Royalties are payments made by one party (Operating Entity) to another party (Owning Entity) that generates value (whether a tangible or intangible asset) in exchange for the exploitation of this asset (see Figure 1).
Figure 1. Royalties: payment scheme.
An investor can purchase the right to collect royalties from the Owning Entity (usually) or from the Operating Entity, which to skip a step in the payment will pay royalties directly to the investor.
Below we will look at how to price royalties and what risks the investor is exposed to. But for these insights it is first necessary to know what types of royalties one can invest in. In fact, this type of alternative investment allows for real portfolio diversification. The best known royalties are definitely those on music, which belong to the broader category of Copyright, which in addition to music tracks and albums also includes books and art in general. Every time a piece of music is played (e.g., on television, radio), a record, a book, or a work of art is sold a royalty must be paid to the rights holder. In much the same way other intellectual properties such as patents whose exploitation can be granted to Operating Entities in exchange for royalties behave.
The extraction of minerals and energy resources (gas, oil, etc.) also generate a flow of royalties to the owners of the land under which these resources insist.
And finally, the flow generated by a franchise agreement is definitely a royalty.
Having established, then, that it is possible to construct a diversified portfolio of royalties, it is now a matter of understanding its risks and, more importantly, how to invest in it. The main risk is evaluative because it involves pricing a stream of future receipts. In this, investing in royalties is not so different from investing in private equity and in fact similar valuation methodologies such as Discounted Cash Flow (DCF) and P/E multiples are used. Needless to say, these methodologies are subject to several critical issues such as determining the cash flow (if not constant), the discount rate (the WACC) and most importantly the time horizon (if not contractually fixed).
Of course, there is also a counterparty risk related both to the insolvency of the debtor and to the fact that it is necessary to ascertain with a great deal of precision and certainty that the seller of the royalties is the actual owner of the rights it transfers.
In contrast, other risks typical of non-alternative investments (e.g., equity and bonds), such as market volatility, do not seem particularly relevant. Indeed, investment in royalties should precisely be non-correlated with traditional asset classes and therefore offer good portfolio diversification.
In contrast, liquidity risk is particularly critical. Usually alternative investments are not very liquid, but in the case of royalties we have quite interesting marketplaces that are true auction exchanges. Among these we highlight:
- – Royalty Exchange: this is the largest royalty marketplace in the world and functions similarly to stock exchanges (in the part that concerns auctions). Potential buyers interested in a rights holder’s complete or partial work bid for the royalty. The winner wins the ability to claim future royalty income.
- – SongVest: Just as individual shares can be sold and traded as bundles, songs, albums, and other music assets can be bundled into IPOs which earn SongVest investors money each time a song or associated composition is played (disseminated), sold, or purchased.
- – Royal: Investors who choose Royal as their exchange receive tokens (on blockchain) correlated to a particular percentage of streaming revenue for a music track. This system allows investors to collect a royalty stream along with the artists who produce their favorite music.
- – Cypress Growth Capital: is a solid royalty option to consider if you are interested in corporate investments, technology innovations, small businesses, venture financing and similar options.
The last aspect of this type of investment that we suggest evaluating carefully is the tax profile, which obviously needs to be analyzed with an experienced advisor regarding the investor’s tax domicile. Generally, royalties avoid double taxation and this clearly determines a competitive advantage over other forms of investment.
Disclaimer
This post expresses the personal opinion of the employees of Custody Wealth Management who wrote it. It is not investment advice or recommendations, personalized advice and should not be considered as an invitation to conduct transactions in financial instruments.
