March 5, 2008
Creative types must face the music
For my Financial Times column this week, I have returned to the topic of Guy Hands’ views of A&R men and taken in Time Warner’s move to fold New Line into its Warner Brothers studio.
I argue that creative executives such as A&R people and film producers must get used to more financial discipline and lower pay because media companies can no longer afford to indulge them.
You can read the column here. Comments are welcome below.
John Gapper’s analysis is clearly correct. He puts his finger on some seriously difficult questions, not least for policy-makers in the UK.
It is interesting to reflect on the significance of Mr Gapper’s analysis for the future of the UK’s creative content sector as the process of global media fragmentation deepens, and to consider the (as yet) largely unaddressed consequences for public policy. The UK film industry is a case in point.
This industry is both an important contributor to our cultural output as a nation and a vital driver of the creative economy, directly employing more than 40,000 people and indirectly tens of thousands more. However, from an investor perspective it is also both financially fragile and commercially under-developed.
The goal of sustainable investment remains as distant as ever. David Elstein, retiring chairman of the UK’s British Screen Advisory Council (BSAC), was right when he said a couple of weeks ago that “our economic model for content production in this country is too weak….”
In November 2002, the then chairman of the UK Film Council, Sir Alan Parker, delivered a landmark speech entitled “Building a Sustainable UK Film Industry”. He started by observing that:
“We can never be the biggest film industry in the world, but we should be right up near the top of the league, not permanently hovering in the relegation zone.”
He continued by remarking that the UK film industry had had enough of “quick fixes and band-aids” and needed nothing less than “radical re-invention”.
Why can’t the UK develop a sustainable film industry? This question was asked by the House of Commons Select Committee on Culture, Media and Sport in 2003 in a report entitled “The British Film Industry”. This highlighted what the Committee regarded as the key structural weakness of the UK industry – that it was producer-driven. By contrast, it noted, a winning film industry is distribution-led.
The Committee cited a blistering analysis of the problem which had been submitted by the Film Council. This is worth recalling at length:
“The scattered and fragmentary nature of the (British) financing model contrasts sharply with the integrated model which forms the basis of US studio financing. The ‘cottage industry’ approach of the UK production sector, comprising scores of film companies, is remarkably successful at delivering excellent, culturally significant but ultimately unprofitable British films. This industrial structure (also) fails to deliver a consistent flow of films such that risk can be spread across a slate of projects. This inability to run a portfolio of films to mitigate financial risk acts as a very strong disincentive to private investment into the production sector. Obviously this approach (also) does nothing to build the significant corporate structures which are essential to achieve a sustainable industry.”
That critique remains definitive and applies a fortiori in the new digital environment.
Since the Select Committee reported five years ago, the scene has of course been progressively transformed by the deepening of the digital revolution and the consequent fragmentation of the media industry. The commercial impact of these developments has often been commented upon. I was especially struck by an interview with Dick Parsons of Time Warner. Asked what the future held for Time Warner he replied with an analogy. He said, “Imagine 1000 buckets on the floor all catching little raindrops of revenue – that’s what Time Warner is going to look like”.
In film, as in music, it is the profits made in the distribution part of the value chain, the profits that for many years sustained these industries globally, that are now most at risk in an on-line world.
The period after 2003 marked a relative boom in the production of British films. It was stimulated to a degree by government tax reliefs, notably at the lower budget end of the market, but was due mainly to equity investment. Much of this investment was attracted thanks in part to decades’ long accounting rules known in recent times, somewhat inelegantly, as “sideways loss relief” - the principle that investors’ losses can, for accounting purposes, be offset against profits.
These rules changed in March 2007. Whereas private investors previously stood to lose only £60 out of every £100 invested, now they stand to lose the lot in an unsuccessful venture. And most ventures in the creative economy are unsuccessful: it is a “hits” and “misses” business where the hits must pay for the misses. This is much better understood in the USA than it is in the UK.
What difference does the arrival of the on-line age make to investors? Answer, it magnifies uncertainty and thereby amplifies investor risk. Why? Firstly, it lowers barriers to market entry. Second, it generates greater competition throughout the value chain. Third, it progressively whittles away the famed power of the “gatekeepers”, who effectively controlled prices at both ends in the pre-digital age, resulting in reduced margins.
Market fragmentation continues to proceed apace. We have more channels; more platforms; and more “choice”. The customer is truly king and, for consumers, this is surely a wonderful thing.
