The MGM Follies: How Hedge Funds Got Taken for a Billion Dollar Ride in HollywoodS

MGM, once known for its roaring lion, Gone with the Wind and James Bond, is teetering on bankruptcy. Author Edward Jay Epstein explains how the studio's latest misadventure resulted from Hollywood's plan to separate Wall Street fools from their wallets.

The movie studio MGM is out of money, near bankruptcy, and it's up for sale. A secret MGM deal book tells the story of the company's finances, and it's not a pretty picture. Revenue has dropped significantly since the company was bought in 2004, and four prominent New York hedge funds have taken losses of nearly a billion dollars.

On the other hand, Hollywood execs at Sony (who put together the hedge fund deal) made out beautifully. It's a story of Hollywood duping Wall Street, and it's not an altogether uncommon one.

Today MGM no longer has sound stages, backlots or other physical facilities, and produces only a handful of movies, but it does own an incredibly valuable asset: a film library with 4,100 motion pictures and 10,600 television episodes. The crown jewels of this collection: its James Bond movies. By licensing these titles over and over again to Pay-TV, cable, and television stations around the world, and selling DVDs from it, the entire library until recently brought in $600 million a year.

But this gross is an elusive number, as it has to be split with others who have rights in the titles. When Viacom considered buying in 2004, it assigned a team of 50 of its most experienced specialists to estimate how much each and every title would bring in over a decade. The Herculean job took the team two months. From this analysis, Viacom's executives agreed MGM was worth between $3.5 and $4 billion. But Viacom's President, Mel Karmazin, predicted that income might well decline in the digital era, so it passed on bidding.

Sony, however, stepped up to buy, realizing that any partnership with MGM would be key in its gambit to establish its Blu-ray DVD format, which at the time was competing against Toshiba and Microsoft's HD-DVD.

To accomplish this strategic goal, Sony did not need to itself spend billions to acquire MGM, it only had get effective control of its library for a few years. So it put together a consortium that would be financed mainly by Wall Street private equity funds. Even though the deal would wind up costing $4.85 billion, Sony invested only $300 million of its own funds (and for that it got the profitable right to distribute MGM movies). Another $300 million came from The Comcast Corporation in return for the rights to put the MGM's library on Pay Per View on its vast cable system. The rest of the equity money came from four renowned Wall Street investors: Providence Equity Partners, Texas Pacific Group, DLJ Merchant Banking Partners, and Steve Rattner's Quadrangle Group. These savvy funds put in a billion dollars. The leverage part of the deal was organized by JP Morgan Chase, which arranged for the consortium to borrow $3.7 billion (or up to $4.2 billion, if needed) from some 200 banks. The deal closed in September 2004.

For Sony, the gambit succeeded brilliantly. Putting some 1,400 MGM titles exclusively on Blu-ray, helped established Blu-Ray as the industry standard for high-definition, and it won the format war. It also made back a large share of its $300 million investment just on the distribution fee it earned on two new Bond movies - Casino Royale (2006) and Quantum of Solace (2008).

But for the Wall Street players, it was nothing short of a disaster. To cut to the chase, they lost almost their entire billion dollar investment. They had naively relied on impressive-looking projections showing that the net cash flow from a movie and television library would be sufficient to pay the interest on the nearly $3.7 billion of debt over a decade. What they had not counted on was a sea change in DVD sales. In the US alone, MGM's net receipts from DVDs fell from $140 million in its 2007 fiscal year (which ended March 31, 2008) to just $30.4 million by 2010. As a result of collapsing sales, higher pay-out for participants, increased distribution costs and other problems, MGM's crucial operating cash flow catastrophically fell from $418.4 million in 2007 to minus $54.2 million by 2010. By October 31, 2009 MGM, sinking in a sea of red ink, found itself unable to make its mandated interest payments on the $3.7 billion it owed banks.

Ordinarily when a company fails to make such payments, its bank creditors can seek to recover their money by forcing the company into bankruptcy. With MGM, however, the bankruptcy option presented a real problem since many of its intellectual property rights, including those to make sequels in the James Bond franchise, stipulate that in the event of bankruptcy they would automatically revert to another party.

So the creditors, learning that bankruptcy would destroy a significant part of the remaining value of MGM, gave it a three month "forbearance," which meant it had until January 31, 2010 to come up with the money. The idea was that MGM would sell itself to a white knight and use the proceeds to repay the banks. So the deal book was sent out to a dozen or so prospective buyers calling for bids by January 15. As for the hedge funds, having already written down 85 percent of their billion dollar investment in preparation for what may be a near total wipe-out, they may have learned the hard way that when a Hollywood deal seems to good to be true — it may not be.

Edward Jay Epstein is the author of 14 books, including two examining the movie business: The Hollywood Economist: The Reality Behind The Movie Business will be published by Melville House later this month, which follows his 2005 book The Big Picture: Money and Power in Hollywood.

Photo via ivolkoff's Flickr