Adverse Selection and Moral Hazard in Equity Partnerships: Evidence from Hollywood's Slate Financing Agreements

• Date: 01 December 2014
• Published date: 01 December 2014
• Author: Christian Opitz,Kay H. Hofmann
• DOI: http://doi.org/10.1111/jems.12069

Adverse Selection and Moral Hazard in Equity

Partnerships: Evidence from Hollywood’s Slate

Financing Agreements

CHRISTIAN OPITZ

Zeppelin University,

ZF Friedrichshafen-Chair for Strategic Management & Human Resources Management

Am Seemooser Horn 20, 88045 Friedrichshafen, Germany

christian.opitz@zu.de

KAY H. HOFMANN

Zeppelin University,

ZF Friedrichshafen-Chair for Strategic Management & Human Resources Management

Am Seemooser Horn 20, 88045 Friedrichshafen, Germany

kay.hofmann@zu.de

We use a movie industry project-by-project data set to analyze the principal–agent problem

in slate financing arrangements. Under this specific film financing regime, which has become

a significant mode of raising capital in Hollywood over the past decade, an external investor

concludes a long-term contract with a film producer and commits to cofinance a larger number

of future film projects of that particular partner. In line with our theoretical conjectures, slate

cofinanced movies receive poorer quality ratings and yield considerably lower return rates. Our

data suggests that a substantial part of these performance differences may be attributed to adverse

project selection and producer moral hazard.

1. Introduction

The formation of equity partnerships in which two or more partners jointly own a com-

mon project or venture is a widespread and increasingly important strategic approach

in many industries. Examples include, but are not limited to, the formation of equity-

backed alliances in research-intensive industries like biotechnology, pharmaceutical,

telecommunication, or automotive and international joint ventures. Moreover, provid-

ing capital to an entrepreneurial venture is the core business of venture capital and

private equity firms. Besides spreading risk, equity partnerships may aid firms in as-

sessing new markets, knowledge, capabilities, and other resources. Yet, largely because

they are jointly owned, these collaborations are especially difficult to manage (Beamish

and Lupton, 2009).

The problems that may arise in an equity partnership are typically analyzed within

a principal–agent framework that is applied to a situation in which two partners ne-

gotiate the financing of a joint company or project (for a summary see Hart, 2001). In

this context, information asymmetries may lead to the well-known conflicts of interest

between the partners. Before the investment decision is made, the investors are subject

The authors thank two anonymous referees, our co-editor,and the editor of this journal for their valuable and

continuous support. Their comments have significantly improved the paper. The authors remainresponsible

for any mistakes or omissions.

C2014 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume23, Number 4, Winter 2014, 811–838

812 Journal of Economics & Management Strategy

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 equity partnerships lags behind (Kaplan and Str¨

omberg, 2001). More-

over, empirical studies tend to be restricted to a limited number of industries.1In this

paper, we provide empirical evidence for the principal–agent problem in equity part-

nerships in 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 industry2and the rather technical circumstance that a wide array of

project-specific information is publicly available.

The financial resources needed to produce a Hollywood feature film have signifi-

cantly increased during the last two decades. While in 1985 a studio incurred production

costs of 16.8 million U.S. dollars for an average movie, this figure had nearly quadru-

pled to 65.8 million U.S. dollars in 2006 (Wasko, 2003, p. 33; MPAA, 2006). The average

costs for distributing and marketing a motion picture have even sextupled to reach 30.6

million U.S. dollars over the same period. In most cases, these large sums, however,

are not entirely covered by the studios’ own financial resources. Other sources include

subsidies, bank loans, and most importantly equity, which may be provided by other

film producers, specialized film funds and—starting in 2004—by strategic equity part-

ners from outside the industry. In this latter set-up, an investor, typically a large bank

or hedge fund concludes a long-term contract with a production company and commits

to invest a predefined amount of money in the joint ownership of a certain number of

future film projects of that particular production partner. In industry jargon these strate-

gic partnerships, which are the focus of our paper, are referred to as “slate financing

agreements.” The expression is inspired by the term “slate,” which is commonly used

for a production company’s list of films that are in development and production. The

invested sums are significant with volumes ranging between 200 and 500 million U.S.

dollars per single deal. The cumulative slate capital that flowed into studio production

funds in the year 2006 alone amounted to more than 2 billion U.S. dollars (Foy, 2008).

In only a few years, slate financing has become the most important strategic source of

equity for the motion picture industry.

Although the phenomenon of slate financing has been discussed extensively in the

trade press (e.g., Epstein, 2005; Galloway, 2006; Mehta, 2006), the academic literature

on motion picture finance has so far concentrated on cofinancing arrangements within

the industry, that is between studios and/or smaller producers (Fee, 2002; Goettler

and Leslie, 2005; Palia et al., 2008). This paper is the first to specifically address slate

financing and the agency problems that might be inherent in this special form of equity

partnerships.

Casuistic evidence suggests that slate financing agreements are challenging, espe-

cially for the investors. There are not only reports on unsatisfactory performance of slate

1. A focus is laid on strategic alliances in the biotech/pharmaceutical industry (Lerner and Merges, 1998;

Chen and Ross, 2000; Lerner, Shane and Tsai, 2003; Filson and Morales, 2006; Robinson and Stuart, 2007),

venture capital (Kaplan and Str¨

omberg, 2003; Wang et al., 2003; Baum and Silverman, 2004; Kaplan and

Str¨

omberg, 2004; Ueda, 2004; Gompers, 2005; Gompers et al., 2009), and on international joint ventures (Reuer

and Ragozzino, 2006; Reus and Rottig, 2009).

2. In 2010, domestic box office revenues reached a recordhigh of 10.6 billion U.S. dollars and the advance-

ments in three-dimensional technologies are expected to stimulate further growth in the years ahead (MPAA,

2010). Over 115,000 businesses support 2.5 million jobs in the U.S. motion picture and TV industry (MPAA,

2009).