Round Hill Music Royalty Fund — High-quality catalogue underpins value

RHMRF listed on the Specialist Fund Segment of the London Stock Exchange (LSE) on 13 November 2020, with the initial public offering (IPO) raising US$276.4m. It was the second UK-listed closed-end fund investing in music royalties (following Hipgnosis Songs (SONG), listed in July 2018). On 19 July 2022, the company’s ordinary shares were admitted to trading on the Premium Segment of the Main Market of the LSE. The company also introduced an additional market quote for the ordinary shares on the LSE denominated in sterling, satisfying one of the criteria for inclusion in the major UK indices.

RHMRF’s IFRS NAV is US$378.7m (as reported in the accounts on 31 December 2022) and the current market capitalisation is US$322.0m (5 June 2023). The economic NAV (see the NAV reporting section below) was US$519.6m or US$1.27 per share at 31 December 2022.

The company seeks to invest in music royalties with a proven track record and wide audience appeal. Further details of the investments are given below. It is worth noting that scale is of value in this industry. The more substantial the catalogue, the greater the bargaining power when it comes to negotiating licensing deals.

RHMRF targets an annualised total return to investors of 9–11% over the medium term, after fees and expenses. It also targets an annualised dividend payment of 4.5 cents per share, payable quarterly. For FY22, the company paid 4.875 cents, with the additional payment compensating for the lack of a Q1 payment in the prior year.

RHMRF publishes NAV twice a year as part of its reporting. Under IFRS, the songs in the company’s portfolio are classified as intangible assets under IAS 38. The catalogues are held at cost and amortised over their useful life (which is determined at acquisition), less any impairment.

As the IFRS approach does not reflect RHMRF’s portfolio value in full, the investment manager also publishes an ‘economic NAV’, which takes into account third-party valuation of its portfolio. The company relies on third-party valuation specialist Citrin Cooperman, and the end-2022 valuation was also confirmed by a second third-party valuation specialist, FTI Consulting, to provide an additional data point for the market on the fair value of RHMRF’s investments. In our analysis we rely on economic NAV as determined by Citrin Cooperman unless stated otherwise.

On 31 December 2022, RHMRF’s economic NAV per share stood at US$1.27 (based on Citrin Cooperman’s valuation, or US$1.28 according to FTI Consulting’s valuation) representing an 18.0% uplift in FY22 in total return terms. The portfolio value is determined using a discounted cash flow approach and the end-2022 valuation reflects:

Management commissioned an additional independent valuation from FTI Consulting as at the FY22 year-end, which was published in April 2023, ahead of the publication of the results. FTI Consulting’s methodology differs from that offered by Citrin Cooperman, and is based on:

This degree of detail (and hence time and expense investment) makes the approach unsuitable for regular usage but serves a valuable benchmark to the standard approach.

The FTI valuation was done on two bases: traditional bank debt financing and asset-based financing, using WACCs of 9.25% and 8.25%, respectively. The outcome is shown below, with the bank financing-based modelling resulting in a valuation 9% higher than that determined by Citrin Cooperman and the asset-based financing coming in 3% below, and therefore giving additional credence to the original valuation methodology.

The Q123 trading update shows that the momentum from FY22 has continued into the new financial year. Combined NPS/NLS was US$10.1m, 91% ahead of that recorded in Q122. Much of this gain is down to the prior year acquisitions of the catalogues of Alice in Chains and David Coverdale. Revenue from the initial investments was ahead 20%, with adjusted income from publishing rights up 22% and from masters’ rights up 14%. Income from the Carlin interest trebled to US$1.0m, with an element of catch-up as revenues were collected from a sub-publisher handling territories beyond the US, UK and Nordics.

The statement also highlights the positive benefits of putting more effort into driving synchronisation (sync) revenue, which was up by 74% on the initial investments, with a number of notable deals mentioned, including the use of Louis Armstrong’s What a Wonderful World on film, TV and advertising projects.

Group revenue for the year to end December 2022 was US$32.4m, a 32% increase over the prior year. On a like-for-like basis (excluding acquisitions made in FY21 and FY22) the growth was still a very respectable 15%. This comprises 16% year-on-year NPS/NLS growth from First Investment Catalogues and 10% year-on-year NPS/NLS growth from the Carlin Investment (all definitions are as per our initiation note). This growth is not solely attributable to streaming, although an improved licensing fee structure with Meta and TikTok has certainly helped. Synchronisation NPS/NLS generated on the initial investments were ahead by 33%, with masters ahead by 13%. Overall masters’ income was up by 70% over the prior year. This is particularly noteworthy as it represents significant outperformance of the industry, which management cites at 9% growth. The breakdown of revenues was as shown below.

