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Scale, risk and investment: Patrick McKenna’s speech to c&binet

Nick | 29 Oct 2009, 11:42

Patrick McKenna, Founder & Chief Executive of Ingenious Media addressed c&binet forum on Tuesday, October 27th, on the challenge of how to increase the flow of capital in to the content industries, to faciliate the growth of smaller companies. He then discussed the issues raised with a range of experts including Simon Fuller, Founder & Chairman, 19 Group, Lorna Tilbian, Executive Director, Numis Corporation, Julie Meyer, Founder & CEO of Ariadne Capital and Daniel Waterhouse, partner at Wellington Partners.

This was his speech:

I am delighted to have the opportunity to get us started in this session as these are questions I have grappled with all my working life. Given the twin challenges of structural upheaval and global recession, that we all know about, it is vital to come up with some answers.

However, we should not hide behind the recession: it is the structural challenge that matters most. The biggest issues are the impact of the digital revolution on business models and consumer behaviour, and changes in the landscape of regulation.

Out of the resulting disruption we have, so far, seen only a handful of proven winners – with many clear losers! There are, of course, also many other businesses and business models, where the jury is still out but right now the consumer is the real winner, with greater and cheaper access to a wide variety of quality content.

This unprecedented level of upheaval creates greater competition and numerous investment opportunities, but with it comes lack of certainty. The only one constant in this ever changing equation is the need for compelling and distinctive content but, commercially, this is perhaps the area of greatest uncertainty.

I think that when talking about the “creative industries” we need to remind ourselves that they are overwhelmingly made up of small and very small companies. Most of them employ only a handful of people, but this is where great content tends to be made. It is also where most future growth is likely to come from if we can get the financing issues right – which is the ground I want to cover today.

Although my focus will therefore largely be on precisely these small companies, the issues will be of interest to everyone. Let me explain why.

I believe that access to finance is now the critical factor determining which type of company will succeed in the digital world. It is no longer simply the old argument about distribution over content, and which business model will prevail.

It’s a fact that with more open access to the new distribution platforms, content companies can move up the economic food chain as a consequence of having direct relationships with their consumers. In the process they can access new profit margins and build value, but none of this is possible if they don’t have the necessary funding to retain ownership in their content and have the monetary firepower to ensure effective marketing penetration.

So far there appears to be little consistent evidence of direct access to the consumer on the part of creative content companies in spite of some well publicised exceptions. Most content producers still access the consumer through the major distribution companies and to a very large extent this is due to a lack of alternative financing.

My central proposition today therefore is that creative content companies now have their biggest opportunity for growth, but only if certain very clear conditions are met.

In setting the framework for our discussion today there are three points I would like to make.

Firstly, when talking about finance and the businesses that comprise the creative industries, one size does not fit all. Indeed from an investment perspective they are distinctly different. These distinctions are not primarily about genre – publishing, games or film. They are about business models - different business models reflecting very different risk profiles.

From an investment perspective we can identify three broad categories of business model. If we think in terms of a spectrum of risk, at either end of the scale we have what I call demand-led and non demand-led business models, with distribution and licensing companies somewhere in the middle.

Let me explain why I use this terminology. By “demand-led” essentially I mean service businesses – advertising and design companies for example – whose work is funded by client commissions and client demand. This is relatively low risk activity in purely investment terms because it’s possible to manage the expenditure base to match the revenues.

By “non demand-led” I mean companies which have no way of predicting accurately in advance the demand for their product - the song, the book, the film. Will it be a “hit”, or a “miss”? As we all know, this is exceptionally high risk stuff.

In these non demand-led content companies the cost of the product and the cost of bringing it to market can be extremely high, thereby exacerbating the risk.

In the middle we have licensing and distribution companies which usually enjoy the benefit both of scale and catalogue.

Understanding and responding to the distinction between these different models and risk profiles is crucial in determining what, if anything, needs to change to stimulate investment in the creative industries.

In my experience it is content businesses, subject as they are to chronic unpredictability of demand, that have the most extreme difficulty in raising investment capital and breaking loose from their dependency on the big distribution companies.

To be clear. The current reality is that nearly all content funding is provided through “the trade” itself – that is to say by well-funded distributors. Very little is currently provided by business angels, venture capitalists, private equity houses or other financial institutions.

Having defined our terms of reference I come to my second point. There is a need to develop new and alternative sources of finance. This is a critical objective. If we fail to achieve it the major distribution companies will continue to dominate the creative economy and the growth opportunity for content companies will remain aspirational only.

Why does this matter?

It matters because the myriad of talented entrepreneurial companies that are involved in the creation of content will be denied an opportunity to develop if their financing continues to be derived almost exclusively from the majors who, as a consequence of that funding own and control the creative output.

It also matters because right now there is a once in a lifetime opportunity for creative companies to develop their businesses free from the grip of the gatekeepers that have hitherto regulated their access to the consumer market.

The central issue in economic terms is control of the IP. It is vital for content companies to retain some ownership in the IP they create so as to generate meaningful profits to fund future growth.

Of course the pre-selling of some content rights to help fund production costs is desirable, mainly to get a degree of marketing commitment from distributors, but too often creative enterprises find themselves locked into a scenario in which they are forced to pre-sell pretty much all of their content.

Unless some IP is retained in a content business it will always be small, project feebased, and commercially vulnerable.

At the same time, creative businesses need to make themselves more attractive to investors if they are to take advantage of the digital opportunity. What does this mean?

This is certainly a question the panel will want to take up, but let me offer three initial thoughts.

First, the vast majority of these companies need to develop business skills to match their entrepreneurial and creative skills, not least so that they are able to appraise and obtain new sources of finance.

Secondly, they need to embrace new, more holistic business models and become much more sophisticated in their approach to funding. They need to be broader and more ambitious – it also means adopting business models that reflect the different ways in which a single piece of content can now be exploited. And it means accessing the multiple sources of funding that arises as a consequence.

In other words they need to raise project financing, including equity, from a much wider range of sources than ever before. The finance function for creative businesses is becoming much more demanding because of the move away from single source funding.

Thirdly they need to be able to draw from a far wider industry knowledge base than previously. The exploitation of content in a multi-channel world requires a greater range of skills and knowledge as business models become ever more complex and the funding environment more diversified. For example record companies are now looking to expand their activities across the spectrum of the music industry and this will involve broadening their skills base across the other parts of the music industry, and beyond!

On a corporate level, most content companies will not be able to achieve critical mass and this will reduce the number of investment sources open to them. Those - the vast majority - that cannot achieve scale quickly enough will need to consider alternative investment sources such as specialist media funds that can offer their investors, through a portfolio of investments, the scale and diversity of risk that investors demand.

These media investment funds understand the market and therefore hold the key to the future partnerships that content companies will need to form to maximise their growth potential. They can provide both project financing and equity investment for corporate development, but the creative industries need more of them.

Knowledgeable investors create sustainable investment and this is what is needed.