Sony Smoothes Investor Trip Down Gun Hill Road--But Where Will It End?

Last year, when Deutsche Bank AG sealed film co-financing deals totaling $1.3 billion with Sony Pictures and Universal Pictures, the pacts were named after Gun Hill Road, the site of a Revolutionary War battle in which the underdogs triumphed. According to several people with knowledge of the deals, investors have had to fight hard for what little they've won.

Until a recent restructuring, investors who'd bought into the riskiest but potentially most lucrative slice of Gun Hill I, a $600 million fund to co-finance 18 pictures, would have been lucky to break even on their investments, according to three people who've seen both the studio distribution statements and the ''ultimates'' - the closely-held analyses of projected movie revenues -- for the deal.

Since more than a dozen hedge funds had bought into this 'equity'' level in relatively small chunks ( average buy-in: $25 million), no single fund would have lost enough money to make a public stink, people with knowledge of the deal confirm. Still, to keep investors in the game, Sony was persuaded to renegotiate the terms of its deal, those sources said.

'We wanted to be good partners,' said Bob Osher, chief operating officer of Sony's Columbia Pictures Motion Picture Group.

Universal was not asked to sweeten its deal because investors were seeing higher returns on its movies, sources said.

Announced in January 2006, the Gun Hill I deal provided about half the financing to produce hits such as last year's 'The Pursuit of Happyness,' 'Ghostrider' and 'The Fast and the Furious: Tokyo Drift' and misses such as 'All the Kings Men' and 'Doom.' Deutsche Bank set out to syndicate chunks of both this deal and its sequel (a $700 million, 19-film co-financing pact known as Gun Hill II) to hedge funds. But according to several sources, the bank has struggled to sell off as much of the investment as it had hoped, even after it raised the rate of return promised to investors.

Gun Hill I and II were structured by Ryan Kavanaugh, the 32-year-old founder of Relativity Media, who was profiled in Portfolio's May issue. Relativity has collected fees as much as $1 million per movie, though the company is required to reinvest some of that money in both Gun Hill ventures.

The Gun Hill deals, like many recent co-financing arrangements that funnel Wall Street money into Hollywood, in essence ask investors to gamble on future performance of films. Investors buy in to groups of upcoming movies at different levels, depending on their appetite for risk. But they're not the first in line to get paid, and most studios prevent them from taking stakes in big franchise film like 'Spider-Man' or 'Harry Potter."

If you think of movie revenues as a waterfall, thirsty investors must wait for their gulps of water until after the movie studio recoups its marketing costs and distribution fees and top actors, directors get their sips. Only then do lower-risk investors, known as senior debt, get paid (usually their capital plus about an 8% return). Then come 'mezzanine' level investors, who are usually promised about a 15% return, as long as the money holds out. At the very bottom is the equity level investor, who own a piece of the ongoing revenue, if any, after everyone else has been paid.

Two movies (and possibly a third) have yet to be released in Gun Hill I, so it remains unclear exactly how much the restructuring will improve investors' fortunes. But according to another person who saw the reports on Gun Hill I's performance before the deal was reworked, equity investors needed a lot of help to remain whole. "It was definitely close to dead money," this person said. Deutsche Bank declined comment, and Kavanaugh was unavailable for comment.

--Amy Wallace