Hipgnosis Songs

Hipgnosis Songs Fund (SONG) currently has net assets of c. £1.2bn, and aims to achieve income and capital growth by owning songwriters’ music royalties. In total, SONG’s portfolio currently comprises over 61,000 songs, of which over 3,100 have been number one hits.

As the portfolio has been built up, the exposure to older hits has increased significantly and is now close to 50%. Evergreen hits are more predictable, and should provide a stream of royalties to the fund for the long term. At the same time, younger songs provide exposure to the potential evergreen hits of the future, as well as those which have higher immediate potential for streaming income.

A recently announced performance metric shows the portfolio is making good progress against expectations, ahead 0.4% over the six-month period to 30/09/2020. Streaming constitutes the largest proportion of SONG’s revenues (36% as at 30/09/2020), as well as leading the growth of revenues in the music industry. According to the recent IFPI release, revenues across the global music industry reached its highest level in 2020 since 2002. With the rise of subscription models, music has moved from being a discretionary purchase to more of a utility.

Over the past financial year, the portfolio’s earnings covered the 5p dividend two times over. More recently, the managers have provided an additional metric (pro-forma annual revenue or PFAR), which shows the annual run rate of revenues (before expenses) for 2019 was 11.04 cents per share (or c. 8p per share). The board is targeting a dividend of 5.25p for the current financial year, a prospective yield of 4.3%.

We continue to believe that the uncorrelated nature of SONG’s NAV and the high income the portfolio provides are attractions. As recent statistics provided by the IFPI highlight, the music industry is experiencing a resurgence. SONG is in a good position to benefit from these tailwinds. It offers a prospective dividend yield of 4.3%, as well as the potential for capital growth.

Aside from an improving background to earnings, the way that music is consumed could also lead to important changes to the way that revenues are valued. With the music industry moving towards a subscription model, this improves the predictability of revenues, and (as one influential academic has already suggested) potentially means that discount rates should move lower. SONG’s independent valuer has so far moved the discount rate in to 8.5%, from the 9% used at launch.

The newly announced portfolio metrics provide a good way for investors to understand the performance of SONG’s portfolio against expectations. They are a good step towards what we expect will be further and enhanced disclosure on the portfolio in time.

Although this is a relatively new area for alternative income investors, and therefore arguably bears higher risks, should the managers achieve their objectives the potential long-term total returns look higher than those currently on offer in other alternative income sectors. Over the short term, the discount rate used to value the portfolio has the potential to fall further, which, if it occurred, would boost the NAV.

Hipgnosis Songs Fund (SONG) was the first fund to come to the London market that invests in music royalties. SONG launched in 2018 and is now listed on the main market of the London Stock Exchange, having raised c.£1.1bn of equity capital. SONG’s manager (The Family Music Ltd) is aiming to deliver total returns to shareholders over the medium to long term of greater than 10% per annum, with a high dividend yield and the prospect of capital growth. It aims to achieve this through purchasing and managing songwriter royalties. We examine the ‘why’, ‘what’, and ‘who’ as regards SONG and the asset class in this recent note. Following an online workshop in which the managers presented some “additional performance metrics” (APMs) with which investors will be able to monitor progress going forward, we review the portfolio as it currently stands.

The manager aims to buy catalogues which include songs with the following characteristics:

• those that are proven hits, delivering royalty income for numerous years
• those that are culturally influential and therefore likely to be continually played and/or covered by new recording artists
• those that are underexploited and for which the manager is able to identify potential sync or cover opportunities
• those offering upside from the improved administration of collecting royalty income

In total, SONG’s portfolio currently comprises over 61,000 songs, of which over 3,100 have been number one hits. 145 of these have been awarded a Grammy. Included in these are significant transactions completed relatively recently, including a 50% interest in Neil Young’s publisher and writer share of royalties. Whilst these are clearly impressive numbers, the main economic interest is likely to reside in a much narrower set of songs. SONG’s most recent purchase announced on 18 March 2021 (Carole Bayer Sager's catalogue) illustrates this well. Carole’s career spans 55 years and contains some of the world's most popular and successful songs amongst the 983 songs that she sold. However, for 2020 the top three songs generated 41% of the revenue, the top five generated 56% of revenue, and the top ten songs equated to 76% of revenue. As this illustrates, the portfolio will consist of a number of gems which deliver the main earnings power, and a long tail of less well-known (or less commercially relevant) songs.