But, and here’s the rub, can anybody make money in this environment? Can they make enough money to build sustainable businesses? The talk everywhere is of new business models, new delivery platforms, new “windows”, the so-called “long-tail” effect, and so on. But would you really advise your best mate to invest their hard earned cash in funding any of these new market entrants?
There certainly are new opportunities out there, some of them very exciting. From an investor perspective however deepening fragmentation is making life much more difficult.
Some have argued that salvation in the future lies with “uncorrelated” investment activity, especially hedge funds. This is surely fanciful, at least for independent production. The hedge fund model should work on the distribution side of the film business. However, it is less appropriate as a model for the industry as a whole. The model is based on the idea that you can analyse the key characteristics of a studio’s entire slate of films over a period of, say, five years, and project forwards from there. It is questionable because unlike, say, the credit card market, where very large numbers of customers provide a solid mass of statistical evidence, in film the data sets achievable are relatively narrow.
There are four factors at work here. First each film is different. Secondly the total number of films made is small, even in the USA. Thirdly market conditions, meaning the state of the theatrical market and the availability of distribution technologies, change so quickly that past experience is never a guide to future performance. And finally, costs are rising, so a well performing historical slate would certainly return less if re-created today.
Hedge funds in the USA have invested in film in spite of this logic because, at least before the credit crunch, they had mountains of spare cash - $13 billion of which was invested in some 150 movies over a three year period. There have, to be fair, been some noticeable studio slate successes - Fox and Dune come to mind. But just now, as readers of the Los Angeles Times will be aware, several hedge funds are beginning to wish they’d never touched film. A number of very big losses are being sustained.
In any event as we all know US experience is not transferable. The big studios run gigantic slates and have a total grip on distribution and other rights. These conditions do not obtain in Europe.
The fact is that most independent films lose money, and that all investment in film is a calculated gamble. It is hardly surprising therefore, that as far as film production is concerned the UK is still chronically short of investment. Yes, we have creative talent in spades. Yes we can go on making the “excellent, culturally significant but ultimately unprofitable British films” that the Film Council talked about in its Select Committee submission five years ago. Yes cinema admissions are rising and the industry’s contribution to UK GDP has increased by 39% during the last two years or so. All of this welcome “good news” was highlighted by the Minister, Margaret Hodge, in her speech to the UK Film Finance Summit on 18th October last year.
But these achievements conceal some uncomfortable financial truths. The total annual production budgets of the Film Council, Channel 4 and BBC combined add up to some £33 million annually. If we assume that between them they account for 30-50% of a film’s budget on average, and add in pre-sales, some bank finance and the UK Film Production Tax Credit, this would give us an independent UK industry worth between £66 million to £110 million annually. On an international scale this is of course pathetically small.
A government which frequently champions the UK’s creative industries and talks about turning the UK into the “world’s creative hub” does not appear to want to face up to these facts. Ministers do not appear to recognise the significance of the investment challenge in a globally competitive world in which both business talent and creative talent is highly mobile.
This raises an obvious question: where is the required risk capital going to come from in the UK? The Treasury response to this question is that it is not their job to “second guess” the markets, which is understandable but doesn’t take us very far.
The unpalatable fact is that the UK film “industry” is still only the cottage industry it was five years ago, and so it will remain unless more sustainable investment is generated.
The effect of digitalisation is to magnify competitive weaknesses. In the global environment that Mr Gapper describes we need to understand that, in UK plc, other things being equal we are likely to find ourselves capturing a smaller and smaller proportion of the commercial upside generated by our glorious creative talent. In the movie business, we may gradually be consigned to the role of suppliers of commoditised, off-shore film industry support services while bigger rewards are enjoyed in Los Angeles, or Mumbai, or who knows, Shanghai.
To be in a position as a nation to capture more of the commercial upside we will have to start building more business capacity. To achieve that we need sustainable investment which, in turn, would then enable us to attract more talent - business and creative talent - to work with us in the UK.
To some extent this is a circular problem, but it should be clear that we will not make progress without first developing sustainable investment models. To do that we need to understand what risk-adjusted rate of return would bring in new investors in significant numbers. That work has not even started.
Martin Smith
Posted by: Martin Smith | March 8th, 2008 at 12:00 pm | Report this commentPolicy Adviser
Ingenious Media plc