Where Does The Pecuniary Loss Guarantee Fit Into The Financing Picture?
In his article for The Business of Film, Special
Greg S. Bernstein
Each year, The Business of Film asks that I write an article for Cannes describing the latest gimmicks in financing independent films.
Last year gap financing and pecuniary loss guarantees were all the rage.
What a difference a year makes!
Last fall, the bottom began to fallout of the gap financing market. By "bottom," I mean exactly that...the bottom of the financing barrel. However, gap financing is still very much alive for most productions. It's the marginal productions that used to be able to be gap financed that cannot be financed this way today.
But, before you breathe a sigh of relief, keep reading.
We all know that the market in Asia has retracted significantly. A year ago a presale was possible in Korea. Now, we hope we can make a sale there, even on the best film, once the film is finished. More importantly, at AFM we found that almost every other market, with the limited exception of Italy and Germany, has become virtually unpresellable and we are beginning even to see signs of change in these two holdouts. Within the year, there will likely be no presellable markets for most films.
Since gap financing requires some level of presales, usually 50-75% of the budget, and the recent gyrations in the marketplace have caused the gap lenders to increase, rather than decrease, the required "coverage." theoretically there won't be any independent productions financed by banks, since very few productions will have any presales to meet the current, let alone the former, banking prerequisites. (Of course, there will always be the exception for the established producer of a series of product who has output deals with various key distributors.)
Actually, what we are seeing is a change in the paradigm for production lending, in much the way there was a shift back in 1994/95. If the banks move with the shift, films will be financed, banks will prosper and life will go on. If the banks don't shift their way of thinking, not only will there not be many production loans, the banks will be out of business. Thus, there will be a shift.
Back in 1994, virtually all production loans were fully collateralized; namely there were presales covering the entire budget of the film. However, in late 1994, as the marketplace began to produce more films, specifically more bad films, territorial buyers, particularly U.S. video buyers, started to back off pre-buying films. As presales became less possible, it became less likely that a film would be totally collateralized by presales. Thus, bankers found themselves with the dilemma of either changing their lending criteria and taking more risk or finding themselves out of business because few films could meet their lending criteria.
Given this dilemma, some lenders changed their paradigm and turned to lending against uncollaterialized rights, known as gap financing. While it sounded risky (the banks called it a loan, but it was really an equity investment), these banks actually found themselves prospering. Conversely, those banks which remained steadfast in their ways, limiting their production loans to fully collateralized loans, found themselves in a very limited, and competitive, market. And while the jury may still be out regarding some of the most recent gap loans, clearly the "loan loss" to date, and probably overall, has been negligible, while the profits for the gap lenders have been enormous and certainly far greater than any loss they may have suffered.
Now, once again, a new form of lending model will have to be written. Gap lending will still be around, just as fully collateralized production loans still exist. However, to remain competitive, and for that matter to remain in business to any significant profitable level, lenders will once again have to shift their thinking.
The model for what is to replace gap lending has already been written. In fact, the finance structure that is currently being applied with pecuniary loss guarantees, and more specifically equity financing collateralized by pecuniary loss guarantees, is the genesis of the model for independent film financing I believe will predominate within the next 12 to 18 months.
While pooh-poohed by traditional lenders and pundits, pecuniary loss guarantees flourished in late 1997 and into this year.
Pecuniary loss guarantees are the insurance guarantees that you've heard so much about. I briefly described them in my last year's Cannes article for The Business of Film. These policies have been used to aid in the financing of films that don't have enough presales or any presales. As with gap financing, the policies won't be issued just on pure speculation. The insurance companies do, of course, require that a sales agent have reasonably and rationally estimated that sales will be more than sufficient for the production loan to be recouped so that the policy will not be called.
How do pecuniary loss guarantees work? In short, an insurance company issues a policy to a bank or other financier which, in effect, guarantees the bank or financier its investment back after a certain specified period of time. For example, if the bank lends $2 million for a film to be made, it can get an insurance policy on the $2 million loan. Usually, the policy specifies that it is drawable two years following delivery. At the end of two years, the bank calculates how much money it has recouped from the film from exploitation of the domestic and international markets, and to the extent there is any deficit, it makes a claim to the insurance company. For example, assume that the bank recouped $ 1.6 million of its $2 million loan through the normal revenues generated by the film's exploitation. Obviously, at this point the bank shows a loss of $400,000. It presents this "claim" of $400,000 to the insurance company, and once paid by the insurance, gives the bank full recoupment.
The premium or price for these insurance policies is usually between 10% and 15% of the policy amount. The policy amount is the amount that has been insured. Typically, the banks want their entire production loan insured, or at least the portion not covered by presales. Assuming a loan with no presales, the full loan includes the cost of the film, completion bond, contingency, bank's loan fees, and interest reserve. Herein lies the major cost of these types of production loans: the interest reserve.
Most of the banks which currently accept pecuniary loss guarantees as collateral for production loans calculate their interest reserve based upon the assumption that very little, if any, revenue will be generated by the film itself to repay any portion of the loan. The banks assume that the loan will be outstanding for the entire period of time from the lending date until the date that the insurance company pays off the loan. Generally, this means that the bank holds an interest reserve equal to what the interest on the loan would be over 2 to 2 1/2 years at, typically, a 10% interest rate. That adds a very significant sum to the loan. For example, a $3.25 million production budget, exclusive of finance costs, might, in a typical gap financing situation, rise to a total loan of $4 million after the bank's loan fees, gap fees and interest reserve is added to the equation. However, in the case of the pecuniary loss guarantee, when the insurance premium, interest reserve and bank fees are added to the equation, the production loan becomes almost $5 million!
