Film investment: all fur coat and no knickers?

Melanie Stern is section editor of Families in Business magazine.

Returns of 500% sounds pretty juicy, but nothing's for free. Melanie Stern scratches the surface of film investment and finds that this silver screen temptation is, well, just a boring old tax shelter – albeit a useful but ill-understood one

You might think it would take a pretty radical game of free association to link film and hedge fund investment, but it's simple. The relation is three-fold - big due diligence and regulatory concerns make them both very high risk.

If one looks behind the proverbial fur coat of the film industry, it's possibly the only instance in which prospective investors will be disappointed to see no sign of knickers. Film investment is simply a tax deferral scheme for the very wealthy, which is fortunate since this group is most likely to have the capacity for losing vast amounts of cash. Experts stress repeatedly that most individual investors never see their money again but the investment can be valuable as a capital gains shelter within the family portfolio – or simply, a pure passion investment with no expectation of returns.

The provision for the wealthy to invest in films has recently come under threat in the UK. Last February, the UK Treasury closed down a number of film production funds operating to the new Generally Accepted Accounting Principles (GAAP) on fears they could give rise to abuses. To keep an eye on money flowing into these schemes and to keep it closer to the country, the Government has also been working to ensure that only 'British-qualifying' films are accessible.
 
One of the more popular tax deferral schemes - due to expire next July - is Section 48 Sale & Leaseback. Focused on production budgets below £15 million for a British-qualifying film, investors put up around 20% of the gross investment, and are permitted to write off the investment to receive a 40% tax rebate on exit from the scheme, paying the money back to the Revenue over 15 years.

It is to be replaced with 'son of Section 48'- but observers say this will benefit only the producers and not investors.

"The whole industry is trying to figure out what role there might now be for the private investor, as there are no solid products replacing the closed schemes," says Martin Churchill, Editor of the Tax Efficient Review (TER) and an expert in UK film partnerships. "I think the market for the private investor will drop away completely post-July."

Section 42, providing tax deferral for budgets over £15 million, remained untouched by the Treasury but is less popular with the wealthy as the tax deferral structure is shorter-term, and because it is focused on smaller, less commercial projects. Institutional investors, though not as commonly involved, can benefit from this scheme because they pay a lower rate of corporation tax.
 
Like the scandal-ridden hedge fund industry, film partnerships grapple with a nascent and shifting regulatory landscape that serves to keep many wealthy investors, such as families, away. In the UK, the Inland Revenue keeps a close grip on these schemes for its own gain, but the UK's Financial Services Authority sees them as unregulated collective investment schemes. Additionally, most companies selling investment participation have not been obliged to take regulatory status from the FSA, although they can be if a large group of individuals decide to sell these schemes together. It's a vague distinction, but it is changing. The Treasury announced in February that all intermediaries will "soon" be required to register with the Inland Revenue, which could improve investor protection and sell-side transparency.

Simon Conder, creative products director of London's Brass Hat Films, accepts the drivers of negative perception and explains that it is down to investors to swot up before they hand over cash to the industry. "You don't need to be regulated in this business but it is in everyone's best interests if you are," Simon says. "If we're selling directly to an individual, we will do it through our FSA-regulated arm which provides financial advice outside film."
 
For the meantime though, many family investors just won't touch anything entertainment-related as a matter of course, and the number of film investment fraud cases can only perpetuate that. "We keep away from entertainment unless we have real inside information on the company and the people," one US-based family office member tells Families In Business. "Private investors are being seduced by the promise of glamour and high returns, but as I understand it, film is very high risk and only offers a very small opportunity for a very large payout.
 
"Of all the private equity opportunities out there, entertainment is the one with the most fluff."

Companies that sell private placement in film do appear to make much of the 'soft' perks, offering investors one's name on the rolling credits, on-set passes, premiere tickets, director's chairs, and lots of other high-falutin activities – but spend less time detailing the financial risks resulting from one of the financial sector's perennial bugbears, due diligence.

There are many risk factors in film investment that merit thorough due diligence before parting with any cash, usually all relating to how commercially successful the film can be, the main driver of returns for the hierarchy of investors.

Everything from the choice of director to the cost of each production stage, to the intermediary going bust, through to the star quality of the cast and the possibility that the film will not even be released threaten the individual investor's chances of a return. (Take the precarious examples of Swept Away directed by Guy Ritchie and starring wife Madonna, or Gigli, starring celebrity ex-couple Jennifer Lopez and Ben Affleck: sure-fire mega-hits on paper, unbelievable loss-making stinkers in reality.)

Some companies allow clients to decide which parts of the process one's money goes to, while others put it all into a pot and decide for themselves. That aside, the distributors always take between 50–75% of the box-office profits as the first creditor in the queue, followed by the major studio investors like MGM who take similarly large slice, followed by region-specific distributors like 20th Century Fox and recoupments for 'print and advertising' costs. Simple arithmetic can illustrate how low individual investors rank. For example, of the total US$22.5m capital currently being invested to make one commercial film starring a top Hollywood star, one leading film partnership company sunk $2.1m for its investors; to its own conservative projections it expects to end up with $571,500 (UK£311,105) to distribute to its clients, who each put in a minimum of £50,000.

"The majority of films turn a profit, but individual investors often don't see it, because they're right at the end of the creditor's line," Conder explains. "But if one of our current projects, Steve Martin's Shopgirl, does as well as Sofia Coppola's Lost In Translation did, then our investors will see a return of around 450-480%."

If that were the case, perhaps film partnerships would be more popular with the wealthy than other risky investments like derivatives or art.

Currently there is no legislation or any best practice guidance for the sell-side to ensure that clients are shown proof of thorough due diligence and risk assessment, and the relevant authorities have so far not shown interest in reviewing this. "There is usually a sponsor involved in projects who conducts the due diligence, but it is a very difficult area and investors need to be extremely careful," TER's Churchill warns. "There's a lot of mis-selling in this business – these are very complex schemes and the risks are not always pointed out. Some IFAs don't even know the risks themselves. I think most investors are told, 'put in £1 and walk away with £1.50', but life is never that simple."

Our family office member concurs. "The golden times of high return, risk-free investment through tax deferrals has gone. Film investment always requires massive due diligence – you've got to know who you're getting into bed with. That's why it is so illiquid as an investment choice. A film investment is not an investment in film – it is an investment in a tax scheme." Despite this, Churchill estimates that in 2003 UK investors pumped some £1.5bn into these schemes

The allure of the red carpet has clout among the wealthy and even with their close advisors, but involvement in the sector is held back by a lack of understanding or education. "People continue to think that film is fundamentally risky, but it is no more speculative that buying oil or commodity stocks," Conder argues. "It is still outside most people's financial understanding and there still aren't enough experts in the field to guide investors."