Lions or Lambs...

Will the latest clutch of equity players come in with a roar and leave with a whimper?

When MGM/United Artists releases the war-themed drama "Lions for Lambs" on Nov. 9, the movie will be more than a test of Tom Cruise's popularity: It also will indicate whether the private investment consortia that have pumped billions of dollars into Hollywood are on the right track.

Three years since hedge funds and other Wall Street financing vehicles started looking at the major studios as a way to diversify assets (backing slates of films in the belief that it's easier to make money by spreading risk over 20-30 pictures at a time), it is far from certain that these investments will pay off.

"The dirty little secret is some of these slates have not done very well," says John Burke, an attorney with Akin Gump and a specialist in film finance deals. "Much of the equity is pausing and trying to reassess whether this is an asset class they want to continue in, and what adjustments need to be made by the studios in order for them to continue."

So far, the funds have invested more than $13 billion in movie production, estimates Laura Fazio, global head of media and entertainment structured finance for Deutsche Bank Securities, who has been involved with many of the hedge-fund-backed slates. (See chart below.)

It is impossible to know just how profitable these investments have been; the precise terms of the deals are closely guarded secrets, and many of the films have yet to be released. But there is a consensus that, at least so far, several slates have underperformed.

"The deals that are out there have had mixed returns, but most are negative," says one financing executive familiar with recent deals. "I don't think there are many deals that are going to return all the capital to investors."

These moneymen are now repricing these deals, meaning they are asking the studios to take much lower distribution fees and cap their expenditures on prints and advertising. Distribution fees that were as high as 15% have been brought down to 10% in many cases, though the studios usually have escalator clauses in their slate deals and earn a higher fee when a movie's grosses are larger.

"We are now looking at pricing the risk associated with those deals," says Fazio. "Certainly, the price of risk has changed."

Bankers and lawyers involved with these deals feel they can, and should, get better terms, both in renegotiating old deals and initiating new ones. The only question is: How much better?

This summer, Legendary Pictures apparently renegotiated its distribution fee with Warner Bros. as part of a recapitalization that brought in an additional $1 billion to the studio. Warners, per two unrelated sources, lowered its distribution fee from the 15% it took when the Legendary pact was first signed in 2005 to 10.5%. (This followed an earlier renegotiation that had lowered the fee to 12.5%.)

Legendary chairman and CEO Thomas Tull declines to discuss specifics, but Legendary had leverage in its renegotiation thanks to the extra money it was bringing in, enough to invest in 45 pictures over the next seven years, bringing the firm's total spend to more than $1.6 billion. (In fact, the sum is even higher than that, given that Legendary has plowed its profits back into its deal.)

Warners is not alone in recognizing that some renegotiation will be necessary on slate deals.

"The good news is, most of the studios are responding in a positive way," says Burke. "They want this capital to continue to invest in film because they get pressure from their parent companies about finding ways to finance their activities. So some studios now appear to be willing to entertain certain structural and economic concessions in order to better align the interests of the investors and the studios to make these transactions more attractive to the investors."

Until they determine just what these concessions will be, however, a pall has fallen on new slate deals.

Ryan Kavanaugh, CEO of Relativity Media and a prime mover behind at least four of the major slate deals, acknowledges that there has been a cooling in deal flow lately. Following the subprime mortgage crisis this summer, backers have been slow to commit to multi-hundred- million-dollar pacts. That is partly because of uncertainty about the deal terms, and partly because the banks are unsure if they can syndicate the deals (that is, get other banks to help underwrite the loans).

"You have a number of banks sitting with senior and subordinated debt they've underwritten, with a view to selling it or syndicating it to other banks and hedge funds, and they have not been able to do so," says Burke. "This situation is exacerbated by the global overhang of unsyndicated debt as a result of the problems of the subprime market. The combination has created a level of nervousness among the banks about underwriting additional transactions in any category."

Adds Stephen Scharf, a film finance lawyer with O'Melveny & Myers: "What happened from June to September was, all of a sudden, there was a huge jolt to the worldwide credit markets. People were frozen. And everybody was looking at risk much more carefully and repricing it."

The "correct" price will be determined in part by the performance of the present slates. So far, three of the major deals appear to have made money, though most analysts caution that it is too early for exact assessments.

"The whole theory behind a slate is, you need to get your entire slate done, because the winners could be in the last two pictures," says one insider. "If you hit 'The Matrix' in the last two pictures, it could make up for a lot of sins." He adds, "It's only in the six weeks after the last movie is released that you can do an 'ultimates' evaluation of what the various returns are going to be." By "ultimates," he means a studio's projection of all likely revenue by the end of the movie's first cycle, a seven-year run.

