Private equity goes to the movies

"Transformers: Dark of the Moon," the third film in the sci-fi action franchise, took $56 million on its opening weekend in China last July, shattering the record set by "Avatar." Within three weeks ticket sales topped $145.5 million, nearly one fifth of the overall foreign takings and equal to 41% of the North American total, according to Box Office Mojo.

Of that $145.5 million, the producers would likely have received no more than $25 million. China only permits 20 foreign films to be shown within its borders each year and overseas producers must work with accredited domestic distributors that keep all but 17% of the box office revenue. Had Transformers been a Sino-foreign co-production, distribution restrictions imposed on foreign films wouldn't have applied. The overseas producers' take would have risen to 40-45%, adding up to $40 million to their bottom line.

There is a compelling economic argument for co-producing films that appeal to audiences in China and private equity wants to leverage this dynamic. Extracting returns from China's film industry, however, is no easy process.

In the past fortnight, two funds have been announced: Sun Media Group has teamed up with the Harvest Fund Management's alternative investment arm to create the $800 million Harvest Seven Stars Media Fund; and Buting Yang, former chairman of state-run distributor China Film Group, is leading a host of domestic film industry luminaries at China Mainstream Media, which has also attracted government backing.

Meanwhile, former basketball star Yao Ming is exploring the possibility of a film financing fund, and "21 and Over," the debut feature from Relativity Media, SAIF Partners and IDG China, in partnership with Huaxia Film Distribution, is already well into production.

"The Chinese film industry has reached an inflexion point in the last year or two - it's grown from being a business that was on the verge of becoming something big to something that is very big," says Robert Cain, a producer whose company, Pacific Bridge Pictures, develops projects for Sino-US co-production.

Expanding market

China is now the world's second-largest cinema market, with box office receipts rising 29% year-on-year in 2011 to reach $2.1 billion. The country had 10,500 screens at the end of the year and Shanghai-based consultancy Artisan Gateway says that current growth rates equate to seven new screens opening each day.

The developments of the past year or so don't represent private equity's first foray into Chinese cinema. In the 1990s, Citicorp Capital Asia (CCAL) set up a fund with Raymond Chow's Golden Harvest, the Hong Kong film production company responsible for launching the careers of Bruce Lee and Jackie Chan, among others.

Karam Butalia, executive chairman of KV Asia Capital, who was at CCAL when the fund was set up, recalls it enjoying mixed fortunes. The vehicle was ahead of its time - China's film industry hadn't taken off - but some of the lessons learned still hold true today. Butalia highlights "The Soong Sisters," a 1997 production backed by the Golden Harvest Film Fund and starring Maggie Cheung, Michelle Yeoh and Vivian Wu.

"The film was profitable but we only broke even because money was taken out by the production house and the distributors," says Butalia. "You have to understand the business and the finances are part of that. In this respect, the difference between success and failure is not that dissimilar from other industries."

The problem is one of transparency. In the West, films are bonded, which gives investors a degree of security, and trusted intermediaries operate in the space between the cinemas and production companies. China lacks an established, uniform mechanism for collecting box office takings.

"The local co-producer who owns the distribution rights deals exclusively with the cinemas," says Mathew Alderson, a Beijing-based attorney with HarrisMoure who advises foreign production companies entering joint ventures in China. "It is incredibly difficult to get valid accounts from the cinemas. A lot of these foreign co-producers probably don't see the true returns to which they are entitled."

Anecdotal evidence abounds of cinemas selling tickets for one film and then printing the names of another on top of the receipts. Even if a share of box office revenue is forthcoming, some local distributors have trouble remitting the funds out of China, often due to a failure to register for the appropriate license or an unwillingness to pay the relevant taxes. It has led some foreign co-producers to sign over all China revenues to their local partners in return for a lump sum payment up front.

Creativity vs finance

Other challenges have commercial implications yet are rooted in the creative side of the business, and the fact that film backers and film makers are cut from different cloth. Talk of finance geeks being seduced by glamorous movie stars seems clichéd, but KV Asia's Butalia attests to its accuracy. "With ‘The Soong Sisters' we were meeting people like Maggie Cheung and it's only later you think about how much money you've made," he says. "You are taken in by the females and the wining and dining."

Beyond that, anyone looking to finance co-productions in China must consider that so far none have managed to be a smash hit in China and internationally. Cultural differences and government policy are both factors here.

"The Flowers of War," a dramatization of the 1937 Nanjing massacre directed by Zhang Yimou and starring Christian Bale with a budget of around $90 million, was the top-grossing Chinese-made film of 2011, amassing $70 million in its first two weeks on release. It took just $205,000 over a similar period in North America and failed to make the Academy Awards shortlist.

International critical reception was mixed. While The New York Observer hailed it as "emotionally shattering" and Zhang's most impressive film since "Raise the Red Lantern," The New York Times concluded that the director had misfired. "Flowers of War" is a "Hollywood-inspired melodrama," it said, criticizing Zhang for his "refusal to take a point of view on one of the most gruesome chapters in Chinese history."

There were no accusations of nationalism that have been leveled at other Chinese historical dramas. However, the suggestion that the director had come up with something bland adds credence to rumors that a compromise was reached in order to please state-backed investors who had certain expectations of the content. Such issues complicate matters for foreign co-producers.

"The authorities have the final cut and some investors don't want to risk that," says HarrisMoure's Alderson. He adds that even the published rules of what is and is not acceptable are widely open to interpretation. For example, in recent months content relating to the supernatural has been deemed unsavory by the regulators and this has prompted some local distributors to pull out of deals for foreign films of this genre.

Lacking crossover appeal

On the flip side, a 2010 remake of "The Karate Kid," this time set in Beijing, took $359 million globally but is said to have performed poorly in China. It begs the question of whether a kung-fu film that takes place in China but starring an American actor could ever really strike a chord with local audiences. Notably, one foreign player that has prospered with co-productions in China is Fox International Pictures. It has released three films, all of them Chinese-language titles.

According to Pacific Bridge's Cain, no one has found the right balance between material that wins over both Chinese and international audiences and is also suitable for co-production. This may change if these new funds have sufficient clout to finance large-scale action features that have true mass-market appeal, but at present there appears to be a dearth of quality scripts.

"There is not a cadre of writers in China that have the first notion how to make a quality movie for a global audience," says Cain. "There are good writers in Hollywood but they don't have any experience threading the needle in writing something that can work in China and elsewhere."

The new funds are a mixture of industry experts, angel investors and private equity firms. An ideal vehicle would combine the best qualities of each, but KV Asia's Butalia, while bullish about the prospects of China's film industry, is not optimistic about PE's potential role in it. If past history is anything to go buy, private equity firms have shown they can make money owning cinemas, not making cinema.

"There will be a few successes but overall, private equity firms will lose money because they don't know what they are doing," he says. "It comes down to whether the GP understands the business and whether the industry structure supports the business."

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• Topics
• Media
• Greater China
• China
• TMT
• Media
• IDG Ventures
• SAIF Partners
• Citigroup Venture Capital International Asia