The manager has a stated aim to diversify the portfolio through genres, with a preference for those that should benefit from strong and rising appeal, such as hip hop, pop and rap – and most especially those which will benefit from increased streaming. We show the most recent breakdown (based on fair value) provided by the company in the chart below.

As the portfolio has been built up, it is interesting to note that the exposure to older hits has increased significantly. The manager aims to own evergreen hits which will prove durable over many years and provide a stream of music royalties to the fund for a long time into the future. In this regard, the exposure to older songs – which tend to have more predictable income streams – is encouraging. That said, the portfolio primarily consists of songs less than ten years old which arguably gives SONG exposure to the potential evergreen hits of the future, as well as exposure to songs which have higher immediate potential for streaming income. The manager believes that streaming is driving a secular uptrend and is leading to a resurgence in income for copyright holders. As we discuss in the Management section, the team believe that they will add significant additional value to what is already a strong tailwind to revenues through focussed and dedicated management of the songs in the portfolio.

SONG’s portfolio has been purchased on a blended multiple of around 15x of historical income, which on a very simplistic basis represents a gross historic cash yield of c. 6.4% (before fees and other costs). As we discuss in the Dividend section, SONG’s board is targeting a dividend of 5.25p for the current financial year, with the manager aiming to deliver additional returns through secular trends (including the rise of streaming) and active management. Streaming already constitutes the largest proportion of SONG’s revenues (36% as at 30/09/2020). According to IFPI, there are 443m paying streaming subscribers globally, which is projected to hit two billion by 2030. After a near 20-year decline in which piracy (initially copies of CDs, but then MP3 files through Napster etc) eroded revenues, streaming is leading the growth of revenues in the music industry.

Indeed, according to recently announced statistics from IFPI, revenues across the global music industry reached their highest level in 2020 since 2002. Revenue for the year increased by 7.4% from 2019, hitting $21.6bn according to these statistics, and representing the sixth consecutive year of growth. Streaming revenues account for 62% of sales across the music industry, reflecting huge growth in the digital service providers (DSP) such as Apple Music, Spotify, Deezer etc. In our view, streaming growth is very simply explained, and in our view is unlikely to prove a flash in the pan. As any user of Spotify will surely attest to, the access and personalized experience that this sort of service is able to offer is significantly better than anything that was previously available for free, illegally. For many consumers therefore, music has moved from being a discretionary purchase made infrequently into a utility in which it is paid for frequently and continuously.

In terms of growth potential, the likes of Spotify have pricing plans for developed markets but also lower pricing plans for developing countries (with lower disposable incomes). This is hugely significant, because, for the first time, emerging market consumers are starting to pay for legally consumed music. This increases the potential addressable market enormously, but is already contributing strong growth for DSPs. According to IFPI figures, streaming contributed to a 16% rise in music revenues in Latin America and nearly 10% in Asia. This compares with 3.5% in Europe and 7% in North America.

SONG’s revenues are derived from all over the world. However, the US is the largest music market globally, but also for SONG. In this regard, it is significant that in 2018 the US’s Copyright Royalty Board (which sets US industry-wide royalty rates) ruled that it would be increasing the share of revenues for songwriters from the overall royalty pot by 44% over the ensuing four years. This provides another structural tailwind to revenues for SONG, and means that for every $1 of revenue that SONG earned from the US in 2019, it would be worth $1.44 in 2022 on an equivalent basis. We understand that the UK government is also looking into whether songwriters are getting a fair share of the action.

