Despite their misgivings, most Hollywood financiers think business will eventually bounce back.

“I think a lot of people are still quite bullish,” said Steve Ransohoff, executive vice president at Film Finance Inc., which sells completion bonds to film producers. “People are still making a lot of movies that will come on the market in 18 months from now, and I don’t think you can get out your crystal ball and say what the market will be like at that time.”