Case Study: How To Value (And Not Undervalue) Royalties

  in Royalty Investing

Jan 15, 2019

By Matthew Smith, CEO @RoyaltyExchange

Today, I'd like to share with you my thoughts on how to recognize value and make informed investment decisions when bidding on music royalties.

To illustrate the point, let’s focus on an actual auction that closed a few months ago. The listing was for sound recording royalties on a 90’s hip-hop catalog. To kick the auction off, it needed an opening bid of $300,000.

We’ve conducted hundreds of auctions on Royalty Exchange. All but a handful have received an opening bid within 24 hours of listing. This was one of the few that didn’t get an immediate bid.

For one reason or another, bidders weren’t interested in this auction. So, after sitting for more than 48 hours with no activity, I personally placed the opening bid. As is our policy, no employee or insider at Royalty Exchange can bid against our investors. But, we can place an opening bid.

The auction ran for several days, but there was never a second bid. As you can see below, I was the top (and only) bidder. Although I was happy to win the auction, I never expected that would happen. I couldn’t imagine I’d be the only one interested. And yet, I was. The question is, what did I see that other investors didn’t?



Outside of Private Syndicates, auctions (currently) are the primary means to acquire royalty assets on Royalty Exchange. The competitive nature of auctions facilitates price discovery, and that’s a good thing. But it also can create a scenario where the role of social proof in auctions overrides sound analysis.  

By that I mean it’s common to feel better about a decision when others are making the same decision and to doubt a decision if we’re the only one making it. We’ve seen social proof drive “bidding wars” in which, sometimes, animal spirits seem to knock investors out of their senses. And we’ve seen the opposite, where a lack of bidding activity paralyzes investors and keeps them from snapping up good assets at great values.

So it’s important to look beyond the social signals of auctions when making investment decisions. The purpose of this month’s letter is to help you understand what makes royalty assets valuable. And, importantly, to help you recognize that often the right move in auctions is the contrarian move.

For instance, most investors focus on three key factors when evaluating a listing on Royalty Exchange before placing a bid.:

  1. The Nominal Price
  2. Multiple of last 12 month’s earnings.

Both of these are sensible guardrails to inform risk and reward in any bidding decision. When the nominal price (position size) and multiple are low enough, bidding on an asset can feel like a no-brainer. But, then there’s the less rational factor...

3. Social Signals. When bidders see that others are actively bidding on an auction, they feel more confident placing a bid as well.  Which increases the confidence of others who then bid further. Conversely, when there are few or no other bidders they hesitate and worry that they might be making a mistake.

These factors all involve surface level analysis. They’re useful, but never complete. And sometimes, used alone, these three factors can lead to mistakes and missed opportunities.   

In the example above for instance: 90s Hip Hip Sound Recording Royalties

  • This catalog was larger than most so the starting price was on the higher side, at $300,000. That’s well above the average starting price of about $40,000.  

  • The starting multiple was also higher than average as well, at 7x LTM. That’s not only higher than the average starting multiple (3x), but also the average closing multiple (just over 6x)

Taken together, these factors affected bidding activity in two ways:

  • Out of Reach—A $300k asset is simply too expensive for many of the bidders on Royalty Exchange.

  • Risk/Reward—For those that can afford six-figure assets, a $300k “position” in a single asset can be perceived as riskier compared to spreading that $300k over several different assets. Add to that, a starting multiple that’s twice the average listing and bidders get, understandably, nervous.

So, why was this catalog compelling to me?

I start looking at auctions the same way everyone does. What’s the nominal price and what’s the multiple?  But, the next step is looking at the Theoretical Internal Rate of Return (TIRR). We derive TIRR in a formulaic way by applying the same financial model universally to all assets on the platform.  

The TIRR on this listing at the starting price was 23.89%. I know TIRR is not a guarantee or even a prediction. The model is built by analyzing the underlying drivers in a catalog. A high TIRR indicates, to me, that there’s something going on with this catalog beneath the surface that might justify a higher multiple.

Let’s take a closer look at the underlying drivers that led to how 23.89% TIRR informed my decision:

Dollar Age

In my opinion, this is the single most important factor when viewing the risk profile of any music catalog. In short, a song released 10 years ago that earned $1,000 last year is far more valuable than a song earning the same released two years ago.

