Hipgnosis Songs Fund - Are Music Royalties Just a Low-Interest Rate Bet?
Thanks to all who are reading this week - criticism is welcome.
A decade plus long period of low-interest rates sent investors in varied directions in search of yield, some more conventional than others. Piling into tech companies that hadn’t yet made money was a well-trodden approach, but asset allocation got weirder as the years continued. The most salient example of this is probably NFTs, although perhaps that was a result of people locked indoors rather than an effect of monetary policy decisions. Another esoteric asset that remained subdued until 2020, soared in popularity, and then came crashing back down to earth was song catalogues. The crude pitch behind investing in song catalogues is that, if well-constructed, they produce a steady stream of income from royalties every year. This idea was especially attractive when people received very little yield in return for holding treasuries. Additionally, people listen to music irrespective of economic conditions, so it should be an asset that continues to perform even in downturns. There were also a few reasons to think that song catalogues would be valuable on top of a consistent music royalties revenue stream:
· Global music revenues peaked in 1999 and then went through a significant decline with the rise of online piracy. Recently, however, that decline has reversed with the growth of streaming services. Should streaming revenues continue to grow, music royalties will increase.1 Investing in song catalogues thus seemed like a good option for the investor who didn’t like Spotify’s negotiating position but believed streaming was the future.2
· The pandemic meant that live performance royalties were artificially suppressed, so valuations would benefit from a return to normalcy.
· There wasn’t a lot of crowding in the song catalogue market. Being early to invest in the asset class meant not only benefiting from a rise in streaming revenues but also benefiting from other investors realizing it’s an attractive asset class.
· The best people to evaluate promising song catalogues probably aren’t those with a Harvard MBA who have spent 15 years in private equity or at a hedge fund. Consequently, there may be a lot of alpha in finding and partnering with talented music executives to help identify and manage the assets. These executives don’t just (in theory) have a better sense for which assets look promising; they also have valuable relationships within the industry.
· There are opportunities for active value creation once music assets are acquired. One way to do this is by moonlighting as a songwriter lobbyist. Pushing up the percentage of revenue Spotify has to pay out to artists is valuable! Another way to create value is by pursuing synchronization revenue opportunities, or revenue produced when copyrighted music is used in film and TV shows. Synchronization fees can come with the added benefit of reigniting a song’s popularity, which leads to more streams and thus more royalty fees. A fund that’s better at pitching its music to film and TV producers should, ceteris paribus, perform better over time.
· The actual collection of music royalties is a massive pain, sitting somewhere between a supplier getting paid by a private equity backed business and a doctor getting paid by an insurance company. A fund that figures out a method to make this payment collection process more efficient gets paid faster and deserves a higher multiple on its own valuation.
It's fair to say that, at this point in time, the bull case for investing in song catalogues hasn’t played out as hoped. One of the most prominent examples of an investment vehicle in this ilk is Hipgnosis Songs Fund, which was, until recently, run by Merck Mercuriadis. Merck spent his career in the music industry, managing artists such as Beyonce and Guns N’Roses. Said differently, he seemed like the ideal candidate to identify promising music catalogs; not many asset allocators would succeed in getting Beyonce to take their call! In addition to running the fund, Mercuriadis also partnered with Blackstone in October 2021, aiming to invest a billion dollars into the catalog asset class. Despite Merck’s bona fides, HSF’s performance has been lackluster, with its market cap now trading far below the fund’s net asset value. Four factors have driven this performance: a lack of clarity into valuation methods, expanding too quickly, interest rate hikes and the reality that most music royalties aren’t all that stable of an income stream.
The downside of investing in a newer asset class is that, even with a former industry executive at the helm, it’s not always obvious how the assets should be valued. There’s essentially one ‘independent’ third party valuer for music rights, Citrin Cooperman, and its methods are somewhat questionable. One of the more entertaining pronouncements made was that it wouldn’t be altering the discount rate it applies to music royalties even after the Fed had raised rates on multiple occasions. More concerningly, it also marked down the valuation of Hipgnosis’ song catalog after a US Copyright Royalty Board ruling that increased the expected royalties artists would receive for their music. Lobbying for higher artist payouts was a worthwhile value creation path for management to pursue, but that was with the assumption that its third-party valuer had a sensical methodology.
The second issue Hipgnosis ran into is a common one: expanding too quickly. As mentioned above, a key part of the fund’s value proposition was the active management of songs. Investing in music wasn’t just about harvesting royalties in perpetuity, but also about pursuing opportunities to grow a song’s popularity. Pursuing such opportunities is challenging, however, if after just a few years you’ve purchased over 65,000 song titles. Said differently, Hipgnosis succumbed to the same temptation that many fund managers fall to. When paid a management fee that’s a fixed percentage of assets, the best way to increase one’s salary is to grow AUM, which necessitates deploying a lot of capital, which probably results in letting investment standards slip, which doesn’t actually matter to the manager because he’s getting rich on management fees not his performance.3
There’s also a question as to whether song catalogs really produce a steady stream of income year in and year out. Mercuriadis often compared music to assets like gold or oil, but it’s probably more like an oil well or a patented drug. It gushes money for a few years, but then revenues drop precipitously and a newer song comes to take its place. That doesn’t hold for all music: Blackstone has Leonard Cohen’s Hallelujah in its catalog, which even though it was first recorded in 1984 accounts for 13% of the music fund’s revenues. But that’s a rare example; on the whole, it’s unlikely that a portfolio of 65,000 songs exhibits that degree of longevity.
Perhaps the biggest nail in the coffin for song catalogs is that the asset class was really a bet on interest rates rather than anything else. Catalogs were attractive in 2020 principally because bond yields were low, rather than for any of the other factors mentioned above. This was reflected in the prices paid. Paying up for an asset that yields 5% a year makes a lot more sense when rates are zero rather than when they’re above 500bps. When rates are hiked, one’s left with an asset that suddenly needs a much higher yield to be attractive to either fund investors or prospective buyers. That knowledge may not be useful in overly exuberant markets. Sequoia and Benchmark had to pay up for startups in 2020, but they could still probably win against a venture investor willing to pay a higher price but who had no brand name. With already famous musicians, however, there’s very little you can offer them other than more money. In that light, the best bet it probably to buy portions of their catalogs rather than buying them outright. In that situation, the abilities of the investment manager do matter to the seller. The more that manager can increase your popularity, the more money the artist and the fund receive over time, and so the more individual competence matters. That music royalties are so sensitive to interest rates doesn’t mean it can’t be an appealing asset class. There are real opportunities for active management there, and someone with industry connections has a competitive advantage that’s difficult to replicate. But, as with most things, valuation matters a lot.
Disclaimer: The information in this post is not intended to be and does not constitute investment or financial advice. You should not make any decision based on the information presented without conducting independent due diligence.
Assuming that royalty rates stay constant.
The other option would be to buy shares in Universal Music Group, as Ackman has done.
OSAM has a piece ‘Alpha or Assets’ that broadly describes this phenomenon. This works differently for public markets investors, where investing at scale is an issue because it’s so challenging to outperform when your investable universe is only large cap names.