Quick idea

Market cap: £944m – Share price at publication: £0.76

September 14, 2023 - UPDATE & CLOSING OF IDEA

Hipgnosis just issued a trading update (Link) in which it essentially announced it would take all the steps I had outlined in the quick idea thesis, mainly selling parts of its catalogue, pay down debt and announcing a share repurchase program. Valuation and execution of the disposal is disappointing though, and the shares seem fully valued here at £0.94. The quick idea is therefore closed.

Regarding the transaction: The fund will be selling off parts of its catalogue to its parent company owned by Blackstone and Hipgnosis founder Mercuriadis, Hignosis Capital. However, the metrics of the deal are disappointing in that the catalogue is sold essentially in-house and that the valuation is quite discouraging at the low end of the liquidation scenario that was published in the quick idea.

Details of the catalogue disposal include:

• Catalogue sales for an aggregate consideration of $466m at a 18.3x HANPSI.

• Buyback program of up to $180m

• Repayment of $250m of debt

• Reducing fees to investors

Particularly the valuation is in my opinion disappointing at just 18.3x HANPSI. In the conservative liquidation scenario, I had assumed a conservative multiple of 17.5x which values the entire fund after liquidation costs at £0.92.

The disposal does not give much optimism at this time that a higher valuation can be achieved for the catalogues and imply that the funds’ shares are now fully valued, hence the quick idea is closed and moved to the archive.

++End of Update++

Why look at this?

Hipgnosis Songs Fund Ltd. is a London Stock Exchange-listed closed end fund investing in music catalogues. The fund trades at a roughly 50% discount to its published “operational” NAV of £1.50 (as of March 31, 2023). Shares in the fund, which went public in July of 2018, have lost about 30% since their initial public offering. The fund is (at least to my knowledge) the only such vehicle in the public markets investing solely in music catalogues.

There are numerous risks and uncertainties around basing a thesis around a NAV discount in closed-end listed funds, particularly when it comes to exotic and non-liquid assets. However, the situation in this case revolves around a key milestone: The fund faces a continuation vote in its upcoming September 2023 AGM in which shareholders will have to approve whether the fund will continue its existence. The vote, required under its incorporation articles, must happen on the fifth anniversary of the IPO and must be held again every five years after that.

As the share price performance has been quite disappointing with the fund trading at a significant discount to its self-proclaimed NAV, investors are likely not happy. Hence, the funds’ advisor has pledged to address the situation and promised to initiate “shareholder value enhancing steps” before the AGM at the end of September.

From the annual report for the year ended on March 31, 2023 (Link to report), in which founder Merck Mercuriadis said (pretty typical stuff when one’s share price underperforms):

„We are aligned with Shareholders in believing that the fundamental value and opportunity of the Company fails to be reflected in the current share price. As a result, we have been working with the Board, following consultation with many of the Company’s largest Shareholders, on a number of options to enhance Shareholder value. We intend to update the market prior to the Annual General Meeting (AGM) and the Continuation Vote.“

As the vote is coming up in about one and a half months (last AGM was held on September 21, 2022), any news referring to steps taken by the advisor on enhancing shareholder value should come soon (if there are any, of course). Last year, the fund sent out its circular prior to the AGM on August 3. Since the annual report was published on July 13, 2023 for the year ended on March 31, the share price had improved slightly but has retreated back to levels of the date of publication.

So, the questions at hand in this special situation are essentially:

• whether the company has already or will undertake any kind of ‘strategic options’ in a bid for narrowing the NAV discount prior to the upcoming vote at the end of September, and

• how serious the chances are that shareholders would actually vote against a continuation of the fund, forcing it to unwind, essentially sell all assets and return cash to shareholders which could result in some upside from current share price levels.

The structure of the fund and the related parties makes this a bit of a hairy set-up with the main catalyst that the fund manager will want to show something in terms of improvements to creating shareholder value before the vote in September to increase the odds of not losing the continuation vote.

