Pitcher Partners Investment Services (Melbourne) | The information in this article is current as at 07 July 2023
With the outlook for global growth deteriorating, we continue to seek out strategies and investment solutions that can deliver unique streams of capital growth and income to your portfolios.
The Alternatives asset class continues to play a critical role in offering these types of solutions for you and we remain committed to identifying and maintaining an approved array of high-quality strategies in this asset class.
We fully acknowledge the complexity surrounding some of these strategies, many of which are relatively new to the Australian private wealth sector. Last quarter we provided an overview of the role and benefits of managed futures (commonly referred to as CTAs). This quarter we turn our attention to royalty financing, an investment strategy which has the potential to generate attractive, unique and resilient performance over time.
What is a royalty?
A ‘royalty’ is essentially a funding method that allows businesses to secure capital in exchange for a portion of future revenues. It can also be referred to as Revenue Based Funding (RBF).
Royalties can be found across a wide array of industries, including but not limited to music, mining, energy, pharmaceuticals, software and water rights. For example, a music royalty could be getting a slice of the revenue that Beyonce, Elvis or the Beatles receives every time one of their songs are played on the radio. You could also receive a percentage of the sales for every tonne of iron ore sold to a steel mill or, in healthcare, a fixed proportion of all sales from a new or existing drug.
There are generally two main counterparties to a royalty. The owner of the asset (which could be a physical or intangible asset such as image rights, music rights, patents and others) and the operator, which is essentially the business or entity that is managing the asset.
An example of how some of these transactions work is made via the schematic below.
Source: PG3, Longreach, PPIS Research
Entering into a royalty agreement can be beneficial to both counterparties. It may suit an owner of an asset who does not have the capability, expertise or physical resources to operate an asset, while the operator of the asset may not be able to create or acquire the asset for financial, legal, jurisdictional or scarcity reasons.
Here is an overview of some of the major industries active in the use of royalties:
- Entertainment and Media: The entertainment industry, including film production, music, and digital media, can benefit from royalty financing. Investors in this sector often provide upfront capital in exchange for a percentage of future royalties generated from movies, music sales, streaming platforms, or licensing deals.
- Pharmaceuticals and Biotechnology: Royalty financing is also prevalent in the pharmaceutical and biotechnology sectors. Companies engaged in drug development or medical research may choose this financing method to access funds for clinical trials or product commercialisation. Investors receive royalties based on product sales or licensing agreements.
- Natural Resources: Royalty financing finds application in the natural resources industry, such as mining, oil, and gas. Investors provide capital to fund exploration or production activities in exchange for a share of the revenue generated from the extracted resources.
- Technology and Software: Many technology start-ups and software companies opt for royalty financing due to its flexible repayment terms. These industries often face unpredictable revenue streams in the early stages, making royalty financing an attractive option to fund growth without immediate repayment obligations.
While the royalty market is relatively early compared to more traditional asset classes, a number of the sectors offer a wide opportunity set.* In North America alone, the energy royalties sector is estimated to be worth >US$500bn with some estimating the value to be closer to US$1 trillion. The sector has established multi-billion-dollar royalty players, such as Franco Nevada (CAD$35bn) and Wheaton Minerals (US$18bn) who have grown materially over the past decade. In the music industry, 2021/2022 has seen major private equity players such as Blackstone and KKR enter the space, deploying US$500m to US$1bn alongside traditional music royalty funds and listed music royalty funds such as Hipgnosis Song (listed in the UK). In the pharmaceuticals industry, the market opportunity is estimated to be worth of US$300bn and has established players such as Royalty Pharma, Oaktree, Blackstone and Canadian Pension Funds as the key players on the large-scale royalty deals.
*Industry size data sourced from PG3.
Royalty investing requires significant expertise
Entering into a royalty agreement is extremely complex. It requires an ability to project revenues, volumes, and also protect your legal rights. It requires considerable resources and expertise across investment analysis, accounting, legal, industry knowledge and deal structuring – essentially sharing several of the major skillsets involved with private equity and other forms of private asset investing. We provide a snapshot of some of those considerations below;
- Revenue Projections: Determining accurate revenue projections can be challenging, especially for businesses in emerging industries, foreign countries or those with unpredictable revenue streams.