In respect of management initiatives to enhance the value of SONG’s assets and revenue stream, the manager has assembled a large team of c. 45 specialists since the launch of the trust. In addition, SONG acquired Big Deal Music Group (now known as Hipgnosis Songs Group) in September 2020, which brought direct music administration expertise in-house, allowing SONG to collect revenue more effectively and actively manage the portfolio of songs. We discuss more in the Management section.

SONG does not anticipate using structural gearing. However, SONG has approval to take gearing up to a maximum of 30% of net asset value. This is envisaged to be used for working capital and short-term bridging purposes only, pending further equity capital raises and provides the headroom to help with the acquisition of song catalogues in the pipeline. This is a relatively tried-and-tested approach to growing a fund where the underlying investment assets are primarily yield-based and hard to access or lumpy. Examples include the infrastructure funds and the renewable energy infrastructure funds which have grown successfully in this way.

As at 30/09/2020, gearing was 20% of NAV. Since then, SONG has made several acquisitions and raised further equity capital. As such, we believe a basic assumption should be that gearing is broadly in line with this level currently. We expect further clarification at the very latest in July when SONG announces its final results.

SONG’s manager aims to provide total returns over the medium to long term of greater than 10%, with a high dividend yield and the prospect of capital growth. The portfolio is formally revalued twice a year, at 31 March and 30 September. The most recent NAV is therefore based on valuations as at 30 September 2020, which was published in early December and also reflected a fall in the discount rate used by the independent valuer from the 9% level used since IPO to 8.5%. This contributed to a 10% (constant currency) increase in the NAV over the six months to 30 September. The managers highlighted that an influential academic’s research (Professor Damodaran) suggests that, with the music business moving to a subscription basis, there are grounds for the industry’s discount rates to potentially move significantly lower.

From IPO in mid-2018 to 30 September 2020, SONG’s NAV has delivered a total return (including dividends) of 37.9%, representing a 40.4% outperformance of the FTSE 250 over the same period. We show the NAV and share price total return performance since IPO to 23/03/2021 against FTSE All Share and MSCI World ETFs below. We believe it is notable that the NAV has shown low correlation to equity markets so far. That said, as we discuss in the Discount section (and discernable in the chart below), the shares were not immune to the market sell-off in Q1 2020. However, appetite for the shares quickly improved when liquidity returned to the market. The trust does not hedge currency exposure, and given that the majority of its assets are denominated in USD, this means that investors will benefit from dollar strength but will suffer when there is dollar weakness relative to the GBP. This has been a headwind over recent months, with GBP notably stronger against the USD, leading to an adjusted NAV for SONG as at 20/01/2021 of 118p.

Past performance is not a reliable indicator of future results

In terms of underlying performance, we have previously observed that one of the crucial determinants of whether a song (of any vintage) is a financial success for SONG will be how conservatively the assumptions used at the time of purchase prove to be. The manager’s recent workshop revealed two new “additional performance metrics” (APMs), which will be provided periodically to enable investors to better understand the performance of the portfolio relative to expectations at purchase. One of these measures is the variance against forecast (VAF), which shows the degree to which the portfolio as a whole has performed based on the latest royalty statements received. SONG recently announced that based on this measure, the portfolio was ahead of forecasts by 0.4%. This is encouraging in our view, and is a key statistic to monitor over time, because it will give investors a feel for how accurate the managers revenue forecasts have been when purchasing assets.

The other measure, of relevance to the Dividend but also clearly a key determinant of total returns, is the pro-forma annual revenue (PFAR), which shows the annual run rate of revenues from the portfolio based on cash royalties received (whether owned by SONG or not) in any year. This provides a good picture of the health of the portfolio and the returns it delivers, without the distorting effect of acquisitions, FX moves and other accounting adjustments. The PFAR of the portfolio owned at 31/12/2020 for the whole of 2019 was 11.04 cents per share (or c. 8p per share). From this, SONG will be paying interest on borrowings, expenses and having to adjust for FX movements to get to an equivalent earnings per share. However, this serves as one measure that highlights the earnings power of the portfolio, and compares to the dividend target of 5.25p per share. We expect that the managers will update both of these key metrics, first revealed this month, in subsequent accounting periods – the next being for the period to 31/03/2021, which we expect to be announced in July.

