Markt- und Unternehmensentwicklung / Markets and Organisations Edited by A. Picot, München, Germany R. Reichwald, Leipzig, Germany E. Franck, Zürich, Switzerland K. M. Möslein, Erlangen-Nürnberg, Germany Change of institutions, technology and competition drives the interplay of markets and organisations. The scientific series ‘Markets and Organisations’ addresses a magnitude of related questions, presents theoretic and empirical findings and discusses related concepts and models. Edited by Professor Dr. Dres. h. c. Arnold Picot Professor Dr. Egon Franck Ludwig-Maximilians-Universität Universität Zürich, Switzerland München, Germany Professorin Dr. Kathrin M. Möslein Professor Dr. Professor h. c. Dr. h. c. Universität Erlangen-Nürnberg, Ralf Reichwald Germany, HHL – Leipzig Graduate School HHL – Leipzig Graduate School of Management, Leipzig, Germany of Management, Leipzig, Germany Kay H. Hofmann Co-Financing Hollywood Film Productions with Outside Investors An Economic Analysis of Principal Agent Relationships in the U.S. Motion Picture Industry Foreword by Prof. Dr. Christian Opitz RESEARCH Kay H. Hofmann Stuttgart, Germany Dissertation Zeppelin Universität, Friedrichshafen, 2012 Erster Gutachter: Prof. Dr. Christian Opitz Zweiter Gutachter: Prof. Dr. Helmut M. Dietl Tag der Disputation: 14. Juni 2012 ISBN 978-3-658-00786-7 ISBN 978-3-658-00787-4 (eBook) DOI 10.1007/978-3-658-00787-4 Th e Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografi e; detailed bibliographic data are available in the Internet at http://dnb.d-nb.de. Library of Congress Control Number: 2012950146 Springer Gabler © Springer Fachmedien Wiesbaden 2013 This work is subject to copyright. 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Springer DE is part of Springer Science+Business Media. www.springer-gabler.de Meinen Eltern Foreword The formation of partnerships in which the project initiator and an outside investor jointly own a common project or venture is a widespread and increasingly important strategic approach. Examples include equity-backed alliances in research-intensive industries like biotechnology, pharmaceutical, telecommunication or automotive and international joint ventures. Moreover, providing financial resources to an entrepreneurial endeavor is the core business of venture capital and private equity firms. Besides spreading risk, these partnerships may aid firms in assessing new markets, knowledge, capabilities and other resources. Yet, largely because they are jointly owned, these collaborations are especially difficult to manage. Information asymmetries may lead to the well-known conflicts of interest between the co-financing partners: Before the investment decision is made, the investor is subject to a possible adverse selection of unfavorable partners and unprofitable projects. Ex post, there is a risk of moral hazard when one partner reduces her effort or engages in other opportunistic behavior that harms the interests of the other joint owners. Compared to the amount of theory, empirical work that elaborates on the principal-agent problem in a co-financing context with an outside investor clearly lacks behind. Moreover, empirical studies tend to be restricted to a limited number of industries. In his dissertation Kay Hendrik Hofmann provides compelling empirical evidence on another sector, namely the motion picture industry. An application of the theory to real world data in this particular setting is promising due to the economic significance of the industry and the rather technical circumstance that a wide array of project-specific information is publicly available. The research at hand is theoretically as well as empirically ambitious. Mr. Hofmann’s findings broaden the empirical literature on the principal-agent problem in equity partnerships. Moreover, film producers and film investors may benefit from the presented analysis when structuring and negotiating future co-financing deals. Finally, the results are relevant for other related media, like for example video games and serial TV formats, where similar financing schemes are about to evolve. I am confident that this competent and well-written work will find a broad audience among both, academics and practitioners. Prof. Dr. Christian Opitz VII Preface In recent decades, the management of motion picture projects has not only become more complex but with soaring budgets, film productions have also turned into significant investments and fairly risky business opportunities. At the same time, a range of private as well as institutional investors have entered the industry in the function of outside financiers. Today, co-financing and thus co-ownership of completed films is a common phenomenon in Hollywood. The work at hand is concerned with the organizational problems that may arise between the experienced major studios and investors with comparably low industry expertise. Guided by principal agent theory, the empirical analysis investigates the relationship between the co-financing parties and aims at illuminating the pitfalls of the current arrangements. The development of practical solutions that follows is not only relevant for current and future investors but also for studios and film producers who rely on the long-term availability of external funds. Working on this project has significantly changed my perspective when ‘going to the movies’. While more details in the front as well as end credits catch my attention and my reflection of a film extends way beyond the storyline, the pleasure of consuming motion pictures has not vanished. In fact, it seems as if Moshe Adler’s (1985, p. 209) remark ‘the more you know the more you enjoy’ adequately describes my novel appreciation for filmed entertainment. Deepest