PE Goes Hollywood

I thought I would reproduce here my reply to a post on a actors’ union bulletin board regarding the role of private equity funds in the EMI world:

Private equity funds, of course, argue that they are “efficient” because they funnel investors’ money into areas where they have special expertise. And when they do so they often take control of a particular company or even an entire industry and thus close the gap between public shareholders and inside managers. So, for example, at one point KKR, a leading buyout fund, owned approximately 40% of the US grocery industry. They certainly had some expertise in that arena and likely increased profitability. But their methods of doing so included laying off workers, closing down many stores, disrupting communities and lives of thousands. The late 1980s buyout of Safeway by KKR was a particularly harsh example. The southern California grocery strike of a few years ago was, in part, a symptom of that buyout as KKR was still on the board of Safeway at the time.

In general the concern that labor unions and their representatives on pension funds are raising about PE is that this strategy relies heavily on the use of borrowed money to take over companies. When you finance a company with debt rather than equity it decreases the flexibility available to management and puts pressure on the company to make regular interest payments on the debt. And there is always the lurking risk of forcing the company into bankruptcy where a federal judge can break union contracts and reduce pension and health care benefits. That is the concern many have about the Chrysler buyout by Cerberus.

The role of PE in film and entertainment is slightly different. For the time being PE is being used as a means of shifting slightly away from traditional bank lending. As readers here know better than me, films are increasingly capital intensive operations – they require a heavy up front commitment to produce and to distribute with lots of risk and uncertainty about eventual box office success. Only a few films become reliable franchises (like the Bond films or Pirates) that can be counted upon to generate predictable revenues for investors. So the studios and producers have often relied on specialized lenders at particular investment banks and commercial banks for funding.

But in the past few years that structure is shifting. My view is that globalization is hitting the entertainment and media sectors in a major way now. The opportunities that new distribution technologies could generate are enormous. I met recently with a company here in Silicon Valley called Vudu Labs. They have a proprietary system that relies on peer-to-peer technology to distribute films in real time directly to the TV without going through the cable pay per view system or the internet. They have a distribution deal in place now with seven studios and a film library of more than 5000 films – far more than Apple (something I discovered when I bought a video iPod recently, much to my dismay!)

As these new digital distribution systems get put in place the potential for new global revenues skyrockets. The global audience could grow by billions according to Michael Eisner. When those kinds of numbers get thrown around Wall Street listens. So bankers and the studios, as well as agencies like Endeavor among others, are forming new investment funds to funnel money into the industry. These are already large – in the hundreds of millions – but could easily grow larger. I think the emergence of these types of funds changes the politics of the industry and shifts power to those who control distribution and finance rather than production. (A similar shift is underway in other industries.) Since much of the effort of the guilds in collective bargaining has been focused on production (divvying up the 20% of revenues left after the distribution arms have taken their 80% cut) the risk is that the new forces in finance, distribution and the super-agencies leave the guilds out in the cold once again as they did with DVDs.

Finally, a note on regulation: yes, the PUHCA regulated the energy industry until it was gutted by a weak Congress bought out by energy industry Enron era lobbyists. The result is a wave of mergers and acquisitions underway in that sector that could result in layoffs and problems in the power delivery system. It turns out that there is still on the books now a New Deal era law, the Investment Company Act of 1940, that is supposed to regulate PE funds. But Congress created some exemptions in the Clinton era to allow buyout funds to escape control of the Act. The AFL-CIO recently sent the SEC and Congress a letter calling for the use of the Act to regulate PE funds – in particular, to be used to regulate the Blackstone Group which is attempting a public offering. I worked with the AFL on the letter and I think this effort is making some headway now in Congress as a new bill has been introduced to eliminate the tax loopholes that PE funds rely on.