Guest Pitch: Hipgnosis Songs Fund (SONG:L)

Potential Takeover – 40% Upside

This idea was shared by Daniel.

Some abbreviations I will be using for everyone’s sake, as this web of arrangements is almost intentionally bewildering:

  • “HSF” refers to Hipgnosis Songs Fund, the closed-end investment company holding the musical IP and listed on the London Stock Exchange.
  • “HSM” refers to Hipgnosis Songs Management, the company’s investment adviser, whose chairman is Merck Mercuriadis and was sold to Blackstone in 2021.
  • “HSC” refers to Hipgnosis Songs Capital, a $1b partnership between HSM and Blackstone setup in 2021. This fund is also advised by HSM.

For the uninitiated, closed-end funds and investment trusts are popular vehicles in the property, infrastructure, private equity and other specialist sectors, with hundreds listed in London. In keeping with the UK’s antiquated financial landscape, some of these trusts have been in continuous operation for over one hundred years.

HSF has raised approximately £1.3 billion through its Initial Public Offering and subsequent issues. It became a constituent of the FTSE 250 index in 2020 and has pursued an aggressive acquisition strategy that has seen it amass a catalogue of 40,000 songs, with a particular focus on “building a portfolio of songs that is unrivalled for its extraordinary success and cultural importance”. I won’t delve too deeply into the makeup of Hipgnosis’ assets as they provide detailed reporting on this in their disclosures, however they have no doubt assembled a collection of some of the most influential music of all time, including the work of Nile Rodgers, Neil Young, Red Hot Chilli Peppers, 50 Cent, Barry Manilow, Skrillex, Shakira, Timbaland and Bon Jovi. It is a high quality, mature and diverse portfolio; the catalogue with the highest income, Red Hot Chili Peppers, contributed less than 8% of overall income in the twelve months to 30 September 2023.

This has been accomplished at a rate that is quite unprecedented in the industry, fueled of course by rock-bottom interest rates. But it has also been supercharged by the growth of streaming as the dominant economic engine of music, and a particular thesis Mercuriadis had about a hidden inequity within this. At the risk of oversimplifying, there are two main copyrights generated by music: publishing and recording. The latter, unsurprisingly, concerns the actual sound recording of a track and is usually held by the label indefinitely, depending on the deal. The former is the right to use the underlying composition or lyrics, typically held by everyone involved in the creation process. This is the right Hipgnosis has focused on acquiring, usually songwriter rather than artist shares. Under the US Copyright Royalty’s Board existing rules, DSPs (the streaming platforms) paid publishing royalty rates of only 10% until recently, compared to around 60% for recording. A mixture of forces including regulatory investigations and appeals from songwriters have pressured the CRB to review this setup, ensuing in a rise to 15% which was upheld in appeals court last year. Mercuriadis and Hipgnosis lobbied heavily in favour of this, and further reviews for upcoming payment periods are ongoing, with an expectation for additional increases. Some credit must be given to the management team for anticipating this, however, other decision-making in recent times has raised eyebrows.

 

Catalyst

As central banks hiked interest rates over, discounts in the investment trust sector began to widen, particularly in sensitive areas like debt and property. Hipgnosis, as a speculative company that had assembled itself during an accommodative monetary regime, was particularly vulnerable. In September 2023, HSF announced an agreement to sell $440m worth of catalogues, around 19% of the portfolio at the time, to HSC, the Blackstone-backed private fund at a 17.5% discount to NAV, with a stated rationale to lower debt, initiate share buybacks and thus narrow the discount. Given the potential for a conflict of interest, this immediately provoked controversy and aggravated concerns around the supposedly independent and rigorous valuation. The Fund’s discount rate had remained at 8.5% throughout the hiking cycle. Worries were also mounting over fees, performance disclosure and potential bonus liabilities on catalogue purchases. In October 2023, an activist investor revealed it had bought a 5% stake in an open letter and urged shareholders to vote against both the deal and continuation so that HSF’s inherent value could be realised.

Later the same month, independent valuers Citrin Cooperman notified the trust that certain retroactive payments would more than half from $21.7m as expected to $9.9m. As a result, the fund was forced into cancelling its dividend to prevent a breach of its debt covenants. This stunned others in the industry, which did not experience anything like these revisions. The outcome of CRB III had been publicly known since July 2022, and the decision was upheld in the summer of 2023. That Hipgnosis managed to incorrectly book over $10m accrued income speaks to either incompetence or highly aggressive accounting to inflate management fees, neither of which inspire confidence in the previous leadership team, adviser, or independent valuer. Even worse is that no room was accommodated for dividend payments in the event of this accrual being adjusted. Another large shareholder, Metage, joined the chorus of voices calling for the board to resign. Reasonably enough, the share price fell precipitously in response and has yet to recover.

