Investors are understandably in a jittery mood. In theory this is the perfect environment to start seeking out alternative sources of return – be it from dividends or capital growth.

Curiously though some of the most ‘alternative’ of asset classes available through the listed fund structure are having a torrid time. The cynic might conclude that just when you wanted said alternatives to provide diversification, the exact opposite is happening.

Over the next two weeks I’ll be looking at two, innovative, fresh asset classes which have raised a tonne of money on the promise of differentiated alternative returns: next week I’ll look at digital infrastructure but this week I want to focus on music royalty funds, namely Hipgnosis Songs (SONG ) and Round Hill Music Royalty (RHM ).

Everything seemed to be going swimmingly for both until the late summer of 2022 – both funds were raising lots of cash and traded at a premium to net asset value (NAV). In the middle of August 2022 Hipgnosis – still the biggest fund by a considerable margin – traded at 115p yet by mid-October that had collapsed to just under 80p. Since last autumn the share price has bumped up and down, and on three occasions has pushed above the psychologically significant 90p level, but overall sentiment remains bearish. Both funds trade at a discount to NAV of more than 40%.

Streaming is growing

Yet look at the six-month returns against listed players in the music streaming business – platform Spotify on one hand and labels Universal Music Group and Warner Music Group – tells an interesting story. Both music royalty funds are down over 20% whereas Spotify is up nearly 20% (admittedly from a depressed level) while both Warner Music and Universal Music are up around 8%. Clearly this isn’t a purely music royalty related story.

Data coming back from the music industry confirms that the long-term narrative driver for the music royalty proposition is alive and kicking. Put very simplistically, both funds aim to generate a steady income from a stream of royalty payments sourced either from streaming platforms or from a wider portfolio of payments including Tv and film sync rights through to traditional royalty payments.

The driver here is that our consumption of music shows no signs of abating and that owners of said copyrights will benefit from a series of tailwinds, most notably the sheer growth of more content using music generally. Within this is a more specific shift towards streaming music which brings with it payments to music royalty owners.

Music industry data from the Recording Industry Association of America (RIAA) in the USA confirms those tailwinds are intact. The latest data for 2022 revealed streaming revenues increased by 7.3% y-o-y in the US, with streaming accounting for 84% of the total recorded music spent in the US.

US recorded music revenues have grown steadily over the last few years, starting at around $20bn in 2020 but rising to $26.2bn in 2022. Within this broad trend US paid music subscriptions rose from 46.9m in 2018 to 92m in 2022 although it’s worth noting that as streaming has gone mainstream the growth rate has dropped from over 30% pa to under 10% pa.

And the price consumers are paying for music streaming has increased as well – the most recent RIAA data implies that US streaming accounts spent $12 per month in 2022, up by about one dollar since 2020. Numbers from Spotify also confirm these trends: Spotify’s fourth quarter results highlighted ‘premium subscribers’ and ‘total monthly active users’ had risen by 5% and 7% respectively quarter-on-quarter (14% and 20% year-on-year).

So, music royalties are growing, and the narrative offered by the funds is in place. What’s even more peculiar is that the numbers coming back from the funds is largely positive. Take Round Hill, which recently announced that in the fourth quarter its book valuation rose 8.4%, hitting $1.28 with the main driver 15% organic growth in the extensive catalogue.

Post-Covid income is picking up and the fund noted that its largest portfolio holding, the Offspring catalogue, ‘has seen a 25% increase in royalty income due to the release of the Greatest Hits album in July 2022 and an extensive touring schedule of the band”, according to Liberum analysts.

The most recent data from Hipgnosis was back in December when the fund reported a small 1% decline of NAV in dollar terms in the previous six months with ‘operative’ NAV at  $1.8312 (164.06p). According to a Numis report on these results ‘proforma streaming revenue grew strongly to $23.56m, up 15.8% year-on-year, reflecting the focus of the portfolio on songs with high streaming consumption (SONG owns a share in 24% of songs in Spotify’s Billions Club).’ The portfolio is valued at a 19.93 times multiple of historical annual net publisher share income, compared to the blended acquisition multiple of 15.93 times.

Valuation questions

These results do, however, give us a clue as to why sentiment might be muted. Take the valuation of their assets by external experts. Both funds use an independent outfit called Citrin Cooperman, although Hipgnosis has also said that it has ‘used Kroll to advise on the reasonableness of assumptions’ while Round Hill has said it has ‘instructed a second independent valuation’. The cynic might question whether the reliance on just one valuer is advisable?

As for dividend cover, Hipgnosis has said that ‘it expects dividends paid for the current financial year to be covered from distributable revenues recognised in the period’ while Round Hill’s dividend is not currently covered and according to a fund factsheet is running at 0.9 cover.

And then there’s the discount rate applied to those hard-to-value private assets. Hignosis has not changed its discount rate as interest rates have increased and it currently stands at 8.5%. Hipgnosis did observe that if the fund increased its discount rate to 9%, NAV would take a 7.9% hit. The fund also highlighted that current share price in December implied a 12% discount rate. Round Hill also uses a 8.5% discount rate.  

Stepping back from the multitude of different data points it’s obvious that there are a handful of interrelated concerns. The first and most obvious point to make is that both funds are largely income plays. Their current net yields run in the 6.1% to 6.3% range whereas investors can access relatively safe, risk-free bonds yielding in the 4% to 6% range. Ideally, in the current rates environment, investors might be looking for yields closer to 8% to be rewarded for the extra risk of investing in a relatively illiquid asset class.

Validation needed

That said these relatively low yields might be acceptable if the funds also delivered significant NAV growth. Round Hill’s latest NAV results – and all that music industry data – does back up this growth argument, especially as both funds become much more active marketing their catalogues (Hipgnosis has a big and growing sync rights agency business which places music in all manner of contents).

But the hitch here is that that NAV growth is dependent on those independent valuations, by the same firm. Ideally investors might seek comfort in other data points, such as secondary market transactions where valuations are established. Both funds can point to second opinions on valuations and to music industry deals but a concern remains – the music rights world is a small one with a limited number of buyers, all of whom work closely with each other. If either fund was a forced seller, the shortlist of buyers would be very short indeed.

Given these risks on valuation – and lack of historic dividend cover – one might be reassured again if the discount rate applied to these valuations was higher. Over in the infrastructure sector for instance discount rates are being nudged up, yet to date both music funds have stuck with an 8.5% rate. Perhaps a more aggressive approach, pushing that rate past 10% might ironically reassure investors even though NAVs would decline substantially.

In the round though, I would argue that the current cavernous discounts to NAV do provide investors with some safety margin, provided they can become comfortable with the valuation methods. The tailwinds I described are real and both funds have quality – if arguably expensively acquired – catalogues which should continue to kick out more cash which in turn over time will back up those dividend payments.

My gut feeling is that the only catalyst for revaluing the funds will be a secondary market transaction to raise cash and prove the valuations. Neither fund will be able to raise fresh cash given these share price discounts, so if they want to buy up tomorrow’s interesting royalty portfolios, they’ll be forced to think creatively. Sell some assets, and prove to investors that these private valuations really are on the mark. 

Any opinions expressed by Citywire, its staff or columnists do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account people’s personal circumstances.