The public is growing more accepting of porn. Unfortunately, financiers haven't adopted this tolerant stance. Despite the fact investment institutions, such as venture capital and private equity funds, are competing more aggressively than ever for a shrinking number of opportunities, they still refuse to consider the adult-entertainment business.
It seems counterintuitive. With a record amount of money on the sidelines, fund managers are struggling to find viable investment opportunities. The adult market, estimated to have been worth $12.9 billion in 2006, is mostly composed of smaller businesses that need infusions of capital to grow or are begging to be acquired or merged. Institutions need to invest, and adult-entertainment companies need investment. The time is right. The market is waiting. The culture is ready. So why isn't anybody investing in porn?
Different types of private money
Businesses that need capital tend to think about VCs first, particularly in light of their eminence during the dot-com boom. From 1995 to 2000, VCs raised a total of $135 billion, according to Private Equity Intelligence Ltd. (PREQIN). In the five years that followed, VC fundraising dropped precipitously, virtually decimating a new venture financing source. Fortunately, there are other ways to fund a business.
As the competition for investment opportunities intensifies, the lines that traditionally have divided private equity and venture capital funds have blurred. Private equity funds are making venture investments, encroaching on VC turf. This could create opportunities for adult-entertainment companies to secure the capital that VCs have been reluctant to provide.
Venture capitalists focus almost exclusively on the next big thing. They try to find new or small businesses that require substantial investment. Made famous during the dot-com boom, VCs gained a reputation for liberal investment. Since the crash of March 2000, VCs have become considerably more rigorous in evaluating companies and allowing investment dollars.
Venture capital has seen a slight upswing in activity since its post-dot-com low of $13 billion in capital invested globally in 2003, according to PREQIN. Since 2002, the year in which fundraising dropped substantially, VCs have attracted new funds every year at a compound annual growth rate of 12.9 percent, but this is a far cry from 2000, in which VC firms invested $63 billion in new ventures. The money has not disappeared; it simply has moved into different forms of private investment, particularly private equity funds.
|
Year |
VC Aggregate Capital Raised (US$ billions) |
|
1995 |
4 |
|
1996 |
5 |
|
1997 |
10 |
|
1998 |
16 |
|
1999 |
37 |
|
2000 |
63 |
|
2001 |
37 |
|
2002 |
16 |
|
2003 |
13 |
|
2004 |
19 |
|
2005 |
13 |
|
2006 |
26 |
|
CAGR |
18.54% |
Source: PREQIN
Venture capital funds are a subset of a greater category, "private equity." Private equity involves the pooling of investor funds - generally from high-net-worth individuals - for use in a wide spectrum of business opportunities. Private equity investments focusing on newer enterprises that show the potential for rapid growth fall into the VC sector. Other private equity funds acquire mature smaller businesses and seek turnaround opportunities (i.e., failing businesses), and others are characterized by specific acquisition techniques (e.g., leveraged buyouts).
As a result of the broad spectrum of investment opportunities that make up private equity - and the bargain-priced private businesses on sale in the wake of the dot-com meltdown - these investment vehicles saw a significant influx of capital from 2002 to the present. Investment in private equity funds has grown at a compound annual growth rate of 30 percent since 2002 and 22 percent since 1995.
|
Year |
Private Equity Aggregate Capital Raised (US$ billions) |
|
1995 |
30 |
|
1996 |
37 |
|
1997 |
74 |
|
1998 |
104 |
|
1999 |
116 |
|
2000 |
187 |
|
2001 |
134 |
|
2002 |
94 |
|
2003 |
93 |
|
2004 |
102 |
|
2005 |
157 |
|
2006 |
270 |
|
CAGR |
22.11% |
Source: PREQIN
With so much attention being lavished on public and private companies by VC and private equity funds, competition for investment opportunities has become intense. Even with the changing dynamics of the private-investment market, few VC and private equity funds have ventured into porn. Most cling to the "moral" objection, though the reality is a bit more nuanced.
When $13 billion isn't good enough
None of the modern-day "robber barons" contacted for this article agreed to talk on the record. Their reasons varied, but most boiled down to two issues: "I don't want to piss off my investors" and "I don't want those (i.e., porn) people calling me." Given the reluctance of most funds to invest in porn, those willing to consider it feared a deluge of inquiries that would be unlikely to lead to a deal.
The fund managers who would consider porn would prefer to find it through their personal networks. Ultimately, most private equity and VC fund managers interviewed for this article said they would evaluate an investment in an adult-entertainment company if the deal met their criteria, including size of initial investment, potential upside and the reliability of the company's operators.
