Union Patriot Capital

The Gap: Closed For Business

Jun. 29, 1998

The Gap: Closed For Business/As 'gap financing' dries up,
producers scramble to find alternatives.

by Jennifer Pendleton

Hollywood's completion-bond industry is alive and well, but the business is poised for a competitive scramble in the changing landscape of 1998 and beyond. The four main companies providing guarantees that a film will be made on time and on budget -- for a fee -- are still in the game, and business in the last 12 months has been good, according to the players. So good, in fact, that a new company, headed by veteran bonder Steve Cardone, has hung its shingle. But the independent film sector seems headed for a slowdown, albeit a temporary one, so the question for bonders is, how will they pick up the slack?

Mega-mergers in the entertainment industry mean there are fewer bonafide independent film producers out there. But there are still plenty of independently financed pictures and always will be, according to entertainment industry analysts. Studios prefer off-balance-sheet financing. These pictures require completion bonds. Also, there's increased production internationally, especially in countries such as Great Britain, with its National Lottery-backed film subsidies.

Steve Ransohoff, executive vp of Film Finances Inc., estimates there are about 400 motion pictures around the globe that require bonds annually.

"There are lots of pictures that need bonds in all price ranges," agrees Lionel A. Ephraim, president of the West Coast Motion Picture Bond Co.

Maybe so, but given the fast-moving marketplace, bonders may have to adjust their strategies.

In recent years, a bright spot for bonders has been the surge in independent production that's followed the popularity of so-called "gap financing" -- the practice of lending independent producers the "gap" between what they need to make the movie and what they have, using expected revenues from unsold territories as collateral. In some cases, the gap has been as high as 50% to 60% of production costs. Today, entertainment lenders are becoming more cautious about what has been a popular means of financing independent production in recent years.

"Gap financing for single pictures may have reached a zenith in the last year because there's a possibility that a number of films that were gapped may not be able to repay the lenders," says David Davis, vp of the investment banking firm of Houlihan Lokey Howard & Zukin, Los Angeles. "Some banks may start reporting losses on those films."

Davis points out that with the Asian economic crisis, territories expected to contribute 5% to 6% of the budget, such as South Korea, evaporated.

Hal Sadoff, senior vp of NatWest Group, the Beverly Hills-based entertainment lender, foresees a shake-out. "If you're around, you know these [gapped] films aren't recouping their costs. Someone is taking a write-off or going to take a write-off," he says.

Morgan Rector, president of the entertainment group of Imperial Bank, a gap lender, says Imperial hasn't experienced any gap-related losses yet. But he says it could happen. "Do I anticipate that we can continue that (avoiding losses) indefinitely? Probably not," he says.

Mike Mendelsohn, group portfolio manager for Banque Paribas, acknowledges he's had two bum loans, but insists the bank hasn't suffered. "Out of over $750 million in loans, we've had some problems on $450,000 in business," Mendelsohn says. "And on that $450,000, our fees and interest spread on those were $1.5 million. So we made money." He declined to name the two productions.

Mendelsohn says Banque Paribas has become more discriminating about the films it finances. It now concentrates on lending to higher-quality fare with known stars, and avoids genres and me-too productions that don't stand out. He reads scripts. He pays attention to casting. "We think it's vital," says Mendelsohn.

Houlihan Lokey's Davis says there's now a movement toward using gap financing for a slate of pictures, as opposed to a single film, to spread the risk.

Imperial's Rector doesn't foresee single-picture gap financing drying up completely, but lenders are definitely tightening their underwriting standards, he says. That may require allocating little or no value to Southeast Asian territories, for example.

Independent motion-picture consultant Seth Willenson anticipates a rocky period for the independent film business, as the recent soft AFM and Cannes markets demonstrate. "It will be a more erratic situation," says Willenson, "a period of losses for independent producers."

Where does this leave bonders? "Conventional wisdom is saying there should be a slowdown," acknowledges Motion Picture Bond Co.'s Ephraim. But he's not felt it yet. "We haven't seen any substantial change in volume. This could be the lag time. If that's going to happen, well, that remains to be seen," Ephraim says.

This is how one senior exec at a major bond company, who asked not to be identified, sees it: "Banks will take a loss, there will be a lull in production," the executive says. But this veteran doesn't foresee the slowdown lasting more than a year or so, given the industry's cyclical nature. "The marketplace will speed up again," says the bonder.

Competition for business is putting pressure on bond rates. Today, the going rate is around 2.5% to 3% of the above- and below-the-line direct costs (the fee is split between bonders and their insurers). Formulas vary. Two years ago, bonders were frequently asking for a front-end fee of 4.5%, then to rebate 1.5% if the bond wasn't called. Before that, it was 6% with a 3% rebate (again, if there was no claim).

This is a sensitive subject. In the early 1990s, the completion-bond industry engaged in a disastrous price war in which rates fell as low as 1%. That pleased indie producers, but ultimately, it wasn't in the industry's best interest. In at least one high-profile case, for example, profit margins were too low to sustain a viable business. After several films generated claims, Completion Bond Co. -- then the biggest player in this specialized niche of the entertainment industry insurance business -- went bust in 1993.

Entertainment lenders don't want a repeat. "Banks don't want the rates set too low," says WorldWide's Cardone. "I've had bankers asking me not to start a rate war."

Cardone realizes he must strike a balance between offering competitive rates and achieving reasonable margins. "Bond companies need to make money," he explains. "They need to have reserves in case of a loss."

The completion-bond industry also has unique dynamics: It's a service business that requires its practitioners to keep a professional distance from clients.

