Hipgnosis Songs Fund: striking a bum note?

The grey world of finance appeared to brighten in the summer of 2018 with the arrival of Hipgnosis Songs Fund (SONG). Led by industry veteran Merck Mercuriadis, a portfolio with Journey's Don't stop believin' among its assets added some colour to a world dominated by earnings ratios and other sober metrics.

This music royalties fund, which seeks to receive and build on the income generated from songs, has successfully issued equity several times since then, helping to take its market capitalisation past £1bn and elevating it into the FTSE 250 index. Hipgnosis Songs has acquired many assets, for example, in the first full week of 2021 its board announced three catalogue acquisitions, which include the work of Neil Young, Fleetwood Mac musician Lindsey Buckingham, and Jimmy Iovine who has worked with U2 and Eminem.

The rise of this asset class was strengthened further by Round Hill Music Royalty Fund's (RHM) successful initial public offering late last year (see box out).

At a time when equity dividends still look threatened, and bond yields are minimal or even negative, royalties trusts offer an attractive total return that includes a decent income. Although Round Hill Music Royalty will take some time to invest its proceeds and generate income, Hipgnosis Songs recently traded on a 4.2 per cent yield. Both trusts also offer returns based on trends, such as the rise of music streaming, that are largely uncorrelated to the stock market or economy.

“With the advent of streaming, and end of or diminished amount of music piracy, there’s a good structural growth story,” notes James de Bunsen, a multi-asset portfolio manager at Janus Henderson Investors. “Spotify (US:SPOT) has tens of millions of subscribers but there’s still more growth to go for, especially in emerging markets. The trajectory is easier to measure than with things like licensed venues.”

Gold rush

However, music royalty funds also incur a number of risks. There are a number of concerns on Hipgnosis Songs Fund, for example, some of which apply more broadly to the asset class. A central criticism relates to how assets held by Hipgnosis are valued. A third party assesses the value of a music catalogue after the trust has acquired it, but this appears to have resulted in significant gains. Analysts at broker Stifel argue that this is “despite the manager not having had sufficient time to add value or for underlying market assumptions to have materially changed”.

The changes relate to fair valuation uplifts, where growth assumptions are revised, and to changes in the discount rate, an interest rate used to determine the current value of future cash flows. The higher the discount rate, the lower the current value of future cash flows. The trust’s most recent C-share issue had its discount rate lowered from 9 to 8.5 per cent at the end of September – despite the relevant catalogues being held for less than three months. Although such gains could be misleading, they allow Hipgnosis Songs Fund to expand quickly, potentially on shaky foundations.

“We use the following analogy to describe the valuation methodology utilised by Hipgnosis,” explain analysts at Stifel. “An individual purchases a house from a willing seller in a standard sales process for £500,000. That individual then goes to an estate agent and asks them to value their new house, and they receive an estimated valuation of £550,000. The “gain” of £50,000 is then immediately booked by the purchaser who goes to their bank and asks for more capital to buy another house.”

When the music stops

Analysts, including those at Stifel, worry that a blanket discount rate is applied to different catalogues even though these come with different levels of risk. And some may wonder whether the numerous Hipgnosis Songs Fund acquisitions could push up prices, while a general lack of transparency has put some potential buyers off.

“They value [assets] on a discounted cashflow basis, looking at 15-year revenues and terminal value, and put a discount rate on it," says Mr De Bunsen. "But there’s not much transparency on how they value the discount rates. They don’t speak about individual discount rates."

The outlook is confused by other factors. As Stifel notes, a song streamed today “may not lead to a cash payment for at least six months and possibly longer”. So it can take investors some time to work out whether previous forecasts were correct.

Countering some of these concerns, Hipgnosis Songs Fund's managers have suggested that the discount rate used by the valuation specialist is fairly conservative, providing a margin of safety. They have also argued that valuation changes reflect the team’s ability to “buy well” and get greater value from acquisitions.

In the trust's half-year report, published in December, its managers argued that the lower discount rate reflected a "decreased risk premium associated with music's ever more stable and predictable earnings as a result of the increased consumption of music through paid streaming". 

If this trend were verified it could prove lucrative for investors.

Analysts at JPMorgan Cazenove similarly argue that rising music catalogue prices are in large part due to strong demand for long duration, low correlation assets – something that has helped infrastructure investment trusts trade on hefty premiums to net asset value.

“Undoubtedly there is a weight of money pushing up prices but it is far from the only reason," they say. "And it does not mean that Hipgnosis can’t make a good return on the assets if it bases its purchase price on a sufficiently high discount rate and leaves some room for upside in its cash-flow assumptions."

<box out> Round Hill Music Royalty vs Hipgnosis Songs 

Round Hill Music Royalty Fund's (RHM) investment team has already managed private music funds and plans to buy into an existing portfolio. A key difference between the two trusts is the maturity of the catalogues they hold. While Hipgnosis Songs Fund (SONG) has tended to have a heavy exposure to newer music, Round Hill Music Royalty has a greater focus on older catalogues. More mature catalogues are generally viewed as preferable because the music has stood the test of time.

Some of these characteristics might be reflected in their pricing, as Hipgnosis Songs shares recently traded on a 3.9 discount to its net asset value (NAV) compared with Round Hill Music Royalty's 5.9 per cent premium to NAV.

But Hipgnosis Songs has also invested in older catalogues, with some of its recent acquisitions serving as good examples. Hipgnosis Songs has also deepened its resources with the acquisition of Big Deal Music Group.

More generally, international exposure could leave both trusts vulnerable to currency fluctuations and their shares could be vulnerable to any broader market volatility.<box out>