The morality issue has been a ready scapegoat used by porn entrepreneurs to explain away their inability to acquire outside funding. Large private investment funds, such as VCs and private equity funds, have to protect their reputations, and the fact that they receive money from public pension funds and other institutions does limit their ability to invest in porn. But looking past the question of morality - or, more accurately, potential investor ire - one sees that there are greater barriers to investment that will not be cured by the continued mainstreaming of the adult-entertainment industry.
According to one private equity fund manager who echoed the sentiments of others, deal size is the first problem. "The deals just aren't big enough," he said. Even smaller funds are looking to invest at least a few million dollars in each deal. In addition to the size of the investment to be made, the upside has to be more substantial. Most VCs, according to another investment source, routinely dismiss smaller deals with an attitude of "If you can't make us $100 million, don't bother us." To attract private investment institutions, porn deals have to be big with the chance to become huge.
Private equity funds do have a bit more latitude, especially if they are smaller funds. One fund manager indicated that he would consider an investment opportunity requiring as little as $250,000 in invested capital, but that is his floor. "It would have to be pretty interesting for me to look at something that small," he said. For most private equity firms, though, even $250,000 would be far too small to consider.
To attract VC or private equity interest, an investment would have to become one of the largest companies in the business in only three to five years. The two biggest companies in the industry, Playboy and Beate Uhse, each generates just more than $300 million a year in shareholder value, which is measured by market capitalization. According to the Securities and Exchange Commission's definition, both could double in size and still be considered small public companies. Adam & Eve, with $109 million in revenue, according to company spokesperson Katy Zvolerin, is what a new porn venture would have to become in order for VCs to take notice.
Private investment institutions don't want to make $5 million in five years. They want to find the next Vivid, Adam & Eve or LFP.
Finding the exits
The problem of size yields the other significant barrier to VC and private equity fund investment: exit strategy. Investors may be satisfied with private company dividend payments for a few years, but they eventually will want a big payout. The disposition of a portfolio company allows the investors to take a profit and frees their invested capital for use in new ventures. Thus, the investors need a way to get their money out of the businesses in which they invest. An initial public offering is the ideal exit strategy, yielding a liquid asset that can be divested in part or whole at any time. A private sale is a viable alternative, but the sale price tends to be lower than that of an IPO - and you have to find a buyer.
Both are possible; precedent does exist. While it can be difficult to take an adult company public, it has happened seven times - not including Interactive Brand Development, which still is trading despite having suspended operations. But public porn is small, with an average market cap of $148.38 million (as of June 26, 2007) and average annual revenue of $118.71 million. For smaller companies, the cost of going and staying public is disproportionately high, and it can be difficult to find purveyors of necessary services such as investment banking and independent audits. Though possible, it is unlikely that IPOs for growing porn companies will become plausible in the next few years.
The other option, a private sale, is risky. Investors will have to find prospective buyers with sufficiently deep pockets. In waiting to find the right buyer, private investors could be saddled with an investment for longer than they had planned, rendering their capital unavailable for use in new opportunities.
Getting out is just as important as getting in, and VC and private equity funds perceive the exit risk to be too high. Porn companies aren't raising enough at the outset and are unlikely to be big enough to matter. "Why would I invest $100,000 in anything?" one private equity fund manager asked. "For me, that could be one day's trading gains or losses."
Through the back door
For deals that are sufficiently large and lucrative, porn entrepreneurs are not locked out of VC or private equity funds. "If the deal's worth it, I'd find a way," explains a New York-based manager of a private equity fund. He said he probably would set up a separate fund for a porn investment, introduce some of his investors to the deal independent of his fund, or simply invest in the deal himself. To take any of these approaches, though, the deal would have to be attractive.
By skirting the fund itself, fund managers can participate in the adult-entertainment market while bypassing the "pissing off my investors" concern. But securing financing through the back door is quite difficult. The transaction becomes more intimate, involving fewer people overall. The fund manager's investors are closer to the investment and will get a closer look at the company. The deal has to be solid, and the company operators have to impress from the start.
A West Coast-based business adviser explained that she has seen some porn companies that may have had shots at raising money, but they refused to integrate into the mainstream-business community. "They just look sleazy," she said, citing revealing and inappropriate attire for business interaction. Pimp hats, low necklines and midriff-baring clothing should be traded for business suits and ties. "At least, khakis and a blue Brooks Brothers blazer," the adviser recommended. "Otherwise, it's hard to take them seriously."