Accruals represent a meaningful proportion of revenues because of the systemic delays in payments within the industry, which are typically of one to six months in the US and three to 12 months elsewhere, with some taking up to 24 months. The investment being made by Round Hill in data collation and management should help speed up this process, although inefficiencies outside of the group will doubtless persist. We would expect the proportion of revenue from accruals to decrease over time.

Excluding the amortisation of Catalogues, operating costs were US$12.0m for the year (FY21: US$10.6m). Costs mainly comprised investment management, portfolio administration, legal and professional, audit and administration fees, in addition to deal expenses incurred to enhance the income streams of existing Catalogues. The increase is largely due to higher Portfolio administration fees of US$0.9m year-on-year, which is due to an increase in NPS, US$0.5m of audit fees for the 2021 audit booked in 2022 and the one-off cost of US$0.5m for the move to the Premium Segment listing on the Main Market of the LSE.

Market forecasts show a slight pause in growth for the current year, but this may not be the case at the organic progress level, as FY22 will have benefited from the shift in the timeline for accruals coming through.

As at 31 December 2022, the ratio of debt to economic NAV was 17.7%, well below the borrowing cap of 25%.

The FY22 accounts show finance costs of US$4.2m, up from US$1.1m in FY21. The largest elements of this cost are the interest expense on the debt drawn down of US$2.2m, US$0.4m of amortisation of the loan arrangement fee and a US$0.1m of non-utilisation charges. The balance of US$1.5m was unpaid at the year-end. Each additional 100bps of interest rate movement up or down would generate a cost (or benefit) of US$0.9m.

We last wrote on the background to the music industry in our January report and there has been limited development since, with a slower pace of deals being agreed. Heavyweight private equity funds remain committed to the asset class, including Blackstone through its backing of SONG, Brookfield Asset Management’s US$2bn investment in Primary Wave, Apollo Global Management, with its US$1bn investment in HarbourView Equity Partners, KKR & Co, Pimco, Northleaf Capital/Spirit Music Group and Lyric Capital Group. Seoul-based Beyond Music has been building a meaningful portfolio, particularly in K-pop, and has made its first forays into the North American market. Weight of capital is important as it facilitates scale, with larger, diversified portfolios earning smoother revenue streams.

Rising interest rates have naturally undermined the relative attractiveness of music royalty revenues compared with other asset classes, but this does not detract from the underlying attractions, particularly regarding perennial music content. The economic backdrop should, at least in theory, have changed the framework for transaction pricing. However, given the levels of interest in assets – especially the headline-grabbing rights portfolios – the adjustment in transaction values may not be as marked as might be expected in more liquid, shorter-term assets.

The resumption of live music events and tours is a clear positive, reinvigorating sales of legacy content as well as newly released material and allowing the industry to return to generating income from merchandise.

In its annual report, RHMRF note the continuing supportive backdrop for demand for recorded music and, by extension, demand for the content within the group’s portfolio. This is particularly the case for digital revenues, where streaming continues to build. The largest streaming service, Spotify, grew its premium subscriber base by an extra five million in Q123, up 15% year-on-year, to 515 million globally. The longer-term record is shown below. This total was 15m above earlier guidance, with the growth across all geographic reporting regions and demographics, which shows a constructive background for demand for content.

In October, Apple Music increased its monthly subscription price for its streaming platform in the UK and the US by £1 and US$1, respectively. As the number of subscribers, songs and subscription prices on the streaming platforms increase, it is anticipated there will be a net positive impact on RHMRF's revenues.

These updates follow the positive news announced on 1 July 2022 that the US Copyright Royalty Board had upheld the 44% staggered increase in streaming mechanical royalty fees dating back to January 2018, which is expected to result in increased fees payable to RHMRF. The renegotiated rate settlement for the next period is for a headline rate of 15.35%, with the increase staggered over 2023–27.

In the UK, the PRS for Music collected a record £964m in 2022, up 23% on the prior year.

Given the pressure on household budgets with high inflation and increasing cost of living pressures, the place of music subscriptions in spending will inevitably come under scrutiny. However, music has become akin to a utility as it is a common accompaniment to daily activities. In more economically challenged households, there may be a return to advertising-supported listening, rather than a full ad-free subscription. However, we anticipate that the overall streaming market will continue to progress as older age groups become more accustomed to passive music consumption, with household penetration growth slowing in the more mature markets such as the US and UK.