thanks are due to my academic teacher Professor Dr. Christian Opitz for inspiring conversations, wholehearted support and for more than four years of academic as well as personal thriving. The countless hours of joint efforts to straighten arguments and tweak papers have significantly improved my economic thinking and the past years do not allow for any other conclusion than remarking that the time at Zeppelin University has been a great pleasure and an outstanding experience. Undoubtedly, meeting and obtaining the opportunity to learn from Professor Dr. Christian Opitz belong to the lucky chances of my life. I would also like to express my gratitude to Prof. Dr. Helmut M. Dietl who agreed to become the second referee. I am indebted for numerous valuable comments and suggestions that have further augmented the quality of this dissertation. Finally, I would like to thank my parents for their continued and unlimited support in all matters. The work at hand is dedicated to them. Kay H. Hofmann IX Table of Contents List of Figures ................................................................................................................. XIII(cid:3) List of Tables ..................................................................................................................... XV(cid:3) List of Abbreviations ..................................................................................................... XVII(cid:3) 1. (cid:3) Introduction ................................................................................................................... 1(cid:3) 1.1 (cid:3) Co-Financing in the Motion Picture Industry .......................................................... 1(cid:3) 1.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)The Filmmaking Business from an Economic Perspective ..................................... 4(cid:3) 1.3 (cid:3) Aims and Scope ....................................................................................................... 6(cid:3) 1.4 (cid:3) Hollywood and Academic Research ....................................................................... 7(cid:3) 1.5 (cid:3) Content and Structure .............................................................................................. 8(cid:3) 2. (cid:3) The Hollywood Mega Industry .................................................................................. 10(cid:3) 2.1 (cid:3) Historic Development ............................................................................................ 11(cid:3) 2.1.1 (cid:3)The Rise of the Entertainment Industry in Southern California: 1907-1930 .... 11(cid:3) 2.1.2 (cid:3)The ‘Old’ Hollywood: 1930-1950 ..................................................................... 12(cid:3) 2.1.3(cid:3) The ‘New’ Hollywood: 1950 - present .............................................................. 13(cid:3) 2.2 (cid:3) The Value Chain of Motion Pictures ..................................................................... 17(cid:3) 2.3 (cid:3) The Players ............................................................................................................ 24(cid:3) 2.4 (cid:3) Revenue Windows and the Exploitation of Filmed Content ................................. 26(cid:3) 2.4.1 (cid:3)Domestic Theatrical Market .............................................................................. 27(cid:3) 2.4.2 (cid:3)Ancillary Media Markets ................................................................................... 34(cid:3) 2.4.3(cid:3) Merchandising Markets ..................................................................................... 37(cid:3) 2.4.4 (cid:3)International Markets ......................................................................................... 38(cid:3) 2.5(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Profitability of Motion Picture Projects ................................................................. 39(cid:3) 3. (cid:3) Contemporary Co-Financing Practices in the Motion Picture Industry ............... 41(cid:3) 3.1(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Studio-Distributor Perspective: Raising the Funds ............................................... 41(cid:3) 3.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)External Investor Perspective: Providing the Funds ............................................. 44(cid:3) 3.2.1(cid:3) Financer Deals ................................................................................................... 46(cid:3) 3.2.2 (cid:3)Slate Financing Arrangements ........................................................................... 49(cid:3) 3.3(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Existing Research on Co-Financing in the Motion Picture Industry ..................... 53(cid:3) 4. (cid:3) Principal Agent Relationships in Co-Financing Deals ............................................ 55(cid:3) 4.1(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Application of the Principal Agent Framework .................................................... 55(cid:3) 4.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Information Asymmetries in Financer and Slate Deals ......................................... 57(cid:3) 4.3(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Adverse Selection .................................................................................................. 57(cid:3) 4.4(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Moral Hazard during Production ........................................................................... 60(cid:3) 4.5(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Moral Hazard during Distribution ......................................................................... 