In addition to their appearance, many porn-company owners and operators need to modify their approaches. Evasive replies to simple questions result in damaged credibility. When asked, the company should be clear and direct. "We produce adult films to sell to distributors" or "We operate a website featuring adult content" are more effective answers to the obvious first question any investor will ask. Too often, "What do you do?" is met with vague or misleading replies.
Honesty does not end with the first question. Any company seeking funding must be prepared to disclose everything, including financials, and those in porn will be held to a higher standard. Supplying financial statements is a first step, but most investment funds will want to contact the bank directly. A history of privacy and evasiveness has made it impossible for institutional investors to trust the porn business.
Conditions will change in a few years
Expect the landscape to change over the next five to 10 years. The market is ready for a wave of consolidation. Even the largest porn companies are small, with the industry mostly made up of businesses with less than $20 million in annual revenue. As the larger businesses need to accelerate growth - or deal with declining revenue - much smaller competitors will begin to look like attractive acquisition targets.
The most successful companies, in terms of annual growth rates, size and brand recognition, will gain control of the industry if they position themselves appropriately. LFP, Vivid and Adam & Eve, for example, could parlay their market positions into acquisition engines using compounded returns on investment from a small number of successful acquisitions to further their buying sprees. While any large acquisition trend would begin slowly, it would gain steam rapidly.
Along with the growth of the industry's largest companies, look for new media to finally make its move. To date, online business has been a drain on DVD revenue, but the proliferation of free content, low barriers to entry and customer-friendly pricing have prevented the online market from compensating for declining film revenue. In 2006, the 13.6 percent growth in online revenue still fell $319 million short of compensating for the 15.4 percent decline in revenue from DVD sales and rentals.
|
|
2005 |
2006 |
% Change |
|
DVD Sales and Rentals |
$ 4,281 |
$ 3,622 |
-15.40% |
|
Internet Content |
$ 2,501 |
$ 2,841 |
13.60% |
Source: AVN Internal Research
The continued maturation of online-business models likely will unleash pent-up growth in the next few years as online businesses refine free-sample tactics and improve monetization strategies. Expect this growth to create large Internet companies with brand and fiscal strength comparable to Adam & Eve and Vivid. While payment processors will own a large share of the next generation of porn, content and service providers such as Naughty America will become acquirers rather than acquisition targets.
As porn matures through consolidation, private investment vehicles will become more interested. Buyouts and acquisitions will show VC and private equity firms that a liquidity event is possible, one of the most important factors that potential investors consider. With a way to exit the investment, porn will attract financing from smaller institutional investors. As the industry reaches a critical mass, it will be easier to see how a multimillion-dollar investment in a midsize porn company could fuel growth - through operations and acquisitions - that could result in the nine-figure valuations needed to justify a substantial investment.
The projected changes to the industry landscape likely will favor private equity rather than VC investment, as the opportunities for outsized returns probably will come from existing operations. Startups, normally the domain of VCs, will be acquisition fodder, indirectly contributing to the growth of the industry and consuming investment dollars through the companies that purchase them.
VC may not be right for porn, though there are bound to be exceptions from time to time. But VCs are only a small subset of the private-equity community, accounting for only 18.04 percent of private-equity investing on average since 1995, according to PREQIN, and 9.63 percent in 2006. Private equity, in general, will start to participate regularly in the porn business as the deals get bigger, and even the beginnings of a M&A wave could be the trigger.
In the meantime, private equity money is not out of the question. In fact, the easiest way to unlock the largess of private equity funds may be through the personal checkbooks of the fund managers. There is nothing like a string of lucrative, successful deals to help fund managers convince their clients to look past their moral objections. When people are making money, they tend to not ask questions.
Accessing the personal capital of fund managers is not as difficult as it appears. Generally, it just requires a change in approach: Dress the part of a businessperson, have a business plan, answer questions directly and be ready to disclose financials.
Nobody is going to invest blindly. Many have been reluctant to use the words "porn" or "adult" in telling potential investors what they do. They'll find out anyway, but the right investors will not consider it a barrier to investment.
Not all investors are ready to plunge into porn. The universe of investors willing to talk is small, but a market does exist. Entrepreneurs seeking financing will hear plenty of "no" before they get to a "yes." In this regard, porn is no different from the mainstream. Plenty of new ventures are repeatedly turned down before they get funding. But now porn finally has a shot.
This story first appeared in the February 2008 issue of AVN Online magazine. To subscribe to AVN Online, go to https://www.avnmedianetwork.com/subscriptions/