There are other structural concerns, for example, industry commentators have highlighted the large number of music tracks being uploaded onto digital platforms and the advent of swathes of AI-generated content is likely to swell these numbers further. Having a high-quality portfolio weighted to classic tracks, such as that of RHMRF, is therefore a clear advantage in holding and growing share of listening.

Another potential challenge is the proliferation of short-form content, such as that on TikTok where short sections, rather than whole tracks, are used, although fee agreements are, at least, improving.

Given the swathes of lower-quality content proliferating on the platforms, there are increasingly voluble conversations between major industry players about how the music industry business model should evolve, and better reflect the value of those creating the content. Lucien Grange, CEO of Universal Music, has put his name to an initiative of a more ‘artist-centric’ model, albeit that this is very short on tangible proposals in the public domain. Negotiations behind closed doors are presumably carrying on with the platforms and other interested parties. A positive resolution here would also be financially beneficial to RHMRF.

The use of AI within the music industry is already well-established, but the framework within which it is being used is not yet fit for purpose. The biggest issue is that the AI models must be trained in order for them to generate output and the likelihood is that they will have been trained on material that is subject to copyright. This copyright may not simply cover the recorded material and may extend to encompass the name and likeness of the artist.

The CEO of Open AI, Sam Altman, recently appeared before the US Senate’s Judiciary Committee’s subcommittee on privacy, technology and the law and in his evidence commented:

‘We are absolutely engaged in that… We think that content creators, content owners, need to benefit from this technology. Exactly what the economic model is, we’re still talking to artists and content owners about what they want… I think there’s a lot of ways this can happen, but very clearly, no matter what the law is, the right thing to do is to make sure people get significant upside benefit from this new technology. And we believe that it’s really going to deliver that, but that content owners, likenesses, people totally deserve control over how that’s used, and to benefit from it.’

Seemingly, the law has yet to catch up with day-to-day activity and RHMRF’s management view is that it may take a couple of years to catch up.

AI is far from an unadulterated negative, though. Machine learning is already an everyday element of the monitoring of content usage and has been instrumental in driving efficiency in collections.

There have been no changes to the portfolio since our last report in January 2023, so the following section mostly replicates and updates our earlier document.

Since 29 December 2021, the group has announced six acquisitions of music publishing catalogues, master royalty income, recorded music income, neighbouring rights and publishing rights (for definitions, please see our initiation report). The investment manager mentions in its 2021 annual report that its strategy is to acquire vintage catalogues across publishing, recorded music and neighbouring rights. Financial consideration remains key, but Round Hill avoids pure asset gathering without fiscal prudency.

The manager’s non-quoted Funds Three and Three Plus have also continued to actively invest over the period and, along with the deals outlined above, a total of over US$200m has been spent on 40 assets. Notable transactions for the private funds have included the catalogue of Nancy Wilson of Heart and the music royalty interests, including producer royalties and neighbouring rights, of the Canadian producer Bruce Fairbairn.

During 2022 Round Hill saw over 100 potential investments with NPS multiples in the range of 15-22x. The management highlights that multiples remain elevated, but pressure on sellers currently translates into fewer deals as sellers pull deals when pricing expectations are not met.

We note that the NPS multiples, at which RHMRF acquires catalogues, have increased over the life of the fund. While the seed portfolio multiples for two catalogues were 16.3x and 16.2x, the average acquisition multiple has grown to 17.9x (see Exhibit 5).

According to the investment manager Round Hill, active management is often not reflected in underlying multiples. It regards valuations of 16–20x NPS for high-quality, iconic, blue-chip, stabilised catalogues as attractive. Management cites a third-party report putting the average multiple paid in 2022 for this type of high-quality, iconic copyrights at 19.4x.

Round Hill has seen significant deal flow emerge from within its existing catalogues (including the pipeline investments) and has a proprietary position on those deals.

RHMRF’s portfolio has 51 catalogues with over 123,600 songs (at end-December 2022). Exhibits 6 and 7 illustrate how the portfolio is diversified by genre and revenue type, with the catalogues representing a rich mixture across artists, genres, vintages and income composition.

Older genre rock (56%, level with June 2022) makes up the largest share of the portfolio, followed by pop (18%) and country (11%). Following the investment manager’s ‘high quality compositions’ approach to primarily acquire songs over 10 years old, more than 94% of revenues generated from the portfolio are ‘vintage’, from songs written before 2010 (71%: pre-2000). The bias to rock is deliberate, as it appeals to a wider range of age groups and geographies, with hits having a longer ‘shelf life’. The portfolio is also diversified by revenue type, as shown in Exhibit 7 below.