Fund profile

The fund was launched by Hipgnosis Songs Management (formerly known as “The Family (Music) Limited”), an investment advisory company launched by Merck Mercuriadis, a Canadian music industry executive, in 2018. Mercuriadis is a former manager of Elton John, Beyonce, and Guns N’Roses. The listed fund is advised by its fund manager, Hipgnosis Song Management, which receives various fees for managing the portfolio.

Mercuriadis idea behind Hipgnosis was to acquire and manage music catalogues and establish music as an investment asset class. The fund would collect cash from its investors and proceed to invest it into catalogues of music. Revenue is collected through licensing fees and royalties (e.g. Spotify, Youtube, radio stations, concerts etc.). The royalties from streaming, performances and licensing are then to be paid out as dividends to the funds’ investors.

Essentially, the fund is a type of fixed-income product with potential upside on improved royalty income over time that the advisor hopes to lift through active management of the portfolio, such as placing certain songs in Netflix shows, console games or in advertisements. The advisor has also stated its thesis that the fund should, over time, profit from a portfolio effect, essentially that it will be one of the few entities with such a large catalogue of songs which should be reflected in a higher multiple than small catalogues on their own.

The Hipgnosis fund launched with its original fundraising and subsequent listing in July 2018 after hauling in more than £200m of cash. It then began a shopping spree for music catalogues, including from artists such as Nicki Minaj, M C Hammer and Neil Young.

The stock price rose by about 25% to its all-time high of £1.256 in November 2021 from its IPO. Between 2018 and 2021, the fund conducted four additional capital raises, hauling in a total of £500m in additional cash from investors. The cash it has taken in has almost completely been spent on catalogues and the fund’s credit line is almost fully used ($600m drawn vs. $700 that are available in total under the funds revolving credit facility that was renegotiated in 2022). Further, the company can’t currently take on more leverage due to its own fiscal rules.

Some people have said that the fund spent the money it had sourced from investors too quickly and purchasing catalogues at too high prices while also unnecessarily increasing leverage to unhealthy levels. Hipgnosis, on the other hand, has disputed this claim, saying it was at times being outbid by its competitors (Link).

Share price performance has been disappointing, with the common share price down about 30% since the IPO (excluding dividends paid). However, the funds advisor states that NAV per share performed to the contrary, rising by 54% since the IPO.

NAV Discount

What I have found frequently with these kinds of listed alternative investment funds that many NAV calculations are manipulated to the upside, so a high degree of caution should be exercised when building a thesis around a NAV discount as even with a high discount, that discount may actually not be there at all or there is no way in materializing it.

At the end of the day, the advisor to a fund pays for the appraiser (be that in a real estate trust or some other non-liquid asset class), therefore there is an inherent conflict of interest between both parties. Wanting to show positive performance of the underlying asset to investors and maintaining a high base from which to calculate the on-going fees may sometimes be a motive for pressuring an appraiser to push valuations. I am not saying that this is the case here (and Mercuriadis has fiercely denied this argument (Link) which was once made by a columnist from the newspaper The Times), but rather just issuing caution as I have seen this behavior between appraiser and advisor before where this conflict of interest did in fact weigh on the valuation that was assigned.

Particularly in the case of Hipgnosis, what is certainly eyebrow raising is the fact that the discount rate used by the appraiser has not moved at all since rates began rising. They have found a number of explanations for this approach (quality of portfolio has gone up, as have revenues making it higher quality and more predictable and essentially outbalancing a higher rate that would be appropriate), but the arguments failed to convince me fully.

One can assume that the risk premium for “exotic” assets such as music catalogues has probably gone up even further than rates for other more established and predictable asset classes. I’d put a huge question mark behind the published “operational” NAV (which itself is adjusted by some key metrics) as likely too optimistic and reiterate that I would not advise anyone build a thesis around some NAV discount alone.