SONG’s objective is to provide an attractive and growing level of income, together with the potential for capital growth. At launch, the fund aimed to pay a full year dividend of 5p once the company became fully invested. Last year, SONG paid four quarterly dividends of1.25p, thereby achieving its original target. This year, SONG’s board is targeting 5.25p as a dividend. Based on this target dividend, the shares offer a prospective dividend yield at the current price of 4.3%. This compares to a simple historic average of 4.9% for listed infrastructure funds and 5.6% for the renewable energy infrastructure funds. We believe that, by comparison, SONG’s dividend is attractive, not least because of the secular tailwinds behind the industry as described in Portfolio, but also because of the potential for capital growth. In our view, although it is a new area for alternative income investors and therefore arguably bears higher risks, should the managers achieve their objectives the total returns look higher than those currently on offer in other alternative income sectors.

SONG’s dividend was well covered in the last financial year to the end of March 2020. Adjusted earnings per share (excluding amortisation) was 10.7p per share, representing over 2x cover of the full year dividend of 5p. As we discuss in Performance, SONG is now providing a pro-forma annual revenue (PFAR) figure, which shows the annual run rate of revenues from the portfolio based on cash royalties actually received(whether owned by SONG or not) in any year. This provides a good picture of the health of the portfolio and the returns it delivers, without the distorting effect of acquisitions, FX moves and other accounting adjustments. The PFAR of the portfolio owned at 31/12/2020 for the whole of 2019 was 11.04 cents per share (or c. 8p per share). From this, SONG will be paying interest on borrowings, expenses and having to adjust for FX movements, to get to an equivalent earnings per share. However, this serves as one measure that highlights the earnings power of the portfolio, and compares to the dividend target of5.25p per share.

We understand that SONG expects to be able to grow its dividend over time though the active management of the portfolio, but also from the tailwinds in the industry that we discuss in more detail in the Portfolio section. We illustrate the historic (and target dividend for this year) in the graph below.

2021 dividend of 5.25p represents a target only and is not to be relied on

The trust’s investment adviser is The Family (Music) Limited, which was founded by Merck Mercuriadis, former manager of globally successful recording artists such as Elton John, Guns N’ Roses, Morrissey, Iron Maiden and Beyoncé, and hit songwriters such as Diane Warren, Justin Tranter and The-Dream. He is also a former CEO of Sanctuary Group plc.

The Family (Music) Limited has an advisory board of music industry experts and is broadly intended to help with acquiring song catalogues, providing a broad range of expertise to the manager on different genres of music. The advisory board includes award-winning members of the artist, songwriter, publishing, legal, financial, recorded music and music management communities. It includes Nile Rogers of Chic and Dave Stewart of Eurythmics.

The Family (Music) Limited has a growing team (numbering c. 45 people) who support Merck Mercuriadis (CEO) in securing new investments for the portfolio, monitoring royalty and/or fee income via SONG’s various portfolio administrators and developing strategies to maximise the earnings potential of the songs in the portfolio through improved placement and coverage of songs. Specific hires that the manager has made since September 2020 include Ted Cockle who will be working on boosting income through management efforts and “working” songs harder, and Amy Thomson who focusses more on maximizing revenues through ensuring the most efficient and effective collection of royalties. We believe it is noteworthy that Richard Rowe joined very recently, having previously been a co-founder of Round Hill Music (SONG’s only London listed competitor fund).

SONG made a slightly unusual acquisition during 2020, buying Big Deal Music, which effectively provides an in-house management resource for the trust. Now branded Hipgnosis Songs Group, this team provides a complete song management, creation and administration service focussed on the US and comprises of around 40 individuals. We understand that this acquisition will enhance the efficiency of SONG’s US administration, although it will increase SONG’s operating costs given the team is “on balance sheet”. Kobalt will remain SONG’s preferred administrator outside of the US.

