Take A Chance On Me (Part 3)
Why is Music IP considered an attractive asset class? … and avoiding potential pitfalls
“I think everyone realized that publishing catalogs were assets you could finance, like a building. And the forecasts the investment banks are making for the number of streaming subscribers in the next 10 years are extraordinary. So investment bankers, hedge funds, private equity -- they all look at this as an asset class. Now there’s an awful lot of them, but those who know what they’re doing will make the right acquisitions. There are some who don’t know what they’re doing, and they’ll buy something and put it in a drawer, hoping that when they open it up, it will be terrific. But there will be others who will buy songs and know how to market, exploit and create more value for them. And some assets will come up for sale because they didn’t meet the financial expectations of the owners, and that might be a good opportunity for some new player entering the world of publishing acquisitions.” – Martin Bandier, former CEO and Chairman of Sony/ATV Publishing[1]
This is the third and final article in our three-part series on music intellectual property (“IP”) investing. In this final article, we will look at why music royalties are considered an attractive asset class in the current market environment. We will also review the main levers that active investors use when attempting to increase the value of their music IP. Finally, we will highlight ways to invest in music IP and some potential pitfalls to look out for.
Why Are Music Royalties Considered an Attractive Asset Class?
Streaming has brought greater stability to music royalty cash flows. As we discussed in Part 2, digital streaming has driven the growth in global recorded music revenues after 15 years of declines caused by piracy and the decline of the physical album. This has created greater confidence in owning music IP assets and the royalty income derived from them. At a song level, new music royalty income typically sees its greatest income 3 to 12 months after release. Income then declines to lower levels over the next 5 to 10 years. At this point, the remaining ‘tail’ of income often bounces around but remains relatively stable thereafter. Please note that this is a generalization as the rate of decline will vary, and each song and song catalog will show its own unique characteristics.
For a real example that highlights the impact of streaming growth, let’s take a look at a catalog of songwriter performance royalty income. This catalog includes interests in hip-hop songs including a partial interest in Jay-Z’s Grammy winning “Empire State of Mind.” The catalog was sold via Royalty Exchange, an online marketplace to buy and sell royalties.[2]
The catalog contains songs released between 2001 to 2009 with an income weighted average release year of 2009. Royalty Exchange provided three years of catalog income data starting in 4Q 2015, implying we are analyzing years 7 through 9 after release (i.e. the typical ‘tail’ of a song or catalog of songs). As you can see in the chart, the catalog’s annual cash flow fluctuates around $30,000 per year. Much like streaming is driving music industry growth, this catalog’s streaming income grew 33% during the twelve month period prior to sale, supporting the catalog’s cash flow stability. Again, each catalog will have different characteristics, but in general, streaming is helping to offset declining income in other formats such as downloads and physical (e.g. CDs and vinyl) sales. Greater income stability provides music IP investors with more confidence in the asset class.
Music royalties are a source of recurring income. As we discussed in Part 1 of this series, music royalty income is collected by several different distributors. This income is paid to music IP rightsholders usually on a monthly, quarterly, or semi-annual basis. These recurring payments are desirable to investors looking for a source of predictable income, typically found in asset classes such as real estate.
Music royalties often have attractive yields. In the current market environment, investors are searching for opportunities to earn something on their cash without a high risk of losing their principal. For example, as of September 2020, the US 10-year Treasury yield was 0.7%. The S&P 500 dividend yield was 1.8%.[3] And the Vanguard High Yield Corporate Bond (VWEHX) yield was 3.9%.[4] In this context, music royalties can often look like a relatively appealing asset class. For example, Royalty Exchange reports that the average annualized return on investment for catalogs sold on its platform was greater than 12%.[5] Hipgnosis Songs Fund’s (SONG) dividend yield was 4.1%.[6] And Mills Music Trust’s (MMTRS) dividend yield was 9.6%.[7] At the same time, it is important to remember that music royalty income fluctuates and is not fixed. And, as we already discussed, music royalty cash flows for a song often decline over time. In other words, the last twelve months’ royalty income does not necessarily mean the next twelve months’ income will be equal or greater. We will cover this dynamic more later in this article when we discuss potential pitfalls of investing in music IP. Even still, investors find the opportunity to acquire, aggregate, and potentially leverage these higher yielding assets attractive.