62(cid:3) 4.6(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Consequences of Adverse Selection and Moral Hazard ........................................ 63(cid:3) 5.(cid:3) Description of the Data and Variables ...................................................................... 65(cid:3) 5.1(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)The Data ................................................................................................................. 65(cid:3) 5.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Dependent Variables .............................................................................................. 65(cid:3) 5.3(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Independent Variables ........................................................................................... 70(cid:3) XI 6. (cid:3) Agency Problems in Financer Deals: Results and Discussion ................................ 84(cid:3) 6.1(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Descriptive Analysis .............................................................................................. 85(cid:3) 6.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Analysis of Performance Differentials .................................................................. 86(cid:3) 6.3(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Adverse Selection .................................................................................................. 91(cid:3) 6.4(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Moral Hazard ......................................................................................................... 93(cid:3) 6.5(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Agency Problems and Film Quality ...................................................................... 96(cid:3) 6.6(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Managerial Implications ........................................................................................ 98(cid:3) 6.7(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Summary and Limitations ................................................................................... 103(cid:3) 7.(cid:3) Implications of the Appearance of Slate Investors ................................................ 106(cid:3) 7.1(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Development of the Co-Financing Market .......................................................... 106(cid:3) 7.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Consequences for Financers ................................................................................ 108(cid:3) 8.(cid:3) Agency Problems in Slate Financing Arrangements: Results and Discussion .... 111(cid:3) 8.1(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Descriptive Analysis ............................................................................................ 111(cid:3) 8.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Analysis of Performance Differentials ................................................................ 112(cid:3) 8.3(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Adverse Selection ................................................................................................ 114(cid:3) 8.4(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Moral Hazard ....................................................................................................... 116(cid:3) 8.5(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Agency Problems and Film Quality .................................................................... 119(cid:3) 8.6(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Managerial Implications ...................................................................................... 123(cid:3) 8.7(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Summary and Limitations ................................................................................... 126(cid:3) 9. (cid:3) Concluding Remarks ................................................................................................ 127(cid:3) 9.1(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Summary .............................................................................................................. 127(cid:3) 9.2(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Transferability of Findings .................................................................................. 128(cid:3) 9.3(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Limitations and Further Research Questions ....................................................... 130(cid:3) 9.4(cid:3) (cid:3)(cid:3)(cid:3)(cid:3)Outlook ................................................................................................................ 131(cid:3) References ......................................................................................................................... 135(cid:3) Appendix ........................................................................................................................... 153(cid:3) A.1(cid:3) The Agency Problem in the Financial Contracting Literature ............................ 153(cid:3) A.2(cid:3) Summary Statistics (Financer Sample) ............................................................... 156(cid:3) A.3(cid:3) Correlation Matrix (Financer Sample) ................................................................ 157(cid:3) A.4(cid:3) Summary Statistics (Slate Sample) ..................................................................... 158(cid:3) A.5(cid:3) Correlation Matrix (Slate Sample) ...................................................................... 159(cid:3) XII