This all culminated in a shareholder rebellion, with a decisive 83% vote against continuation at its AGM. Following this, HSF announced a strategic review, intending to appoint independent advisers for due diligence and put forward proposals within six months, whilst removing the chairman. A new chairman and non-executive director have since joined, both from Round Hill Music Royalty Fund, which is particularly interesting (more on that below). The newly constituted board have made their intention clear that they seek to terminate HSM as adviser. HSM has very little to its defense, having more recently agreed that it had incorrectly inflated NAV by 8% due to not adjusting for accrued income at the point of future sale of catalogues, thus admitting to overcharging millions in advisory fees.

The board is expected to present proposals before the end of April 2024, though this could easily be extended. Mercuriadis does not seem to have any material stake in HSF as of 31 Dec 2023, which does mean the company is free to act in the interests of all stakeholders.

 

Recent transactions

Perhaps the closest comparator is the recent take-private of Round Hill Music Royalty Fund, a smaller vehicle listed in London that was purchased by music rights-holder Concord (majority owned by Michigan Retirement Systems). Its portfolio was roughly a third the size of Hipgnosis’ but was nonetheless one of the largest transactions in the music business in 2023. Concord paid an EV/EBITDA (or “net revenue”, the two are largely analogous in this space) multiple of 17.3x, and 14.2x expected 2023 revenue.

A larger deal was Universal’s buyout of Chord Music in February 2024 at a 17x multiple. This was a very close peer to HSF, an owner of both active and passive rights and worth around $1.85b according to UMG, so similar in size.

The closest public peer is Reservoir Media Inc, an independent music management company. It also owns a slew of smaller record labels, which means its margins are much lower than a pure play investor like Hipgnosis. It has traded at an average EV/EBITDA of 15.6x since the start of 2023.

song

 

Valuation

Citrin Cooperman has been fired and replaced by respected US boutique Shot Tower Capital, who is advising the review and recently came up with a much more robust valuation of $1.74bn-$2bn, around $1.08 (85p) per share at its midpoint after adjustments and a 16x multiple at a discount rate of almost 10%. As such, the discount to fair value has reduced from over 50% to around 30% at the time of writing (March 2024). A lot of that is probably pricing tax/transaction costs from a sale.

The most likely outcome however is still a partial or even full sale to HSC or Blackstone. That is due to a call option held by HSM that allows it to purchase the portfolio at the higher of fair value, a third party offer or the market capitalisation. As both the market cap and third parties will likely never overtake HSF’s fair value, any bidding war will likely have to spar with Mercuriadis, probably close to NAV. This is discussed in more detail below under Risks.

Operative NAV is around $1.3b, against debt of $600m, which is higher than the covenant limit of 40%. At $120m annual income, there is at least a 12 month wait until dividends could feasibly resume, adding to the pressure for a sale sooner rather than later.

The 16x multiple is lower than Universal’s Chord buyout. At a 17x multiple, 6% more than the recent Shot Tower valuation, a bid would come to $1.14 (90p) per share. The Round Hill acquisition was at an 11.5% discount to NAV, however the discount rate used was 8.5%. If adjusting closer to HSF’s present discount rate of 9.63%, Concord’s purchase actually represented a premium of around 3.5% to fair value, equivalent to around $1.12 (88p) per share for HSF.

The $440m Blackstone deal was actually not at such a large discount as it seemed given the lowered NAV. It’s safe to assume Blackstone and Mercuriadis were trying to escape with high quality active catalogues, thus the actual assets were probably worth upwards of $425m. It would not be surprising if HSC were to bid again.

Assuming HSF repays $100m in debt this year, setting aside the rest of its income for legal/restructuring costs, borrowings would reduce to $500m, boosting the NAV from $1.08 to $1.15 (around 91p). So there is upside optionality should a sale not be imminent.

 

Risks

The main risk at present surrounds litigation against founder Merck Mercuriadis. The company is seeking to indemnify itself against liabilities arising from his misconduct, which he has refused. He may also be terminated as the investment adviser which may result in further litigation, both against HSM and HSF’s investors, and trigger the “call option” provision outlined above.