Music spending has historically shown little correlation to broader economic activity. As we discussed in Part 2, music spending and the associated royalties are holding up well relative to other industries during the COVID-19 pandemic. Historically both recorded music and music publishing data has not seen a clear correlation with broader spending activity. In the below chart, Goldman Sachs highlights this lack of correlation by comparing the recorded music industries 15-year decline due to piracy and its subsequent streaming driven rebound versus personal consumer expenditures (“PCE”). Per Goldman, recorded music spending has outgrown PCE growth by a factor of 2.4x since 2016.[8]
Music publishing income has been more resilient through economic cycles. The below CISAC data shows music collections for its members remaining steady during the Great Recession.
Public equity markets provide a couple of examples of music IP assets’ relationship to the broader market. For example, Mills Music Trust (ticker: MMTRS) has a -0.65 beta indicating MMTR generally moves in the opposite direction of the market.[9] Hipgnosis Songs Fund (ticker: SONG-GB) has a 0.21 beta suggesting much less volatility than the broader market.[10]
The combination of stability, recurring income, attractive relative yields, and less correlation to broader economic fluctuations has made music royalties an attractive asset class for investors.
What are the Main Levers Active Investors Use to Increase Value of Music IP?
In addition to the above reasons, investors in music IP can actually work to increase the value of their investment. Active investors use three main levers to increase value:
1) Developing performing artists and songwriters who create new music IP. Traditional record labels and music publishers spend significant time and capital identifying talented performing artists and songwriters and then helping them create and market new music IP.
2) Finding creative licensing opportunities for existing music IP. Labels, publishers, and royalty funds, which have the ability to license their music IP, will “work” their existing catalog of songs by finding new licensing opportunities in film, TV, advertising, cover songs, and video games.
3) Decreasing cost and payment timing of royalty collections. As we saw in Part 1 of this series, the flow of funds from end consumers to music IP rights owners is complex and often involves many “middle men” collection societies and agencies. Payment timing between these royalty collectors and rightsholders can take 6 to 12 months or more. Labels, publishers, and royalty funds, which have the ability to administer their catalog of songs, will look to minimize these costs and the time lag between payments in order to maximize cash flow available to shareholders.
What are Some Potential Pitfalls to Consider?
There are many potential pitfalls to consider when investing in cash flowing music IP assets and the companies that own them. We will narrow these risks to ones we see as most important when acquiring income producing music IP. Notably, we are not considering the risks with finding and developing new artists and songwriters.
Valuation Risk. When purchasing a music IP asset, there is always potential that you could overpay. For example, as discussed earlier, music royalty income typically declines rapidly in the first several years after release before leveling off in years 10 and beyond. If you paid 8x last year’s cash flow for a song catalog that is, on average, 1 year old, that implied 12.5% yield will likely be much lower in year 2 if the cash flows follow a typical song decay path. On the other hand, if you paid 8x for a catalog that is 15 years old with a history of consistent income, that 12.5% yield will likely, all else equal, be more stable in the future. To this point, music industry journalist Cherie Hu published an essay on Hipgnosis that covers the company’s average acquisition multiple in relation to its catalog age in which she states, “Multiple sources I spoke with were concerned that this maturity mix would struggle in the long term to generate the returns Hipgnosis is promising for investors, especially given the 13.9x multiple that the fund is paying for its acquisitions.”[11] Catalog age is very important, but it is just one important factor to consider in music IP valuation. Some others include royalty type, genre, income diversification by song, and termination rights. In summary, paying a reasonable price is critical in order to generate compelling returns.
Counterparty Risk. It is important to do the necessary legal diligence to verify the chain of title and confirm the seller owns what he or she says they own. Some special considerations that can add complexity to a transaction include liens on the seller’s asset, bankruptcies, divorces, and estates.
Technology Risk. Napster disrupted music in the 2000s leading to 15 years of recorded music industry declines. The proliferation of smart phones and streaming has reversed this trend and helped the industry return to growth. Technological innovation can have a material impact on music royalties.
Regulatory Risk. As we discussed in Part 1 and 2 of this series, many music royalty rates, especially rates related to the musical composition copyright, are regulated. For example, US musical composition mechanical royalties are regulated by the Copyright Royalty Board, a panel of three judges who determine music royalty rates and terms over a period of time. While most of the recent royalty rate decisions have been positive for music IP rightsholders, future changes to rates could have a material impact on music IP cash flows.