Catalog Dollar Age is a measure of The Lindy Effect, a concept popularized by Nassim Taleb in his book The Black Swan.

The Lindy Effect suggests that the future life expectancy of some non-perishable things like a technology or an idea is proportional to their current age, so that every additional period of survival implies a longer remaining life expectancy.  Where the Lindy effect applies, mortality rate decreases with time.

In this case, over the last 12 months, the top-earning songs are all 20+ years old. Streaming wasn’t even a format when these songs were released, yet they lead the catalog’s streaming activity.


These are songs that have stood the test of time. They’re not dependent on a short-lived fad, or a sync placement, or an active touring schedule to remain relevant. They just are relevant. They're still streamed by a fan base who remain attached to the songs out of nostalgic value, not fickle whims.

Songs this old that receive this kind of streaming activity today are a rare opportunity and should not be overlooked.

Now let’s take a closer look at those earnings...

Earning Trends

When evaluating any investment, you want to examine prior earnings. While past performance is no indicator of future success, it remains a key stat in understanding the value of a music royalty catalog...

We do this by comparing growth across 12-month periods. In this example, the total earnings for the period of April 2017 - March 2018 grew 117% over the total earnings during the period of April 2016 - March 2017.  



But what was particularly notable was the fact that this growth rate is increasing. Total earnings from April 2016 - March 2017 increased 25% over the total earnings of April 2015 - March 2016. Most catalogs with a similar Dollar Age are either decreasing or if increasing, doing so at a decreasing rate. This catalog is increasing at an increasing rate.

Format Trends

How a catalog earns is just as important as how much it earns. That’s because you want to make sure the source of those earnings is sustainable.

In the example catalog, the primary driver of growth is streaming. In fact, 80% of the catalog’s earnings come from streaming. That makes it more valuable because streaming is a growing format predicted to continue growing well into the future. It’s not like radio airplay (which naturally declines for all music) or downloads/sales (which is on a sharp downward trend).

What’s more the catalog’s streaming growth outpaces its overall growth. For instance, in the timeframe when its overall earnings grew 25%, the catalog’s streaming earnings grew 62%. And in the timeframe when overall earnings grew 117%, streaming earning grew 279%. Both well outpace the overall industry’s calendar year growth rates as well.

It’s also worth noting that this is a hip-hop catalog. And whether or not you’re personally a fan of hip-hop it is the most-streamed genre of music.

Payments

It’s always good to look for a spike in earnings, and determine the reason for them. You don’t want to pay a higher multiple for earnings spikes that aren’t repeatable.

Personally, I’m highly suspicious of sync payments.  These are one-time licensing fees for the use of a work often in TV or film.  Sure, they can be lucrative, but I think it’s a mistake to count on them being repeated.

That said, you don’t want to undervalue a catalog for certain one-off payments either. In the example catalog, 2017 earnings averaged around $2,000 a month until November, when it spiked to over $10,000. The cause of this was a large lump-sum payment from the service Pandora, which had held back royalties during the negotiation of a direct licensing deal. While the spike was not repeatable, the long-term results of the direct licensing deal produce a structural change to the income profile of the catalog... with monthly averages subsequent to the deal totaling over $3,000.

Additionally, I liked the fact that royalties from this catalog paid monthly.  With more frequent payments, I could better monitor the performance of the catalog. And, of course, what investor wouldn’t prefer monthly income vs. quarterly or semi-annually as is common with other catalogs?

Returns

Two weeks after winning the auction, I received my first royalty statement and payment. I was expecting around $4,200 but to my surprise, the payment was over $9,100.

Conclusion

A few months later, we relisted the same catalog at the same opening price to give investors another chance at it. This time, 22 bids came in. Once investors had a better sense of the key metrics worth analyzing, the value and potential of the catalog became much clearer, which led to more confident bidding. 

Key Takeaways

So let’s summarize the key points we’ve covered.

  1. Don’t let social proof override investing decisions.

  2. Higher Dollar Age implies higher quality and lower risk

  3. Earnings either decrease, increase at a decreasing rate, or increase at an increasing rate. Changes in earnings matter at least as much as earnings themselves.

  4. Streaming is the industry’s tailwind. Look for catalogs benefiting from that trend.Investing in streaming gives you a tailwind.

  5. Price and Multiple are just a guide, not the full story.