With many films still unreleased, Legendary is one of the better- performing entities. The company has invested in seven pictures. While "Lady in the Water" and "The Ant Bully" were indisputable flops, "Batman Begins," "Superman Returns" and "300" grossed more than $200 million apiece domestically.

Industry insiders questioned the success of "Batman" and "Superman," given their huge budgets, but international grosses and merchandising revenues appear to have put them in the black. "Superman" alone purportedly brought in more than $60 million in merchandising revenue.

Doubts about Legendary's early performance were put to rest with the success of "300," in which it had a one-third stake. "We are very pleased with where we are," says Tull. "We have a very large war chest of capital and feel great about the future."

Another hedge fund, Cold Spring Pictures, provided $200 million for Tom Pollock and Ivan Reitman's Montecito Picture Co. in a deal signed in August 2006. It, too, got off to a strong start with the profitable "Disturbia."

By far the most successful of the slate deals, however, is Dune Entertainment. Signed in 2005 and recapitalized twice, Dune covered a number of films made by 20th Century Fox. It started out as 25 films, then it was increased to 40, then to 60. The Dune films have included such hits as "The Devil Wears Prada," "Borat," "Fantastic Four" and "Walk the Line." "Basically all the Fox pictures in recent history," says Fazio, who helped broker the initial Dune pact while working for Dresdner Kleinwort bank.

Other deals, however, have been far less successful. One of the first to take the plunge, Virtual Studios, provided Warners with $528 million for a six- picture slate that included such flops as "Poseidon," "The Good German" and "V for Vendetta," as well as "Blood Diamond" and the current release "The Assassination of Jesse James by the Coward Robert Ford." Virtual redeemed itself somewhat by taking a one-third share of "300," along with Legendary. But insiders derided recent reports that "300" made good for the other movies' weakness.

Disney's Kingdom Films slate deal has also apparently underperformed. Signed in August 2005, it provided $500 million for 30 films, but it did not include the "Pirates of the Caribbean" movies.

Among the more controversial deals have been two pacts that Relativity's Kavanaugh brokered with Sony and Universal. The first, known as Gun Hill I, pumped $600 million into an 18-picture slate of films from both studios. That pact climaxed with the recent Jamie Foxx actioner "The Kingdom," which to date has earned only $44 million at the boxoffice.

Kavanaugh is adamant that the slate will be profitable, bringing an estimated $150 million to investors. But that number has raised eyebrows within the legal and banking community.

"It is clearly not a runaway success," says one banker aware of the deal. "Will people lose money? That has yet to be determined."

Relativity followed its first foray into slate financing with a second Sony-Universal slate, Gun Hill II, which is still rolling out its pictures. That deal provided $700 million for 19 films and was signed in May 2006. So far, it has released only the flop "Evan Almighty" and the hit "I Now Pronounce You Chuck and Larry," as well as "The Messengers" and last year's "Marie Antoinette."

Melrose I, which covered a slate of Paramount films released in 2003-05, including "Mean Girls," "Get Rich or Die Tryin'" and "The Longest Yard", performed below expectations. A follow-up, Melrose II, has done better, with hits like this year's "Blades of Glory" and "Transformers" making up for boxoffice disappointments like 2006's "Flags of Our Fathers." Paramount is currently looking for a new slate deal.

Fazio, who is putting the financing for Paramount pics together, is optimistic that she will succeed, but others are skeptical.

"Fat chance," scoffs one rival banker. "They are trying, but the banks are all saying that there are not going to be any new deals this year. And there are some bankers that think these deals are dead altogether."

Many investors continue to be drawn to film because it is not "correlated" to the stock market (that is, boxoffice does not go up and down with stocks and thereby provides a counterbalance for financiers who wish to diversify).

This year, new deals have indeed been struck, including a $350 million pact for a slate of 20 films from New Line brokered by Royal Bank of Scotland and a $550 million deal, Beverly, that Relativity arranged with Sony. Kavanaugh says he is negotiating a second Beverly deal with another studio, but he declines to name it.

"There are many deals moving forward," says Burke. "It is just a question of when the banks will decide to take the underwriting risk."

Still, he and others acknowledge that enthusiasm is considerably more muted than it was just a few years ago. Studios like Universal — which has been trying to put a deal in place for several months — are discovering that investors want a lot more stringent terms.

"They're taking a close look at the returns from the initial round of investments," says Hal Sadoff, head of ICM's international/independent film division. But, he adds, "there is still significant interest in financing films."