Royalties were invented in the commodity industry to finance the development of mines around the world. Yet this innovative financing structure has been making its way into other industries, a trend that is set to continue.
Artists have long used royalties, created when a piece of music is recorded or published, as a means of compensation and a way to link it to commercial success. The concept of buying and selling these royalties is a recent trend.
The last decade has seen funds form that have specialized in purchasing large catalogues of royalties. The poster child is the Hipgnosis Song fund, SONG, listed in London in 2018. The ride for investors (see chart) hasn’t been a good one partly because of the opaque management structures, related party transactions and other issues. This experience highlights how important it is to pick good royalty companies with strong experience management teams and operating records
Interestingly music royalties are starting to make their way directly to private investors through platforms like Royalty Exchange and the recent initiative from Public.com. There investors can buy and sell individual song royalties such as those from the Shrek motion picture. The attraction is owning an uncorrelated asset, linked to growing streaming markets while earning a contractual income. These attractions are certainly there, but need to be carefully balanced against any risks and the illiquidity of owning such an asset.
Drug development is notoriously expensive with a major upfront multi-year outlay against substantial future cash flows. This structure makes it similar to a mine. Drugs are also pieces of intellectual property which, when licensed, often lead to the creation of a royalty stream for the selling party. The combination is a perfect environment for royalties to develop.
The most well known company in this space is Royalty Pharma but there are others more under the radar firms. They effectively arose from initially building a platform technology (for example specific antibodies) to develop drugs which they license to larger pharmaceutical players in return for royalties. Examples include Ligand and Genmab. Both firms earn most of their revenue from these royalties and recycle it as a source of financing for their R&D efforts. Xoma is an interesting amalgam of these companies, starting life as a tech platform that sold IP for royalties, it has pivoted to buy up royalty interests from other biotech firms. As this slide from Royalty Pharma shows, this market is just getting started in terms of penetration
Like pharmaceuticals, technology often involves the creation of patents that are valuable to others. Through licensing firms can offer this technology and enable other firms to prosper. No example is more apt than Arm Holdings that IPOed in October 2023. From its modest roots as a UK computing pioneer ARM was the first to crack low power computer processing unit (CPU) design. Instead of using this design to build its own chips, ARM licensed this technology to others. As the mobile revolution took hold almost the entire gambit of smartphones was powered by Arm architecture, earning ARM a small royalty on every phone sold. This is a great example of the types of innovation and market growth a royalty company can foster
So What Unites this Trend?
Royalties are a growing form of financing, which is proliferating from commodities to other sectors. Rising interest rates and tough financing conditions often lead to companies seeking alternative forms of financing. As with other financial assets ecosystems develop as sellers and buyers often find each other, and royalty companies begin to capture this growth. We would not be surprised if royalties start to develop more fully in other markets in the future. As we have seen so far this is likely in sectors with a combination of high upfront capital cost, high intellectual property content, and long future cash flow streams.