The construct behind and around SONG

Hipgnosis is a bit confusing to the outside observer with three separate entities bearing that name. To explain the construct, one needs to understand the relationship of the three entities:

• Hipgnosis Songs Fund Ltd. (LSE:SONG) (HSF) is the entity we are looking at primarily as it is the LSE-listed closed-end fund that fully owns or owns stakes in some 65,000 songs;

• Then, there is Hipgnosis Songs Capital (HSC), a private entity formed with about $1B in capital from Blackstone (NYSE:BX) that was launched in 2021 and has spent about $700m acquiring music catalogues, including from artists such as Justin Bieber, Leonard Cohen and Justin Timberlake;

• Finally, there is Hipgnosis Song Management (HSM), the investment advisor to both entities that was founded by Merck Mercuriadis. The advisory business is majority co-owned by Blackstone (51% ownership stake) after it bought Mercuriadis out in October 2021 (Link).

Hipgnosis Structure

Blackstone

BX purchased a majority stake in the GP Hipgnosis Song Management from Merck Mercuriadis in 2021 for an undisclosed amount and formed a separate, private entity (HSC) to do what the public entity is doing, only with funding exclusively from BX (Link). While the public entity has not made any deals this year, the private entity bought, among other deals, Justin Biebers’ catalogue for an estimated $200m (Link).

Sources (Link) have also reported that through the takeover, Blackstone now has, through HSM, a right of first refusal over the public entity. This would mean that selling assets from the public fund in order to raise funds for e.g. a buyback program, would have to at least be run by BX first.

The issue with the situation that BX essentially now controls the advisor, and its own fund is that it is in their primary interest to collect as much fees as possible from the investors in the public entity and have its own entity perform as stellar as possible. Rumor has it that Merck Mercuriadis put the proceeds from selling part of his stake in the GP to BX into the newly formed private entity, essentially creating another conflict of interest.

Fee structure

The structure as it is in place currently (at least regarding the public vehicle) is a fee-printing machine for the manager, charging investors a 0.8% advisory fee, 1.21% in “on-going charges” calculated on the “operational NAV” which is 100% higher than the share price and a 10% cut from share price returns in excess of 10% subject to a high-water mark.

From the advisor’s standpoint, keeping the fund going and the fee structure intact makes a lot of sense given the absurdly high fees (particularly in light of the share price performance). With the disappointing share price performance and being charged those kind of fees, I personally would find it very difficult to justify this compensation structure to the manager.

Threat of non-continuation

The shareholder structure is highly fragmented with just two shareholders holding close to 10% and a myriad of smaller stakes held by other investors.

At last year’s AGM (with the share price about a third higher than today) all resolutions passed almost unanimously. A 2023 circular has not been published yet. Notice of the AGM was given on August 3 last year. It’ll be interesting to see the wording on the continuation vote item, but I would estimate that it has to be a “in favor” vote in order for the fund to continue its existence.

I am really torn to estimate the risk of shareholders voting against a continuation. There are no activists around among the shareholders and those that make up large positions are (at least not to me) not particularly known for being aggressive in pushing a management in a certain direction.

Last year, all resolutions in the AGM passed with flying colors. I am sure any news by Hipgnosis on a potential disposal and subsequent share buyback program would almost certainly ensure a continuation vote but I struggle to see investors uniting and pressuring for a dissolution of the fund even without any good news before the AGM.

What news would be “good” news before the AGM

Given the wording by Mercuriadis in the annual report, I think there is a good chance that the advisor must have at least tried to take steps in order to somehow validate the value in the fund prior to the AGM and the continuation vote.

My expectation as existing investor would be a straightforward process in which the fund announces that it has sold some non-core assets from its catalogue at an attractive valuation that validates the NAV calculation, with a subsequent initiation of a buyback program funded with the proceeds from the disposal.

I would argue that this would be the most obvious route the advisor could take, if (and that’s a big if) it is able to sell assets that are non-core.

Essentially, what is needed are news in the notice of the AGM that the fund sold assets at a much better valuation to the current pricing of the fund in the public market.

