Institutional Investors Changing Independent Film

In the last post I wrote about how the dynamics of the film industry are changing. Stars are no longer a reliable predictor of financial returns for film investors.  Return on investment today is far more predicated on a film’s marketability.  However, the predominant factor that I believe will influence the film industry over the next few years is capital availability.

Throughout 2006 and 2007, Hollywood received a large influx of capital from Wall Street hedge funds and investment banks.  The recession has prompted this institutional capital to shift their asset allocations to more liquid investments.  Asset allocation is how investors divide capital among different asset classes like stocks, bonds, leveraged buyouts and venture capital.  Film is an illiquid asset.  Because films do not trade on an open market, investors have little to no liquidity once an investment is made.   Furthermore, the lack of a market mechanism prohibits film investors from determining the exact value of an investment.  This increases the risk perception of film investments as well as the return expectations.

I believe the rebalancing of asset allocations among institutional capital will result in two broad impacts for the film industry.

1. The number of films produced by MPAA studios will continue to decline.
2. The disparity between studio and independent budgets will grow.

The reason that institutional capital left Hollywood, and why I believe it will stay away for a few years, boils down to two elements: liquidity and the rebalancing of asset allocations.

Institutional investors favor liquidity
Liquid assets like stocks and bonds are more conservative because they have efficient markets of buyers and sellers that determine the exact value of assets.  In addition to liquidity, markets allow institutional fund managers to determine the performance of their investments on a daily basis.

Redemptions are causing institutional investors to rebalance their asset allocations
The economic crisis created a panic among investors and brought on a wave of institutional redemptions.  This forced institutions to sell their liquid assets to meet redemptions, causing billions of dollars to flow out of the capital markets.  The result was the contraction of institutions, particularly hedge funds (many hedge funds have merged or gone under).  Because of the sell-off, illiquid assets now comprise a larger proportion of institutional investment portfolios.  This has and will continue to result in the decline of investment in illiquid assets.

The argument to refute my first point is that studio film production will not decline because film is a recessionary-resistant industry that tends to outperform in economic downturns.  I agree that the film industry has historically outperformed in bad times.  However, as institutional capital shifts asset allocations to more liquid investments the result is that instead of investing in Miramax’s fall film slate, institutions will simply invest in Miramax’s parent company, Disney.  This preserves liquidity while maintaining an entertainment investment pure-play.  In return, Disney will focus on maximizing intellectual property, resulting in a decrease in the number of films produced and an increase in film budgets.  Studios will narrow their focus to generate the highest returns on the most marketable properties.

Institutional asset reallocation is the crux of my second point.  I believe that asset reallocation will result in a budget disparity because less institutional capital will be available for independent films to be financed.  However, that does not translate to a decline in the production of independent films – it just changes the model.  New distribution channels are creating opportunities for low and ultra-low budget independent films to generate attractive returns.  The emerging viability among low and ultra-low budget indies will likely result in growing popularity among individual film investors.

Only time will tell if my theories become a reality.  It is certainly a tough time to raise capital, but that should motivate filmmakers!  Change always sparks innovation.