Bonders drop buzz words, such as "user-friendly," when explaining what they do. They insist they don't try to make trouble for producers, but they sometimes only half-jokingly earn the nickname, "production cop." If bonders are living up to their responsibilities, they function as adversaries to producers. They spot flaws in production plans. And that leads to tough talk.

"The first thing you say to a producer is, 'You can't do that,' 'You can't do this,' 'This is under-budgeted,' 'How user-friendly is that?'" says Marty Fink, president of Complete Film Co., a Santa Monica-based production consulting firm, and an ex-in-house bonder for Carolco Pictures. "The line you have to walk is to be helpful to the producer without being unhelpful to your insurer."

"Every producer wants to make their picture their way, and if they're interfered with, they'll object," says Motion Picture Bond Co.'s Ephraim.

If a bonder overlooks potential production problems in the interest of being "user-friendly," and that comes back to bite the insurers, "you're going to have to be user-friendly in a different business," Fink says.

Bonders may never win popularity contests with producers, but indie producers know they couldn't get their films made without them, and for that, they earn a grudging respect.

If bonders are to keep growing, they must constantly be on the lookout for new opportunities. Where will they come from? Nearly all bonders say they're bonding TV movies, miniseries and even series, such as the syndicated "Baywatch" (the Motion Picture Bond Co. had that honor). That type of business was unheard-of a decade ago. Multimedia productions, such as theme park ride films, CD-ROM and Internet games, have provided some opportunities, but to date, bonders say it's not been a consistent source of income.

Fink thinks bonders will capitalize on a growing market for lower-budget movies for international television out of necessity. "Television seems to be exploding, cable services are expanding throughout the globe, especially in places like South America,"

he says. Bonders who have focused on higher-budget studio pictures in the past will have to court lower-budget productions to make their business thrive, says Fink.

In addition to the inevitable search for new business, bonders are likely to try the old standby: Take the market share from competitors. That may mean offering more thorough services or more attractive rates. In tried-and-true Hollywood fashion, it often means cultivating relationships with key producers who will steer multiple projects their way.

Here's a brief look at Hollywood's leading completion-bond firms:

Motion Picture

Bond Co.

This shop, majority-owned by London Insurance Group of Ontario, Canada, bonded around 100 pictures in 1997, up 10% to 15% from the previous year, according to Ephraim. Motion Picture Bond Co.'s typical project is in the $5 million to $25 million range -- "Little guys with no studio involvement," says Ephraim. At this moment, it's bonding 18 pictures in North America, such as the mid-sized Jean Claude Van Damme picture, "Inferno," about to start principal photography in Hollywood. Motion Picture Bond Co. has completion-bond contracts for 24 other films, and Ephraim says he's ready to accommodate any market shifts. "We're wide open to move where the entertainment industry moves," says Ephraim.

Film Finances, Inc.

Film Finances, at 48, is the oldest competitor in the completion-bond business. It focuses on productions in the range of $3 million to $15 million generally, but sometimes it's taken on productions with budgets as high as $50 million.

Film Finances' Sunset Strip office is bustling: It bonded around 120 movies in the last 12 months, an approximately 20% jump from previous year levels, according to Ransohoff. Its worldwide organization bonded an equal number through its eight international offices.

Cinema Completions International

Since opening in 1994, CCI, a joint venture of Continental Casualty and AON Entertainment Ltd., has concentrated on bonding a few films each year, including indie films with budgets upward of $75 million. CCI's minimum fee is $75,000, so it declines most productions with budgets under $3 million. In 1997, it bonded eight pictures, including Stanley Kubrick's "Eyes Wide Shut," still shooting after a year, and Terence Malick's highly anticipated, "The Thin Red Line." This is around the same level of volume the company had in 1996.

Early this year, CCI opened a London office at Pinewood Studios, its first outside the United States, a response to the European production boom and a desire to be near several important international sales companies there.

International Film Guarantors

Steven Mangel, a 12-year veteran of LIVE Entertainment (now Artisan Entertainment), recently replaced Joan Stigliano as president of IFG, the limited partnership that includes Near North National Group and Fireman's Fund Insurance Co. In the past, IFG has focused on higher-budget indie films (a half to 60% in the $15 million to $30 million range). But now it's broadening its reach to include smaller movies, and contemplating its first foray into television.

In the last 12 months, IFG bonded around 30 films, such as "Sliding Doors," "I Know What You Did Last Summer," "Les Miserables" and "The Wedding Singer"; this year's target is 40. Mangel subscribes to the value of relationships in creating new business opportunities. To wit: IFG has bonded the $20 million Roman Polanski-directed "Ninth Gate," starring Johnny Depp, its first project from Artisan, Mangel's former haunt.

In the next two to three months, IFG plans to open a three-person London office headed by IFG British head Malcolm Burgess. "Our expectation is this year we'll do at least 12 films out of Europe," says Mangel.

WorldWide Film Completion

WorldWide is new, but its principal, Steve Cardone, isn't. He's a 10-year veteran of the completion-bond industry with stints at IFG and the defunct Completion Bond Co. It's starting small: WorldWide is a boutique firm (four executives) that aims to bond about 20 films annually with budgets below $20 million. Ten entertainment lenders have approved it for business. "We're not looking to corner the market," said Cardone. "We're looking to be able to do enough to turn a favorable profit and continue in business to see what emerges next."

Cardone says WorldWide has established a relationship with Seagal-Nasso Productions, Steven Seagal's production company. "We're in the process of underwriting two films," he says. Cardone wouldn't reveal titles.