- Valuation: Valuing royalty agreements can be quite intricate. Investors need to assess the company’s revenue potential, growth prospects and market conditions to arrive at a fair value for the royalty stream they will receive.
- Due Diligence: Investors need to evaluate the company’s financial health, market position, competitive landscape, and intellectual property rights. Understanding the risks, potential legal issues and contractual terms associated with the royalty agreement is critical.
- Monitoring and Reporting: Investors must monitor the performance of the company and the accuracy of the royalty payments received. This involves ongoing communication and financial reporting from the business to ensure transparency and track the revenue generated. It requires the use of dedicated resources and systems, which can also involve the appointment of external auditors and forensic accountants.
- Exit Strategy: Exiting a royalty agreement can be more complex compared to traditional investments. Investors need to consider factors such as the length of the agreement, potential restrictions on transferring or selling the royalty rights, and the marketability of the royalty stream.
- Legal and Contractual Considerations: Royalty agreements involve detailed contracts that outline the terms and conditions, including the percentage of revenue, payment schedule, and rights and obligations of both parties.
Navigating these complexities requires careful analysis, risk assessment and a thorough understanding of the investment opportunity. It’s perhaps no surprise that the best investors in this field are those that exhibit deep specific industry expertise and experience. We clearly recommend advocating the use of specialist fund managers in this space.
Features Of Royalty Investing
Royalties potentially offer several benefits to prospective investors:
Source: Longreach, PPIS Research
A lot of these benefits can be secured contractually, providing a lot more security around your investment outcome than, say, investing in listed equities – the downside being that the return potential can be more limited. There are also some potential disadvantages or issues to be aware of when investing in royalties. A lot is reliant on the capability and trustworthiness of the operator of the asset. You are effectively ceding control of an asset to them, which is why so much emphasis is made of the due diligence and contractual terms between both parties. In addition, the unlisted/private nature of the asset does impact liquidity, although some royalty markets, such as energy, can be very heavily traded during certain points of the cycle. Some of the major considerations are listed below:
- Unpredictable income
- Lack of control
- Limited upside potential
- Market and industry risks
- Lower liquidity
- Complex valuation
- Legal and contractual risks
The critical components that ultimately determine the performance of a royalty transaction are volume and price, each of which are then valued using appropriate discount rates. Reflecting the dynamics of certain sectors which can exhibit differing growth or demand dynamics, there can be a lot of volatility and variability of performance outcomes across this market segment.
Music royalties were in high demand during the COVID period as demand for streaming content surged, while musicians saw other forms of their personal income, such as concerts, disappear in wake of lockdowns. Mining and energy royalties can be volatile as commodity prices peak and trough, even if contractual volumes may be far more stable, though some of the pricing can be hedged using derivatives. Pharma royalties can be entered into pre or post Food and Drug Administration (FDA) approval; naturally any rejection by the FDA could render the value obsolete entirely. These are just a few of the numerous factors influencing return outcomes.
Benchmarking performance against a widely representative index is a challenge in this sector. Royalties are private assets, so there is no public exchange to easily monitor pricing and volatility. Some deals are liquid, some do not trade at all. Individual contractual terms dictate the outcomes for each royalty and there can be a lot of nuances across each one that drive different performance outcomes. Some are struck over differing time periods, some royalties deliver a greater share of the returns to the owner at the start, before allowing some of the greater gains to flow to the operator across later years. Some deals, such as such intellectual property rights, amortise over time, whereas some assets can be held by the owner permanently.
This is still a nascent investment opportunity for Australian private wealth investors. Offshore institutional investors can gain access to specialist sector strategies via closed end funds. There are also several listed companies in the UK and US which specialise in investing across a wide variety of individual royalties, providing an indirect but heavily diversified solution that listed investors can use to access this sector.
From our observations and discussions with fund managers to date, we believe a high single/low double return is achievable from this sector, albeit via a specialist active manager. Volatility is expected to range between equity and bond market-like levels, which is in part due to royalties commonly being priced on a monthly or quarterly basis.
We believe investing in royalty financing can offer investors a unique and attractive level of return, with lower volatility than equities. Its uncorrelated returns with the major asset classes highlight what an attractive role it could play as part of a diversified Alternatives portfolio. It is a highly specialised field and, in our view, best exploited via the use of leading fund managers in this field. Please contact your Pitcher Partners adviser should you wish to learn more about this sector.