UK FILM INVESTMENT IN THE DIGITAL AGE
I hardly need to make the case to this audience that the film 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.
To be frank, the goal of sustainable investment remains as distant as ever. And David Elstein was right when he said a few weeks ago that ''our economic model for content production in this country is too weak….'' That is also our perspective at Ingenious and this is what I want to talk about this afternoon.
Gordon Brown became Chancellor in the Spring of 1997. His first official party at 11 Downing Street was for the British film industry. Some of you were probably there! Against the advice of his officials, the new Chancellor announced that there would be 100 per cent tax relief for films costing under £15 million.
Fast forward five years to November 2002, when the then chairman of the Film Council, Sir Alan Parker, delivered a landmark speech. It was 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 also asked by the House of Commons Select Committee on Culture, Media and Sport in 2003 in a report entitled The British Film Industry. This report 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.''
Quite so! That critique remains definitive and applies a fortiori in the new digital environment.
What, objectively, has changed since the Select Committee's report was published some five years ago? Globally, 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 was explored by several speakers at this event last year. I was especially struck by the reference to an interview with Dick Parsons of Time Warner. Asked what the future held for Time Warner he had 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''.
I don't intend to go over that ground again, except to point out that 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.
In the UK, one of the things that happened after 2003 is that Ingenious created a number of integrated film funds. These were based on the realisation that the keys to commercial success in the film business were, exactly as the Select Committee had described, distribution, sustainable financing and an uncompromising practice of working with the best creative talent available. This allowed us to raise several hundreds of millions in investment capital which was invested, alongside a variety of partners, in such films as Girl with a Pearl Earring, Vera Drake, Hotel Rwanda, Bride and Prejudice, Notes on a Scandal, Hot Fuzz and The Golden Compass.
The period after 2003 in fact 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 - and we should be clear about this - 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.
As everyone knows, the 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.
What difference does the arrival of the on-line age make to investors? Answer, it magnifies uncertainty and thereby amplifies investor risk. Why? Well, 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, speaking as a consumer, this is surely a wonderful thing. I personally look forward to enjoying weekends of wall-to-wall Eisenstein or Chabrol, and more generally the development of a new world of specialist micro-markets.
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? Would you advise your clients to do so?
There certainly are new opportunities out there, some of them very exciting indeed. From an investor perspective however I have to say that deepening fragmentation is making life much more difficult.
I was therefore interested in December to read a paper on investment in the creative industries, including film, by a firm of economic consultants, mainly ex Treasury guys, which had been commissioned by NESTA. Not surprisingly market failure was diagnosed everywhere. The consultants' report ends, nevertheless, on a note of tentative but in my view questionable optimism. Salvation may lie, they speculate, in the long-term growth of the activities of so-called ''alternative'' or ''non-correlated'' investors, and specifically hedge fund investors.
I think this is fanciful, especially for independent production. We strongly agree that the hedge fund model should work on the distribution side of the film business. However, in our view 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 or the insurance industry, where very large numbers of customers provide a solid mass of statistical evidence, in film the data sets achievable are not wide enough.
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.
In our view 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 - and being swept under the carpet!
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. Even when talking up our credentials in this business, and proudly demonstrating our track record of success, we never attempt to hide the fact that this is high risk stuff.
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. Yes cinema admissions are rising and the industry's contribution to UK GDP has increased by 39% during the last two years. 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 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.
Faced with these facts the response from government worries me. I think that ministers have frankly been in denial, on one occasion deriding investors who form part of ''wealthy partnerships''. This raises an obvious question: where is the required risk capital going to come from? The Treasury response to this question privately is that it is not their job to ''second guess'' the markets. So we have made zero progress on this the most vital issue of all.
Let me conclude with Sir Alan Parker again. This was his warning in 2002:
''…now is the time, once and for all, to recognise that our industry's obsession with public funding for production is taking us nowhere.''
That remains true. And 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 our competitive weaknesses. This doesn't mean the end of film-making in our time of course. There will always be passionate film-makers and visionary cultural entrepreneurs who are able to get the money together somehow. And thank heavens for that!
But we need to understand that we, in UK plc, are likely to find ourselves capturing a smaller and smaller proportion of the commercial upside generated by our creative talent. 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.
Some will be satisfied with that. At Ingenious we would prefer to raise our sights a little higher. But 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.
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, I suggest, to understand what risk-adjusted rate of return would bring in new investors in significant numbers. We would be very happy to work with the Treasury on that one!
Are we optimistic about the future? If to be optimistic is to be contrarian, then we are optimistic! We also have some pretty smart people at Ingenious, most of whom are unfailingly upbeat.
But we are also realistic. Our investors know that we do everything possible to mitigate their risk and so persuade them to stay in the game. They know that we know that investors will only commit capital to an investment proposition that earns a return on capital greater than the cost of capital. That's the test.
They know, too, that we only work with the best, that we have a track record of delivery, and that we are uncompromisingly commercial in our approach.
This does not always make us popular in the business, but it surely demonstrates our continuing commitment to film.