Inflation Risk. Most types of music royalties do not immediately react to price inflation. As we discussed above, many royalty rates are regulated with a rate structure set for multi-year periods. In their 2011 research paper, professors Peter Alahdeff and Caz McChrystal noted that regulated US physical mechanical royalty rates paid to songwriters and publishers in the US have been “devaluing steadily against inflation since 1976.”[12] At the same time, unregulated royalty rates often have a duration of more than one year. Meanwhile, streaming services, such as Spotify, have not focused on increasing prices to the consumer, resulting in a decline to their average revenue per user and per stream royalty rate over time. In short, a sudden increase in inflation is unlikely to be reflected, at least in the near term, in music royalty rates.
How to Invest in Music IP?
We think about investing in music IP assets in three ways: 1) record labels and publishers; 2) music royalty funds; and 3) direct purchases of music IP assets.
1) Traditional record labels and publishers are difficult to gain direct investment exposure to because most are a part of a larger conglomerate (e.g. Sony, Universal, BMG) or private (e.g. Concord Music). However, more traditional labels and publishers are going public. Warner Music Group (ticker: WMG) priced its IPO in June 2020 and Vivendi (ticker: VIV.PA) announced that an IPO of its subsidiary Universal Music Group is planned by 2023 or earlier.
2) Music royalty funds are mainly private but a few are public. Hipgnosis Songs Fund and Mills Music Trust are two examples of publicly traded companies that own interests in music royalties and distribute the majority of available cash flow after expenses to shareholders. In the private market, Shamrock Capital recently closed a $400 million fund focused on music and other content IP.[13] Round Hill Music has mentioned that it is currently fundraising for its third music IP fund.[14] However, these private royalty funds typically have significant minimum investment amounts ($5+ million) meaning their target investors are often institutions and ultra-high net worth investors.
3) Direct purchases of music IP occur in the private market. Online marketplace platforms, such as Royalty Exchange, are making direct ownership of music IP assets more accessible for the average investor. Royalty Exchange offers smaller deal sizes that range from $5k to less than $1 million and also typically offers passive interests in a catalog of songs, so an investor is only collecting the ongoing distributions, much like “mailbox money” that you sit and wait to collect. However, there is some work required on the part of an investor to properly value the catalog, as opposed to relying on (and paying) the managers of a record label, publisher, or music royalty fund to do this.
In short, many find music IP investing attractive given greater stability, recurring income, attractive relative yields, and a lack of correlation compared to the broader market. There are several ways to gain exposure to the space depending upon an investor’s preferences with regards to investment size, liquidity, growth vs. dividend yield, and active vs. passive ownership. We hope this three-part series has provided you with a helpful introduction to music intellectual property investing. And if you decide to take a chance on this interesting asset class, we hope that it continues to be a resource along the way.
[1] Billboard, “Martin Bandier Bids Adieu to Sony/ATV Music Publishing”, https://www.billboard.com/articles/business/8504735/martin-bandier-leaving-sony-atv-interview[2] Royalty Exchange, https://auctions.royaltyexchange.com/auctions/jay-zs-multi-platinum-empire-state-of-mind/?origin=listings#Overview, note that 2016 is 4Q 2015 to 3Q 2016; 2017 is 4Q 2016 to 3Q 2017; 2018 is 4Q 2017 to 3Q 2018.[3] https://www.multpl.com/s-p-500-dividend-yield[4] https://investor.vanguard.com/mutual-funds/profile/VWEHX[5] https://www.royaltyexchange.com/buy-royalties[6] https://www.marketbeat.com/stocks/LON/SONG/dividend/[7] https://www.marketwatch.com/investing/stock/mmtrs[8] Goldman Sachs Investment Research, “Music in the Air: The Show Must Go On”, May 2020.[9] https://finance.yahoo.com/quote/MMTRS/[10] https://www.cnbc.com/quotes/?symbol=SONG-GB[11] Cherie Hu, “Will Hipgnosis Actually Work?”, https://mailchi.mp/cheriehu/hipgnosis?e=15f0232717[12] Peter Alhadeff and Caz McChrystal, “Inflation and US Mechanicals, 1976-2010”, https://cyber.harvard.edu/sites/cyber.harvard.edu/files/Rethinking_Music_Inflation_US_Music_Mechanicals.pdf[13] https://shamrockcap.com/news/shamrock-capital-announces-the-close-of-its-second-content-fund[14] https://www.musicbusinessworldwide.com/josh-gruss-round-hill-anyone-can-go-out-and-spend-1bn-the-trick-is-getting-a-good-return-for-your-investors/