Editor: Steve, you have been quite active in counseling clients in the private equity, venture and hedge fund industries, particularly in terms of media companies. Please tell us what in your background makes you uniquely qualified to counsel clients on media matters.
Jacobs: My expertise in counseling private equity funds, hedge funds, and venture capital funds grows out of the 15 years I spent in a variety of different operating roles working for media companies owned by private equity funds. My experiences ranged from CFO to COO to General Counsel to running a database publishing business. I also have gained the perspective of being on the advisory side through my role at Kramer Levin.
Editor: Why are these properties well designed to shoulder more debt than capital-intensive companies?
Jacobs: Media companies have historically been very attractive to investors: They generally have very predictable cash flows, they tend to have very modest capital needs and they have comparatively small operating and production costs. As a result, investors are able to put a large amount of debt on these companies' balance sheets that can easily be serviced by their historical cash flows. Specifically in this environment, these elements create a very attractive model for a variety of different investors, such as private equity funds, to earn large returns when monetizing their investments.
Editor: What risks do private, venture and hedge funds need to protect themselves against when they purchase media properties?
Jacobs: Some of the risks are the same that you would see in any type of investment. There are obviously the normal sorts of diligence issues that need to be done - you need to understand the business. But with media companies, you also need to get into the mindset of the consumer, because, in many cases, these are content businesses which are notoriously fickle. Consumers' tastes change from day to day - many of these businesses are "hit" driven, particularly the entertainment business - which, absent a "hit," can be disastrous. In addition, advertising-based businesses are subject to the vagaries of traditional ad cycles. And time and again we have seen that lenders to private equity funds tend to be willing to over-leverage these companies. The situation which prevailed until recently - with lenders providing credit with minimal covenant protections - was symptomatic. Anyone who has lived through a downturn in the market knows that eventually this degree of leniency will come back to bite you.
Editor: What types of media properties lend themselves to ownership by hedge funds, knowing that hedge funds flip their properties very often?
Jacobs: The historical model for hedge funds has been to purchase more liquid investments and to turn these investments over fairly quickly. I think that model has changed as we see the convergence of private equity funds and hedge funds. Hedge funds are frequently investing in somewhat more illiquid, longer term investments. But that being said, the media properties that are most attractive to hedge funds, specifically in this market, are those investments that are underexploited or inappropriately risk- adjusted for the market. The goal of the hedge funds has traditionally been to bring a rational analysis to what are, in many cases, an irrational business. One area in particular where hedge funds have begun to invest is in the film-finance area. These are risky deals, but obviously where there is great risk there is also great reward.
Editor: Film financing differs markedly from other types of media financing. Why are private equity and hedge funds attracted to single films as well as slate deals and funds?
Jacobs: Hedge funds have tried to come up with certain algorithms or other rational models to bring order to an otherwise irrational business. In the film business, there is even a name for the model they've invented, called a "Monte Carlo." My understanding is that this model derives from some early research done with respect to the oil wildcatting business - which is in many ways not all that different from the film business. They are both hit-driven businesses, and in both if you have one hit you can make up for a huge number of losses. Finding the right hit is unpredictable, and the film business, time and again, shows its unpredictability. In addition, there have historically been various inefficiencies in the way in which films were financed. Typically the studios, which were the entities taking the least amount of risk, were reaping the lion's share of the profits. Hedge funds realized that they could find a way to exploit these inefficiencies and they have come up with several strategies to take advantage of the financial characteristics of film financing. Films, specifically successful films, have very long tails in terms of their revenue stream. In addition, they have other types of revenue that go beyond the theatrical release. For instance, they may have revenues associated with ancillary rights or presales. Hedge funds have correctly identified some very attractive characteristics in this business that, when appropriately structured, can help to mitigate the overall risk of the investment.
Editor: How do you define "slate deals"?
Jacobs: Various types of financial entities have raised large sums of money to produce a slate of films, or a series of films. I recently closed a deal in which a venture capital firm invested in a slate of approximately 20 low-budget comedies which will be produced over the next five years. By creating a pool of properties, they believe that over the life of the deal, they can mitigate the risk of one or a few films failing. There have been a couple of slate deals which have been very successful and a couple which have not done as well out of the gate. The problem is, if your first few films are not successful, there may not be sufficient cash flow to support films later in the cycle.
Editor: Why have financial buyers failed to make a success of purchases of DRTV (or infomercials)?
Jacobs: DRTV is very analogous to the film business in that it is a pure hit-driven business. When you have a hit in the DRTV area, it can be a billion-dollar product and extremely lucrative, but a misjudgment as to consumer taste can cause the whole house of cards to fall. Financial buyers are generally not the most savvy in predicting what consumers are going to like. When they entered this arena, they assumed they could treat the DRTV market similar to the way in which they had dealt with other brand-marketing businesses. Unfortunately, they were wrong.
Editor: Have the new marketing guerillas, such as YouTube, undermined this business as well as the old line media such as radio, TV and cable? How can "old" media sustain itself?
Jacobs: There is no doubt that YouTube, MySpace and Facebook are taking away time and eyeballs from what traditionally was a place where people spent a good deal of their free time - watching broadcast TV and cable, as well as infomercials. The brand marketers who are active in DRTV either will have to adapt to the web and to the ways in which they use it or find some other way to attract people to their products on TV.
However, at the end of the day, it does not change the fact that "content is king." Other than user-generated content which is prominent on the web, there is not a lot of original content that is being created specifically for the online market. It's mostly content that has been repurposed from old media outlets. That may change drastically, but for the moment I believe that old media is safe.
Editor: How do you account for the recent resurgence of interest in newspaper media?
Jacobs: We have heard for a long time that "newspapers were dead." Although newspapers are less profitable than they have historically been, at their core, newspapers remain profitable, high margin businesses. Local newspapers are particularly attractive from a cash flow and operating margin perspective. Furthermore, most newspapers have a diversified revenue stream, so that they have advertising, subscriptions, as well as other sources of revenue. Finally, most newspapers produce a high quality product that is very hard to duplicate. This content can be repurposed in a number of different ways whether it is on the web or in other contexts that allow it to have a life beyond the printed newspaper. In the current environment where we have a robust advertising market, newspapers continue to look very good.
Editor: What typical exit strategies are used by funds in flipping these properties?
Jacobs: Over the last few years equity owners did not have to think very much about innovative exit strategies. If the investor was able to ride the wave correctly, it was easy to make money by selling when the multiple on these businesses rose. In addition, if a fund was able to increase margins or decrease costs, it could count on an even greater success. To add to the attractive quality of these properties, in the past few years private equity and hedge funds have been able to refinance their investments through the lender-friendly debt markets, extracting a large portion of their equity investments through increased leverage. As a result, upon any exit, the funds are already "in the money."
Editor: Many long-term lenders, such as TIAA-CREF, have pulled out of the LBO market. Banks are now holding paper they had hoped to sell off. What do you see as the future of leveraged buyouts, particularly in the media industry?
Jacobs: Right now the markets are particularly frothy. The difficulty in the debt markets seems to worsen every day. I heard that one of the major private equity lenders told his desk to take the month of August off because they were not going to make any loans into this market. I think this is an anomaly. While there has been a tightening of credit owing to the sub-prime mortgage crisis, I do not think that the underlying characteristics of the markets have changed so dramatically. As people recognize that the underpinnings of the economy, and the media sector in particular, remain strong, lenders will continue to come into the market. Personally, I see the current situation as more of a market correction and not a paradigm shift in terms of where things are going.
Published September 1, 2007.