RHMRF delivered an 18.0% economic NAV return in 2022 in total return terms, slightly outperforming the MSCI UK High Dividend Yield Index, which posted 17.4%. Since its inception in November 2020, the NAV total return is 35%, or 10.5% pa (compared to 34.5% and 10.4% delivered by the index, respectively). We note that RHMRF’s performance is significantly ahead of broader equity markets, with the MSCI World Index deteriorating by 17.7% in total return terms in 2022.

Meanwhile, RHMRF’s shares declined by 22.8% during 2022, which resulted in the discount to NAV widening to 38% at end-2022 (at the same level on 5 June 2023), compared to just 5.4% at end-2021 (see Exhibit 9).

We compare RHMRF to Hipgnosis Songs (SONG) as a direct comparator company, also generating royalty streams from music rights (for a detailed comparison see our initiation note). While the companies are similar in nature, we note that RHMRF’s track record is still relatively short and may be affected by ramp-up effects (SONG launched in 2018). Both funds report their NAVs twice a year, but due to the timing (RHMRF being June and December; and SONG March and September) a direct comparison of NAV performance may be inaccurate.

Having said that, both portfolios (RHMRF and SONG) are valued by the same independent advisor (Citrin Cooperman), which further strengthens the comparability of the companies. Despite significant widening of the discount (as described above) RHMRF’s discount is slightly lower than SONG’s discount to latest available NAV as at end-September 2022 (47.3%). Over the year to end-December 2022 RHMRF reported 18.0% NAV increase in total return terms, whereas SONG showed 9.2% NAV accretion over the year ended September 2022.

RHMRF is allowed to gear up to 25% of economic NAV, calculated at the point of drawdown. As at end-December 2022 RHMRF had US$91.7m drawn down from its revolving credit facility (including accrued expenses), translating into 17.7% of economic NAV.

In February 2023 RHMRF entered into a new revolving credit facility with City National Bank, replacing the previous agreement with Truist Securities. The new facility has a US$120m capacity (compared to US$110m with the previous one) and bears interest of SOFR + 2.25% (Libor + 2.25% previously). While the interest specification is unchanged, the new facility has an improved non-utilisation fee agreement, which stands at 0.375% and 0.25% if more than half of the facility is drawn (0.375% flat in the previous facility). The facility matures in February 2026.

Assuming RHMRF has drawn from the new credit facility the exact amount it had outstanding as at end-2022 (US$92m), it would currently have US$28.3m available. We calculate that even full drawdown of the RCF would translate to 23% of NAV – below the 25% threshold. Considering it had US$10.9m in cash as at end-2022, we calculate RHMRF has US$39.2m available for investment, which is 7.5% of end-2022 economic NAV.

RHMRF targets a dividend payout to produce a 4.5% yield on its IPO price of US$1.00, which translates to a 5.8% yield based on the current share price. It pays dividends quarterly (in March, June, September and December), with the latest payment of US$0.01125 (in line with the target) paid in March 2023. The dividend policy aims to pay dividends out of royalty income but allows for payments out of capital if necessary to reach the target.

In 2022 RHMRF reported dividend cover of 0.98x, which is calculated as net profit for the period and amortisation of catalogues compared with dividends paid. While the company expects the revenues to show strong growth (FTI and Citrin Cooperman assume 5–7% annual growth of portfolio cash flow generation) it highlights that the impact of recent successive interest rate rises puts downward pressure on 2023 dividend cover. However, the company anticipates dividends to revert to being fully covered by the end of 2024.

RHMRF’s board currently consists of four non-executive directors.

In November 2022, Trevor Bowen announced his intention to step down from the chair and as a non-executive director, having steered the group through a successful listing process on the Premium Segment of the Main Market of the LSE. His remuneration in FY22 was £66,667. His successor is Robert Naylor, who has over 25 years' experience in capital markets and investment trusts. A qualified chartered accountant, having started his career with Ernst & Young in 1996, Robert has held various positions within JP Morgan Asset Management, Panmure Gordon (UK) and Cenkos Securities. He is currently CEO of Intuitive Investments Group, an AIM-listed investment company, providing investors with exposure to a portfolio concentrating on fast-growing life sciences businesses. Additionally, he is a non-executive director of Light Science Technologies, an AIM-listed controlled environment agriculture company.

RHMRF has a strong institutional shareholder base, with generally relatively little trading activity. In recent weeks, Josh Gruss, the CEO, has built his position in the stock to 6.34%.