Of course, since the film will in fact generate significant revenues before the end of the 2 1/2 year period, so that the full loan will not, in fact, be outstanding for 2 or more years, a large portion of the interest reserve will remain unused and, therefore, not have to be repaid to the bank (i.e. , at the end of the day if an average film returns its investment within one year of completion, it makes the real cost of the loan somewhere in the $4 to $4.25 million range). However, the insurance premium was calculated on the full original loan, namely $5 million.
Why would an insurance company assume these kinds of risks? Well, the insurance companies have calculated that,historically, over a large number of films, the motion picture industry (on a film by film, not a business operations basis) does not show a loss. Hence, the theory is that if they insure a large enough number of films, and collect a lot of premiums, while there will be payouts on some films, the films will not be entire losses and, according to their calculations, the premiums will exceed the anticipated payouts.
If you think about it, this is no different than car or home insurance. Statistically, each one of us will get into a car accident once every so many years. In fact, at a given point of time, several of us will be making claims on the insurance company. But, over all, the insurance company collects more premiums than it pays out in claims (or so it hopes).
Although many of us have been skeptical as to the long-term viability of these insurance policies, and for that matter their underlying rationale, the insurance companies are in fact currently providing the necessary tools to allow some films that might otherwise not get financed through traditional or gap lending to be financed. Although, the insurance companies might get burned on some policies at first (such as is rumored on the Phoenix deal or various Screen Partner deals). However, most who understand the insurance industry believe that the insurance companies will refine their policies and requirements as time goes on rather than drop out entirely.
What most experts believe is currently missing in the insurance companies' equation-which will literally lead to changes in their policy methods and practices - is the fact that the insurance companies are insuring a group of films based on "average film performance" without having the full benefit of a film's success. Average performance means there are films with large profits, small profits, small losses and big losses. However, insurance companies will soon realize that they are in the awkward position of bearing the full risk of loss on the "loser" films, without the advantage of receiving the profits on the "winner" films. Since the insurance companies are not capturing the profits, their averages will be less than they have anticipated and, therefore, they will, theoretically, in the end, have more of a loss than a profit. By analogy to Vegas, when you play roulette, typically the payout on winning on a number is either 35 to 1 or 36 to 1 (depending upon which casino you are at) despite the fact that there is actually 38 numbers on the wheel (you should be paid 38 to 1 for a win just to stay even, not just 35 or 36). Thus if you stay at the wheel long enough, you will lose in the equation and the "house" will pick up the extra $2.00 to $3.00 spread.
So, if the insurance companies are playing in a game where the deck is stacked against them such that they will fail and may drop out, and the banks are changing their policies so that they won't be lending the way they used to, where is this all headed? Well, we have already seen it.
In the latter part of 1997, several companies combined the insurance guarantees with equity investment. These companies created funds which are investing in a large slate of films under the theory that they will hit the averages the same way the insurance companies have calculated. These funds have, however, taken a very large share of the profits (not to mention the deferral of sales agents fees the way the banks do), thus, theoretically, shifting the odds back in their favor. If that were not enough, these equity funds have backed up their investments through pecuniary loss guarantees. Thus, they have protected their downside.
Typically, no presales are required to participate in these programs. Slates of films from established producers and, more importantly, a respected and reputable sales agent attached, have been the main requirements. While some genre films have been financed through these programs, mostly films that typically could not get presold because they were a drama or other more difficult "presell" type film, have been financed via these programs.
The producers who have participated in these programs have been, for what I've been able to tell, very satisfied. Even production companies that have traditionally been able to finance their films the "old fashioned way" have participated in these programs, giving up a significant portion of their upside potential in the process. Why? Because they received funding for a slate of films, rather than only one or two films, and, more importantly, obtained the financing for a slate of films without the requirement of having any presales. Moreover, the financing has been for the exact amount of their production budget, exclusive of any type of financing costs and insurance premiums, etc. The bottom line has been less time figuring out how and when a film could be made, concentrating more on just making the films, being able to cast because the money is there and putting more money on the screen. That has also meant they could make more films over the course of a year than what they otherwise could have "financed," leading to less profits per film but more profits in the aggregate.
As these new equity funds enter the marketplace and the banks that have traditionally provided gap financing find their market changing once again, with presales becoming a relic such that producers cannot get presales totaling even one-third of their budgets (let alone 50% to 60% of the budget) the gap lenders will find that they cannot make the volume of loans that they have in the past couple of years. To stay in the game, these banks will have to do the complete opposite of what they are doing now - namely, increase their risk (i.e. make greater equity investments) rather than find ways to lessen their risk.
"Super gap" will become the rule, not the exception.
In other words, the traditional gap lender, or rather the new breed of lender, will truly make "investments" rather than loans. The first couple of years will be slow going. Most of the first few of these "equity" loans will be at a very high price for producers and will only be with producers or production companies and sales agents with very strong track records and long histories with these lending institutions.
It will also be slow going because the "new" loans will in fact be equity investments, traditional banks may find themselves hampered to make these loans due to existing banking regulations. Foreign banks and non-bank lenders (such as Newmarket Capital Groups and the latest incarnation of the Lewis Horwitz Organization) will find themselves at an early advantage since they will be able to make these loans unhampered by banking regulations. It would not seem unlikely to me that the traditional bank lenders will find themselves spinning off their entertainment groups as unregulated investment banking institutions.
As with gap financing, as the lending becomes more frequent, and history proves that these loans are no more risky, given the profits earned, than other forms of investment, more and more lenders/ investors will enter the market for these types of loans. Competition will take hold and these types of loans will become more readily accessible and less expensive. I suppose there will also be some fall-out. Some growing pains and some mistakes.
Of course, a year or two from now we will all be talking about these new methods of financing, and, I suspect, what the horizon holds to replace these financing tools given another shift in the marketplace.
Reprinted with permission by The Business of Film
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