Over the Hedge (Fund)!

In my last post, Kat Evans commented…

My goodness Keith, if I didn’t know better, I’d say you’re becoming an economist on the side.

You don’t know the half of it, sister! Heheh. Here’s even more “economist-speak” from me.

Hollywood relies on an ever revolving door of suckers to finance a lot of their films. Hollywood studios are no dummies. They only put their own money into films they have reasonable confidence will return that money. But they also have a slate of films that they’re not so sure about but still think might turn out OK. Films like The Ant Bully (seemed like a good idea at the time). So a studio like WB looks for somebody to to help pay for it. When we were working on The Ant Bully at DNA we all noticed a tag at the front of the trailers for “Legendary Pictures”. A lot of folks in the studio were like “Who are they? We’ve never heard of them before. Why do they get their name and logo on the front of the film and DNA doesn’t?”. Well, “they” are a large source of financing to a portion of WB’s film slate. (here’s a slew of links for your own investigation). Investment wise for the financiers sometimes the gamble works (Batman Begins, 300), sometimes not so much (Superman Returns, Ant Bully, Lady in the Water). Legendary Pictures is the invention of a Wall Street hedge fund (MC Venture Partners). Hedge funds are the investment playground of the rich and anonymous. Hedges are always seeking out higher returns than you can get by just sticking to the S&P Index.

Hedge funds are an intriguing beast. They’re exclusive, usually only allow in high dollar investors and promise amazing returns. They’re like uber-investments. Most of them use a bunch of super sophisticated MIT built math models to play market volatility and risk to their advantage, so as a result they seek out risk rather than avoiding it (no wonder why they’re involved in making films!). They place offsetting bets on things doing well and things not doing well according to the statistical “norm”. So far sounds good, but they do even more. They amplify this earning power by using investor’s deposits as collateral to borrow money from other places (banks, securities firms, pension funds, foreign governments, etc.) and invest that loaned money as well. Then they use the investments from that borrowed money as further collateral to borrow ever more money and invest that as well. It’s like a rising spiral of loans- all using the previous investments (bought on credit) as collateral for getting a new loan. For every $1 that an investor has deposited into a hedge fund a typical hedge will borrow another $10 and invest that as well.
Anyhow, because they have all this borrowed money to invest these hedges have been looking for places - anyplace!- to put it to use. One place they have rolled their dice is with Hollywood (where the math models seem to have figured out how to parlay the winners and losers). Legendary is just one example of many of these kinds of investment vehicles financing films. Hedge fund money is helping to get a lot of films made. (Google “hedge fund investment in Hollywood” for interesting reading)

Sounds like a wonderful game! Indeed it all works like Christmas when the world plays along with your ‘normative’ math models. When things don’t ‘follow the norm’…. well, let’s just say it can get messy.

And right now things are getting a little messy. Hedge funds are taking a beating these days. Seems there was a problem in their math models. This little problem called “sub prime mortgages” aren’t playing by the “norm”- they’re defaulting at much higher rates than the math genius experts thought they would. And if that weren’t enough, now alt-A and ARM mortgage defaults are going off the norm, too. Hedges have a boatload of borrowed money tied up in these mortgage backed securities (to be honest everybody in global finance does. I could fill three full posts on this mess). Several hedges (and a UK bank) have gone belly up already and economists expect more to do the same as the housing bust in the US goes deeper and these exotic interest only, teaser rate, adjustable rate, reverse amortization, ninja (no income, no job) loans go flop.

End result? Lotso’ these hedges gots’ no money to repay the loans, repay their depositors or to do anything else (like invest in films). This is amusingly referred to as ‘bankruptcy’. And there are a bunch of these hedge funds that could unwind in a very messy manner in the next 12-18 months.

What does this mean for Hollywood? Well, the money might dry up a little bit. Not totally of course- there will always be another sucker. But when you add in the looming WGA and SAG labor tensions we might find that in 2008 and 2009 things may be a wee bit tight in Hollywood. As for animation, players like Disney/Pixar, DW and SPA are all in with their own cash. But the secondary markets for VFX work and lower budget second tier animated films might get squeezed. Or maybe not. But I wouldn’t be at all surprised if things slowed down some beginning next year. It’s not like any of this is especially new. The film biz has always been up and down- animation even moreso. Folks who’ve been around for a while understand this. But there’s a lot of younger folks in the game now who have never seen a down cycle yet. Perhaps they believe such a down cycle will never come. Ah, the innocence of youth. Heh. At any rate, regardless of your age if you’re in the animation biz and you’re not regularly saving a chunk of money each month to get you through the inevitable rough patches then you are playing with fire.