SONG publishes NAVs twice a year, reflecting the fact that revenues of the catalogues are also accounted for twice a year. The music royalty industry traditionally works on a 90-dayaccounting cycle, with royalty statements for January to June being settled on30 September, and statements for the period July to December settled on 31March. The ‘fair value’ of these songs will be evaluated by an independent company (Massarsky Consulting) using a minimum of three years’ historical normalised revenues, and using expected industry trends. The valuer then uses a DCF methodology to calculate a value which is compared with recent prices for similar transactions (if available) and other factors. This ‘fair value’ NAV will differ from the IFRS NAV, which reflects the a mortised cost of songs written down over their expected economic life. We believe the market focusses more on the ‘fair value’ NAV than the IFRS NAV.

At the time of writing, the most recent ‘fair value’ NAV was 125.35p as at 30/09/2020. In January 2021, SONG announced an adjusted NAV of 118.31p as at 20/01/2021, mostly reflecting the decline in the value of USD (most of the portfolio is denominated in dollars) relative to GBP, but also the payment of dividends. At a share price of 122p, the shares therefore trade at slight premium to NAV currently of 2.9%. It is worth noting that the 30/09/2020 NAV reflected a fall in the discount rate used by the independent valuer from the 9% level used since IPO to 8.5%. The managers highlight that an influential academic’s research (Professor Damodaran)suggests that with the music business moving to a subscription basis, there are grounds for the industry’s discount rates to potentially move significantly lower.

The graph below illustrates that over the life of SONG, a strong ostensible premium rating has been more usual. SONG was not alone in seeing a sharp sell-off in the share price in Q1 2020,with many other funds that offer exposure to alternative asset classes also seeing significant sell-offs in their shares and significant widening of discounts. In most cases, they have subsequently recovered the lost ground since then. Asthe market becomes more familiar with the investment qualities of SONG’s asset class, it might be hoped that discount volatility becomes less of a feature in the future, but it is worth remembering that a combination of fear and market illiquidity can lead to significant and rapid de-ratings of listed funds.

It is worth noting that should the shares slip to a meaningful discount over anything other than the short term, there is no formal discount control mechanism. However, the board has stated that it “will be mindful of the share rating and will consider buybacks should there be sufficient cash available”. A long-term discount control is the provision that a continuation vote is proposed five years after the IPO, and every five years thereafter.

The manager charges a base management fee based on market capitalisation (rather than NAV), tiered at a rate of 1% p.a. up to and including £250m, 0.9% p.a. from £250m to £500m, and 0.8% in excess of £500m.

In addition, the manager is entitled to 10% of any total shareholder return (share price performance plus dividends paid) over and above a 10% hurdle, subject to a high-water mark. The performance fee is paid in shares, which are locked up for 18 months. The total fees are capped at 5% of NAV p.a.

The most recently announced OCF (at the interim report as at 30/09/2020) was 1.35%, down from 1.76% at the same time the previous year, thanks to the increased size of the trust. The board has stated that it expects the OCF to continue to fall as the trust gains size and acquisition costs start to tail off. The published KID RIY is 2.18%.

Music Royalties are in our view a relatively problem-free area as regards to ESG. That said, revenue collection is relatively opaque, which might pose some ESG risks. We understand that the manager sees the reputation of a performer or writer as an important part of the sustainability of revenues, and so will not invest in catalogues that feature questionable artists.

On the other side of the coin, the manager recognises that artists are protective over their legacies and want the comfort of knowing that their songs will be used in line with their tastes/beliefs. According to the manager, when compared to the major publishing houses the trust is viewed as a safer alternative which can protect this legacy. As such, the manager would like SONG to be seen as a protector of writers’ rights, and an advocate for their role in the creative process.

SONG’s manager is formally committed to the UN Principles for Responsible Investment and to the UK Stewardship Code, in so far as they are applicable to SONG’s investment portfolio.