Valuation perspective

The appraiser is a firm called Massarsky Consulting specializing in “copywright economics” that was taken over by full-service tax and advisory firm Citrin Cooperman in 2022 (Link). I have absolutely zero experience in the valuation of music copyrights, however given how niche this sector is and that Mr. Massarsky seems to be one of the OGs in valuing these assets, it appears that these valuations can’t seem to be completely detached from reality.

In the 2023 annual report, the appraiser gives some detail on its reasoning of the valuation. In its reasoning, it states that it values the catalogues based on a DCF using a discount rate and checks it against a multiple based on a metric named “historical annual net publisher share income” (let’s short this to HANPSI). So, let’s assume that this metric is the income that the publisher or owner of a catalogue receives in income from royalties based on historical figures.

In the annual report, the appraiser states that as of March 31, 2023, the catalogues of the listed Hipgnosis fund are valued at $2.8B, resulting in a HANPSI multiple of 20.9x. The appraiser further states that the blended acquisition multiple of the portfolio is 15.9x HANPSI.

Reverse calculating that figure, we get US$134.04m of HANPSI over the total portfolio.

Massarsky also attaches a table with recent transaction comps that took place in 2022 & 2023 that are comparable to the SONG portfolio.

Essentially, the portfolio, if compared to recent market transactions, can be purchased a pretty attractive multiple currently in the public market. However, there is likely no way to monetize that delta with the assets held in the current Hipgnosis fund structure.

However, I found another comp from 2021 in which Kobalt Music, a privately held company that had also sold a large portfolio to Hipgnosis in 2020, divested another portfolio, the “KMR Music Royalties II” portfolio to KKR and its co-investment partner Dundee Partners, for $1.1B (Link). That portfolio consists of 62,000 songs (vs. 65,000 for the Hipgnosis fund at a $2.8B valuation per appraisal in 2023), though I am unsure about the quality of the portfolio compared to the Hipgnosis catalogues. Nevertheless, the difference in valuations is quite stark.

To conclude, in order to calm investors and demonstrate that the valuation of the portfolio is justified, Hipgnosis must sell a part of the non-core portfolio of catalogues at an attractive multiple, say at least 20.0x HANPSI and announce a buyback program with the proceeds.

Margin of Safety

While a liquidation scenario is unlikely given the reasons stated previously, let’s take a quick look at a theoretical liquidation scenario.

Assuming the portfolio would be liquidated at a discount to current valuation, somewhere in between acquisition and current HANPSI multiple of 17.5x @ HANPSI of $134.04m, taking into account a tax charge that Hipgnosis stated in its annual report in the case of a complete divestiture of US$245m (maybe a scare tactic) and an estimated divestiture fee of £100m, one would arrive at a distribution of £0.92 per share and a theoretical upside of 21% to the current share price.

This would be a very conservative scenario compared to the NAV stated by Hipgnosis and leaving a lot of room for things to go wrong.

The issue with this scenario is, however, that its far from the actual worst-case scenario of the fund not demonstrating the value of its portfolio before the AGM and the continuation vote passing. I struggle to see how the shares would re-rate in the short or medium term without Hipgnosis taking any actions, given that its financial wiggle room is tight as the maximum LTV ratio is almost reached.

Conclusion for the time being

There certainly is some value in the assets and I would feel mildly comfortable in a scenario in which there would be the binary outcomes of:

• The fund demonstrating value through selling non-core assets at an attractive multiple, shares re-rating upon buybacks and the fund continuing, or

• the fund not being able to demonstrate value and the majority of investors deciding to block the continuation vote and the fund liquidating.

With a third outcome in the cards that would make the realization of value very unlikely as the pressure won’t be up for Hipgnosis for the next five years until the next continuation vote, I’ll put this situation on the pile that could be re-visited very quickly in case Hipgnosis shows that it has an ability to sell non-core assets at attractive multiples or an announcement of liquidation following a rejected continuation vote.