Why private equity firms are now investing in content creation and how streaming has changed overtime

If I asked you where you would rather invest your money, giving you two options -- a streaming company like Netflix or a content creation business -- which one would you choose? I bet most of you would opt for Netflix. But while this may look like an obvious choice, I would like to take a moment to reflect on this. Private equity companies are now doing the exact opposite, investing heavily in content creation companies.

According to Joe Baratta, Head of Private Equity at Blackstone “the way content gets made, distributed and consumed has changed fundamentally.” So let’s try to get a better understanding of the how these companies are making their decisions and what we can learn from it.

But first let’s go back to streaming. The subscription streaming market has become an extremely crowded space where a growing number of big players is engaging in a global war. Netflix, Disney+, Paramount +, Warner Media’s HBO Max, Discovery +, NBCUniversal’s Peacock, Viacom CBS’s, Amazon Primer Video, Microsoft and Apple TV+ are just the most prominent players and everyone is trying to get the biggest part of the streaming cake.

All these companies are competing against each other to conquer the time, attention and money from subscribers across the planet. There are longstanding brands as well as newcomers from various kinds of industries who are expanding their consumer offers to include films, series and other content. With regards to this overwhelming choice, it is not surprising that Netflix CEO Neil Hastings declared that Netflix’ biggest barrier was the consumers’ need for sleep.

For the time being, the main goal of all these companies is to grow their subscriber base. It is a business of size and expanding the number of subscribers is the holy grail. The subscribers are also an important asset from a marketing perspective. When subscribers talk to their friends about a series such as House of Cards, these word-to-mouth recommendations generate a strong association with the brand that has created it, in this case Netflix, driving an urgent need to sign up to be part of it. This is the only way to stay tuned and to be able to participate in discussions. Only if you have access to Narcos, The Crown or Stranger Things you can participate in the office conversation with your peers.

If we look at the market, worldwide subscribers are still growing, but lately the pace has slowed down. As an example, Netflix reported a net gain of 8.3 million new subscribers in Q4 2021 (+4%) to reach 221.8 million subscribers in total. The company forecasts 2.5 million additional net subscribers for the first quarter of 2022, this lower growth is a direct consequence of both saturation and increased competition.

The rivalry for content is at its highest level in 26 years. Demand for new television shows is here to stay, and more than ever this will be premium on-demand content. These companies are pouring unprecedented amounts of money on new series and programming (a whopping $115 billion just in 2022) to feed their streaming services. The top winners are growing their profits but second-tier companies are still losing money.

And this is where the private equity businesses I mentioned at the beginning enter the game. Capital expenditures investing to produce or buy exclusive films and series are skyrocketing. Exclusivity is what differentiates one streamer from another as these series and films can only be seen on the platform that owns the rights. Why so much focus on series? Because series create loyalty for longer periods than movies, and they are a great tool to get new subscribers.

Piles of cash are being transferred from streaming platforms to movie, series and documentary producers. There has never been more money available for new shows and films. It is difficult to predict how this model will evolve. The sustainability of streaming businesses will depend on their size and the smaller ones will at some point disappear. The mathematics of this are simple: the cost to produce or acquire content needs to be divided by the number of subscribers and compared to the subscription fees. This is the gross margin generated to pay for operating expenses and leave a profit at the bottom. Size matters.

The streaming market is still growing worldwide. If we apply Geoffrey A. Moore’s product life cycle model from “Crossing the chasm,” we see that it is already very much established amongst innovators, early adopters and the early majority. In the years to come it will shift to the late majority cycle, which means that there will be less growth and lower pricing power for streamers as pricing competition will step up.

In this context, private equity (PE) boutiques across the world have done their diagnostics of the market, analyzed their options and moved their focus to content production. Production companies have never been so hot and the sentiment to buy them so bullish: first of all, we can see a new trend emerge where movie studios and production companies are bought or even built from scratch by players like Apollo, Blackstone or Centricus. There is a fight to get high quality content by leveraging scaled producers of premium content. The new big idea is to invest in companies that can funnel content to the streamers. Indeed, investing in content production can be more profitable than investing in streaming platforms as the pricing power is moving down on the value chain. These businesses are all capital-light and cash generative and bring high returns on equity. They generate movies and series but also special interest content such as documentaries about the corporate world, the world of sports and much more.

Private equity firms went through their valuation models for their decision-making process and found all-stars aligned:

1. The streaming segment is a market with massive potential.

2. Companies with a capacity to produce qualitative content have increased the pricing power.

3. The chances that new acquisitions will be profitable are high.

4. The risks are limited, as these companies have variable production costs. The biggest danger is linked to the quality of the content, so they need to succeed with a certain percentage of their films and series.

As an outcome, private equity companies are currently buying small independent production start-ups in a market that is dominated by large conglomerates.

In the past, private equity has flourished through decisions where big money was at stake, with a high chance of winning. Fighting for yield is the new leitmotif in a world of abundant liquidity. This abundance and fight to buy quality is increasing the valuations of good companies. Now the biggest risk is to buy too expensive and to buy too late, taking the last available producers on the market.

In the years to come this decision might impact the market in unpredictable ways: We can expect to see growing pricing power for great content creators. This battle will also generate additional production costs for streaming companies, which are going to struggle to pass them on to their subscribers by increasing the monthly fees. Therefore, they may cut costs on lower quality and generic content, paying lower fees to the producers of the last quality tier. At the same time talent will be scarce and expensive, further driving up salaries and lump sums for the greatest movie directors and content generators.

What is the consequence of these investment decisions? They will bring fat margins for private equity first movers, la crème de la crème of buyers, they will delight consumers worldwide with rich content for all tastes and interests and will bring high remunerations to talented directors. The world is changing as a consequence of decision making!