Prospective bidders may be put off by this, with fewer likely to want to take on the complexity of matching a multi-billion HSC/Blackstone offer. A complete acquisition would also be one of the largest music deals in recent times at an enterprise value exceeding $1.5b. Having said that, the recent reduction of its valuation should help buoy interest, and shareholders have approved a £20m incentive to third-party bidders to sweeten the deal. The company reported that there were 17 interested parties during the go-shop period of the $440m HSC/Blackstone transaction, and that most of their concerns related to the high valuation watermark (the main reason only one bid was submitted). It is worth pointing out that Round Hill had a similar call option, which didn’t seem to affect the submission of a proposal at a 67% premium to the share price. With a 26% haircut, financial conditions easing and a £20m incentive I would imagine sentiment to be considerably different now.

Should the company sell only part of its portfolio, it may be liable to pay taxes on realised gains. The exact scope of this is unclear and depends entirely on the structure and makeup of any arrangement, however the fund itself is incorporated in Guernsey, which is a tax haven with corporate rates at 0%. This is somewhat of a known unknown. “Unknown unknowns” may also materialise, such as further hidden accounting malpractice from the previous leadership team, which could adversely affect the liquidation or sale of the company.

Finally, liquidity of the Fund’s shares may be hampered towards the end of the strategic review process should the company have sold more than half of the portfolio, as it would likely no longer be large enough to qualify for FTSE 250 index inclusion.

I do not believe that shareholders would pressure to reverse the continuation vote cast in 2023 and can see no precedent of this happening with a closed-end fund in the past, so I am not listing this as a risk at present. However, depending on your risk tolerance and investment horizon, this may be something worth keeping in mind.

 

Conclusion

This is clearly a situation with lots of moving parts but with HSF trading around 60p, I believe it is highly probable that a significant portion of the company’s value is realised at close to the 90p per share level within the next 12-24 months, with the potential for a debt paydown or refinancing enhancing equity value further, representing an annualised return of 21-42%. I believe such an outsized yield allows for a sizeable margin of safety should the strategic review and discontinuation process take an unexpected turn. With shareholders’ and management’s incentives aligned and little operating risk, I expect a conclusion and timetable laid out within months.

14 Comments

14 thoughts on “Guest Pitch: Hipgnosis Songs Fund (SONG:L)”

  1. Below is a quick exchange between me and Daniel with some additional information.

    Q1: Publishing vs recording rights – do both of these generate income when the song is streamed and can both of these rights be thought as just a different % of the same royalty pot (i.e. just a lower % amount paid whenever the song is streamed)? Or is this way more complicated?
    A1: It is a complicated area but they are essentially part of the same pot. My understanding is the exact rates can vary depending on several factors but those headline rates are generally representative. It’s hard to glean the size of the overall pot as the labels deals with each platform differ and there’s very few details of the commercial arrangements. But on average you have the DSPs (Spotify) taking around 30%, and the resulting 70% being split 15/55 between publishing and recording respectively. You can then have a variance in the income depending on who’s administering, particular territories which each have different collection agencies. I’ve been in music finance for over 4 years and it can still be hard to grasp!

    Q2: Is the song portfolio a diminishing asset? Akin to oil wells where each subsequent year generates lower throughput. If yes, has the decline rate been reported or estimated? And how much the company needs to reinvest each year into new song royalty purchases to maintain current revenue levels.
    A2: That is the question, so to speak. Mercuriadis and co would say that with the rise of recurring streaming revenue and better collection processes it isn’t. To some extent he in particular has a point because he’s bought some of the most culturally relevant music ever made, which will be played, covered and remixed for decades or more. In reality of course it is a diminishing asset with income that decays over time, especially over the first few years of a newer track. It is worth pointing out this is very extensively studied and baked into all the catalogue valuations across the industry, even the big hits Hipgnosis bought. For reference that’s why there’s a massive chasm between IFRS and Operative NAV, they have to be amortized over expected life under IFRS. I mention this in the final question but since lots of people are willing to pay far above amortised cost it may suggest they’re not as diminishing as the accounting would have you believe. You could argue Hipgnosis is less exposed to this as most of their portfolio is older (they report on performance by age bracket/level of decay quite regularly) but on the other hand there’s only so many times you can cram an ancient hit into the latest netflix show! There was a critical piece in the NYT about this recently: https://www.nytimes.com/2024/03/18/opinion/private-equity-music-spotify.html

    Q3: Has the increase in publishing royalty rate from 10% to 15% already been reflected in SONG’s financials?
    A3: Yes, they have already made the accruals required (controversially as I mentioned in the piece). As streaming is only one part of the portfolio’s income and the uplift only covers 2018-2022 it wasn’t a dramatic windfall. Future increases haven’t been reflected in the financials, though to an extent they were taken into account when Mercuriadis acquired catalogued for hefty multiples before and during COVID (I know anecdotally up to 19x).

