KEY POINTS:
On a blazing hot day in California five years ago, Yahoo boss Terry Semel, rose to his feet to address a technology conference in which he lambasted record companies for being "paralysed" by the threat of online music.
Semel's words were met with rapturous applause from an audience made up largely of new media executives from Silicon Valley with a vested interest in the digitalisation of music.
The timing of Semel's speech was significant: the music industry had just succeeded in shutting down Napster after a court ruled it should stop offering pirated music over the net.
The Napster case infuriated Semel and others who believed that the music majors were showing a lack of imagination about how the market could expand via new technologies.
Far from grasping opportunities, the companies were still reeling from the impact of MP3 files, a format that compresses music into data that can be quickly downloaded over the internet, and which Napster was exploiting with phenomenal success.
As one analyst remembers: "Executives were running around like headless chickens because they sensed that here was a technology that would destroy existing channels of distribution. How right they were."
Critics say that instead of embracing the internet by hiring visionary and innovative individuals, the firms turned to their lawyers in a fruitless attempt to crush illegal downloading before it could get off the ground.
Chris Parry, founder of radio group Xfm and Fiction Records, says: "Of course the industry has a duty to protect copyright, but ... the majors should also have taken the initiative by recruiting people who were internet-savvy. Few did so at the time." It has taken this long for the record companies to fight back by collaborating with legal downloading sites such as iTunes in a bid to offset lost revenue from plummeting CD sales.
But internet piracy is still costing them billions a year and the recorded-music arms of the majors look to be in terminal decline.
According to the IFPI, the international music industry lobby group, 40 songs are being downloaded illegally for every legal download. Put another way, they say 20 billion songs were downloaded illegally last year and the situation is set to worsen following the spread of broadband to eastern Europe and other emerging markets.
The effect of piracy on the industry has been to spur consolidation as the big players scramble to cut costs by merging. There are now only four major music groups: Universal, Sony/BMG, EMI and Warner Music.
Last week, British-based EMI said it was recommending to shareholders a takeover approach from Terra Firma, the private equity group headed by Guy Hands.
The idea of private equity getting involved with the topsy-turvy world of the music business surprised observers. But the attraction of EMI for Hands is that about 60 per cent of its income is from publishing. The publishing arm collects royalties when a track by one of the firm's artists is played live, on the radio or via any other medium, offering private equity a reliable stream of revenue.
EMI has an enviable roster of artists including the Beatles, Robbie Williams, Norah Jones and Coldplay.
But what will Hands do with EMI's recorded music arm? His associates say he could keep it, and that there are plans to extend its reach, but exactly how remains to be seen.
"Perhaps he has in mind a business model that pays more attention to the internet than EMI's previous owners," says Lorna Tilbian, an analyst at Numis Securities.
But within the music industry there are those who suspect that Terra Firma will sell on the record company to America's Warner, which this weekend is weighing whether to launch a counter-bid for EMI, headed by Eric Nicoli.
Tilbian says: "People still want good music: the thing that is different is the distribution platform, not people's appetite for entertainment. That's the challenge for EMI's management, private equity or otherwise."
But Paul Brindley, head of digital music research consultancy Musically, thinks the outlook "is not terribly encouraging".
"There are no easy solutions while piracy remains rife," he warns. But his advice to the record companies is not to repeat the mistake they made with Napster by failing "to grasp the internet nettle".
He suggests that the industry should "rewire itself" by creating more web subscription services, as well as look to advertising for revenue streams by launching free or nearly free web networks of their own, or forging alliances with new players.
He says: "The real challenge is to capture business in a market where many consumers believe that they should be able to download what they want, when they want, free of charge."
In the interim, legal challenges to protect copyright continue: US and UK trade bodies have reached a settlement with Sharman Networks, which distributes software applications that are believed to account for 15 per cent of music file-sharing.
Some 18 months ago, there was a landmark US Supreme Court ruling in the MGM-Grokster case, which undermined the legal status of file-sharing networks by stating that they could be held responsible for copyright violations committed by their users.
Following the hearing, Grokster ceased operating, while other networks agreed to install filter technology to curb abuses.
But piracy remains rampant. A US study has found that, while there is evidence that the number of homes involved in illegal downloading has held steady, the amount of content they are taking has increased. Also, as file-sharing services are closed down, new ones spring up.
But Geoff Taylor, of the British Phonographic Industry, says the primary motivation behind legal action is to raise consciousness: "We want to establish that file-sharing is illegal."
The problem has been exacerbated by the fact that a lot of song swapping on the net now takes place on closed social networks or blogs. Brindley says it is hard to know "which business model will fly and which won't".
If he is right, the future owner of EMI's recorded music division will quickly discover that running the business is not a whole lot different from pushing water uphill.
CAREER OF A WHIZZ-KID
Guy Hands, the head of private equity group Terra Firma, is known as a financial whizz-kid after turning around the fortunes of businesses that include the UCI cinema chain and energy group WRG.
As an undergraduate at Oxford, he shared a home with future British Conservative party leader William Hague before joining Goldman Sachs.
He made his name as head of a London-based buyout group owned by Japanese banking giant Nomura, becoming the country's biggest pub landlord after buying the betting chain William Hill and assets such as Angel Trains and army housing estates.
Setbacks include failing to acquire Thames Water and Alliance Boots.
Whether he will succeed in purchasing EMI is open to question. His £2.65 ($7.23) a share cash bid is seen as gutsy, but Edgar Bronfman's Warner Music is poring over EMI's books with a view to making a higher offer.
Rival private equity groups, such as Cerberus, are also circling. But Hands will be reluctant to let it slip through his fingers.
- OBSERVER
