Royalties are now investable assets, with large pools of capital moving into areas ranging from music and film, to healthcare and energy rights.
As private markets strategies continue to expand and specialise, royalties have emerged as an asset class with an estimated market size of US$2 trillion and growing.
Ranging from the ownership of rights to future revenues in music and pharmaceuticals to interests in carbon credits, this diverse asset class has distinctive characteristics including low correlation with financial markets, predictable and attractive income streams, and exposure to high-growth sectors.
The inclusion of royalties in a diversified portfolio can benefit investors seeking long-term capital preservation, growth and attractive yield, plus material diversification to more traditional asset classes.
What is a royalty?
In its simplest form, a royalty investor receives a percentage of revenue generated by an underlying asset. The asset can include rights to intellectual property (IP), such as patents, trademarks or copyrights, as well as exclusive rights over natural resources like gas or minerals.
The terms of a royalty contract are negotiated between the owner of the asset and the operating company. The contract grants the operating company the right to use the asset, and, in exchange for this, the owner receives a royalty payment (i.e. a percentage of the revenue). Examples of this include the revenue generated from the sale of a pharmaceutical product, the use of a musician’s song catalogue, or the sale of gold from a producing gold mine.
These rights, or simply, these royalties, can then be sold to third party investors. As a royalty investor, the investor can either buy royalties that are already in existence (like the examples provided above), or, alternatively, a royalty investor can “create” a royalty by providing capital to the owners or operators of an asset in exchange for a portion of the revenue that the asset generates. Such transactions create a synthetic royalty that mirrors the economics of a traditional royalty for the royalty investor.
Where royalties sit
The structured nature of many royalty investments provides clarity and control over payment terms, akin to private credit instruments. However, unlike private credit, royalties also offer potential upside driven by the underlying asset’s performance. This places the risk-return profile of royalty investments between that of private credit and private equity.
Moreover, royalty investments are typically cash-yielding from day one as the investor receives a portfolio of the asset’s revenue stream. This increases the multiple on invested capital (MOIC) over the holding period. In cases, where royalty investments have long-term IP exposure (such as music) or sub-surface ownership (mineral rights), there is also the potential for long-term NAV accretion to complement the yield generated by the royalty investment.
In contrast, a typical private equity buyout offer sees most of its value creation after two-to-three years of implementing operational initiatives, followed by a sale that ultimately realises the value.
This places the return profile of royalties closer to that of private credit. Yet, the royalty investment’s initial and final internal rate of return are expected to be higher over the long term.
Potential risks
As with any asset class, it is essential to recognise the potential risks associated with royalties. Specific sector-related risks, including regulatory changes, technological advancements and shifts in consumer behaviour must be considered and addressed through prudent underwriting and sector selection.
Appropriate structuring and documentation are essential to ensure that royalties provide downside mitigation, similar to credit instruments, while still retaining attractive upside potential linked to asset outperformance or an exit at higher multiples than underwritten.
Additionally, counterparty risk, legal and regulatory risks and lack of diversification are important factors to be aware of and actively managed when investing in royalties.
At the investment level, factors such as asset impairment, operational issues within the operating company, unexpected leadership changes and other specific risks can all impact performance and returns.
While it is challenging to completely avoid these risks, steps can be taken to mitigate them to the greatest extent possible. Protection mechanisms can include economic structures that have “step-up” or “step-down” features to protect the investor once certain IRR or MOIC hurdles have been achieved.
In some cases, royalties can also include “make whole” payments to the royalty investor in the event of asset underperformance or early repayment, and investors may opt to use hedging strategies to mitigate pricing risk.
Evergreen fit
Within the private markets space, investors have typically tapped into royalties through closed-end, commingled fund structures. While these structures have their benefits, their standard 10-12-year fund life often does not match the typical duration of royalty investments.
This misalignment can bring about challenges and undesirable outcomes, such as funds being forced to sell off investments prematurely or having limited flexibility in allocating across different sectors. For investors seeking to align the lifetime of their investments with the underlying assets, evergreen fund structures may offer a viable solution.
These funds are not restricted in their investment horizon, or tied to a fund-end date, more easily matching the duration of the underlying investment portfolio. Additionally, they often offer regular liquidity events (typically quarterly), allowing investors to adjust their exposure to the asset class.
Within a decade, the royalties landscape is likely to have evolved further as a result of greater understanding of its merits among both institutional and private wealth investors. It is reasonable to expect that such assets will sit alongside other alternatives in diversified portfolios built for the needs of individual investors.
By Stephen Otter, head of royalties at Partners Group