    Q4: Could you clarify what the outcome of CRB III was and why that resulted in the halving of retroactive payments?
    A4: I don’t think anyone except Hipgnosis management, advisors and the former valuer know the answer to that question. No other companies had to make similar adjustments. One can only guess that they over-estimated their gain from it, accrued too large an amount and had to correct. As far as I am aware, only an accrual was halved, rather than actual payments.

    Q5: Round Hill Music – does it also concentrate on publishing rather than recording rights?
    A5: I’m not that familiar on Round Hill’s own strategy but from their last annual report I can see their income was split 70:30 towards publishing, so fairly similar to HSF.

    Q6: You say “shareholders have approved a £20m incentive to third-party bidders to sweeten the deal.” – could you clarify what this incentive is?
    A6: It looks like the board is authorized to pay a bidder up to £20m to acquire assets. The rationale would be to encourage offers in the face of competition from HSC, but I’m not sure if this will end up being necessary as Round Hill’s advisor had a similar “call option” yet the fund got bought at attractive terms.

    Q7: Why would anyone be willing to pay 17xEBITDA (i.e. 6% yield) for song royalty assets, when the 10-year risk free rate stands at 4%+? Especially if this song portfolio is a diminishing asset? Or are these buyouts based on the expectation that the royalty rates on the rights in portfolio will increase further above the 15%?
    A7: It is partially a bet on the publishing rates increasing from a low base, and the continual growth of streaming which together should increase income modestly over time and (in theory) offset the general decay of the songs. The main buyers for catalogues in the secondary market are the smaller outfits like Concord, private equity and if the catalogues are of a high enough quality (which HSFs is) the labels themselves. Even Universal, which being the biggest player has a very high bar, spends at least hundreds of millions a year on acquisitions and is happy to pay a 16x multiple because they can monetise the assets better than those other buyers (a couple years ago they released a slide showing they get the multiple down to 13x after active monetisation https://www.musicbusinessworldwide.com/universal-annual-music-catalog-spending-shrunk-by-61-in-the-past-two-years-why/). That’s kind of what Hipgnosis do in that they have the licensing and adminstration rights to a lot of their catalogues, and that control can be very valuable if you know what to do with it.
    So it’s a fairly established market, there have been strong consolidating forces for a while, and it’s part of the long term investment strategies within the industry. I’d also say, as an alternative asset, that a Fed cut would boost liquidity enormously. PE is ravenous for this type of thing as you probably well know, and it’s clear they’re waiting for it. HSF having 17 interested parties in September despite a compromised sale process speaks volumes I think.

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  2. What brokerage firms in the US charge the least commission on these international trades? Fidelity in an individual account charges 9 pounds plus a 1% currency conversion fee. If done in a retirement account through Fidelity international trading, they charge an additional $82.95 commission plus the 1% currency conversion fee. There is an OTC equivalent but the spreads are very wide, and the volume is very low. Thanks.

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  3. Thanks Dalius! Can see HSF is up 7% this morning after the board confirmed the previously announced Shot Tower valuation. If anyone has any other questions I’ll do my best to answer.

    Interested to see how this one plays out.

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      • Thanks! Personally only got a total return of around 0% from my old stake but happy to have provided a successful idea to the community!

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    • Interested if anyone is still holding on? There’s a full on bidding war now between Apollo-backed Concord and Blackstone, which I wasn’t expecting. Blackstone bid $1.24 last week, and Concord raised their offer to $1.25 today, to which Blackstone replied that they will respond.

      To anybody that hasn’t sold, I would wait until the Blackstone counter-offer. I don’t think either would be willing to go much further than that, and with legal uncertainties surrounding the advisor remaining it wouldn’t be worth waiting for an incremental gain.

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      • Blackstone raised bid to $1.30 and board accepted.

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      • Thats 1.05 in pounds/pence to keep the units consistent. Great win Daniel!

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      • Terrific idea and timing Daniel. Do you invest in the rest of the music royalties universe as well?

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