Investing in royalties: commodities, private assets & real contractual income

Chris Semenuk
By Chris Semenuk
Investment Partner
August 17, 2023

Royalties stand out in the equity investment landscape by offering a combination of three areas -commodities, private assets, and income generation. This blog explores the royalty business model and how we believe this combination makes these companies a potentially attractive investment opportunity, especially in the current environment.

Key takeaways

      Royalties are a form of financing and are typically found in the commodities, pharmaceuticals, entertainment, and technology industries.

      Royalties largely avoid the operational, financial and equity risks of the underlying asset while retaining exposure to its growth.

      Royalties offer exposure to unique private assets that are otherwise hard to access.

      Royalty equities are attractive because they have historically outperformed commodities and mining equities. [1]

      Royalty companies are a source of real contractual income.

      Royalty companies operate in a growing market with scalable business models.

      Tema Global Royalties ETF (ROYA) is the first US-listed ETF to invest in royalty companies.

For a list of current fund holdings, please visit the fund web page at www.temaetfs.com/roya. All investments involve risks, including possible loss of principal. For a more complete discussion of the potential investment risks to the topics discussed below see the disclosure section at the end of the page.

What are royalties?

A royalty is a share of an asset’s future revenue in exchange for upfront investment.

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Royalty companies own a collection of these royalty streams, using the cash flow generated from their existing portfolios to invest or to distribute to shareholders. They are effectively providing upfront financing and are repaid through the commercialization of the asset which they provided the financing to. This repayment cycle is typically contractually tied to either a minimum period or a minimum return threshold. In the case of intellectual property, like music, the “upfront financing” takes the form of creating the actual intellectual property.

Royalties span several different industries

Royalties arise in several different industries spanning natural resources and intellectual property, as effectively an alternative source of financing for privately held assets.Slide2-Feb-01-2024-03-34-27-2598-PM

Mineral royalties

Royalty ownership in the mining industry originated in the mid-1980s when Franco-Nevada spent half its corporate treasury to acquire 4% of the annual gold production and 5% of the net profit interests [2] from Western State Mineral’s Nevada mine. At their core, these contracts involve a mining company selling future production (called streaming, settled in physical delivery of metal) or revenue (typically referred to as royalty, settled in cash) of a particular asset in return for up-front cash which is in turn used to pay for developing the mining asset. Since the first royalty was struck, the popularity of using this form of non-dilutive financing grew, especially in the precious metals industry.

Oil and gas royalties

Oil companies often require considerable capital expenditure to drill both onshore and offshore wells. To finance this, they can turn to royalties – selling a share of future oil revenues against capital upfront to fund drilling. Royalties can also arise from land ownership on which oil and gas resources are found. For example, Texas Pacific Land Corporation owns 24,000 acres in the Permian Basin [3] , one of the most resource-rich assets in the US, and collects royalties from exploration and production companies that it hires to exploit oil and gas reserves under this land. Less than 15% of the land has been developed leaving a long runway of future growth[3].

Pharmaceutical royalties exemplified by Royal Pharma

In the mid-1990s, Pablo Legorreta began to establish the proof of concept for investing in drug royalty streams, and in 1996 established Royalty Pharma [4] . His company would acquire royalty interests in approved drugs. Usually these were bought from the non-profit sector (foundations, universities) that originally researched the drug, and received a royalty from licensing them to biotech firms for future commercialization. The structure of these contracts has evolved over time but the key principle of owning a royalty stream has remained. Royalty Pharma IPO’ed in 2020 and remains the leader in the space and has been followed by companies like Xoma and Ligand.

Music royalties

Music, when it is produced and recorded, leads to the creation of a copyright royalty. This means that when that music is played anywhere, whether on streaming or a CD, a small portion of the revenue generated is paid to the owner of that copyright. Most of these royalties are owned by the record labels, like Universal or Warner. The most recent decade has seen the rise of independent funds that purchase catalogues of music royalties, for example the Hipgnosis Songs Fund. Rights related to artists like Fleetwood Mac, Neil Young, John Lenon and Dire Straits have been acquired in this way.

Are royalties riskier than the underlying asset?

Part of the attraction to royalties is the reduced risks. The revenue-based nature of most royalty agreements means that royalty companies benefit from topline revenue growth while avoiding the risks affecting bottom-line profit growth. These risks, borne solely by the ultimate owner of the underlying asset, could include cost increases which depress margins, capital cost overrun which hurt free cash flow, and capital raises which dilute equity. Often underlying assets also face heightened financial risk from leverage or reputational risks given direct owners of an asset (say a mine) may be held accountable in ways that a royalty owner cannot be. In that sense, royalty owners benefit from top line growth while largely avoiding the many risks faced by that asset.

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Royalties are a potentially attractive investment opportunity

Royalties are attractive for several reasons which tend to differ by sector.

Royalties do better than underlying commodities and mining companies

Royalties are an interesting way to get exposure to commodities while avoiding some of the risks described above. As a result of this dynamic, the royalty stock universe has historically outperformed both the underlying commodities and mining equities over multiple periods.Slide5-Feb-01-2024-03-34-27-0088-PM

Royalties are a structured exposure to hard-to-access private assets

Royalty companies effectively buy financial exposure to private assets. In this context there are several advantages:

       Some of these private assets are almost totally inaccessible to most investors directly, such as music catalogues or innovative life science assets. For example, Universal music owns royalties on 15 of the top 20 global artists today [6] .

       Employing royalty structures, a firm receives a preferential position in the capital structure. In the case of a liquidation of the underlying asset, equity is wiped out and debt often takes a substantial haircut, while a royalty contract would survive.

       Royalty companies have management teams with expertise and a track record finding and selecting royalty assets.

       Royalty companies own a portfolio of royalties, thereby leading to diversification over the collection of underlying assets, which can help reduce risks.

Royalty companies provide real contractual income

Royalty companies effectively own a stream of contractual cash flows. They use this cash-flow to grow by re-investing in new royalties, while distributing excess cash back to shareholders in the form of dividends and buy-backs. Historically this has meant attractive dividend yields for royalties as seen in the chart below, especially when compared to the broader market (S&P 500) or underlying commodities (which pay nothing). For example, Wheaton Precious Metals has paid a progressively higher dividend to its shareholders for the last eight consecutive years [7] and projects that its key will grow organically by 40% over the next five years [8] .

Unlike broader equity dividend streams, this income stream is underpinned by real (i.e., inflation sheltered) and contractual sources. This is because if prices rise, revenues increase, and royalties earn a fixed percentage of a rising pool. This percentage is guaranteed by contracts. In the case of general dividend income – there is an entire P&L and capital expenditure between revenue and final dividends, exposing equity holders to all kinds of risks, potentially restricting final payouts. Slide6-Feb-01-2024-03-34-27-0029-PM

Royalty companies have many attractive qualities

Royalties are a growth industry

Royalties are a growing form of financing. For example, biopharma in the past five years has raised about $260 Bn in total financing, with royalties representing just 2% of that number [10] . Over the next five years, starting in 2022, Royalty Pharma expect the amount of capital raised to be almost double, to $450 Bn[10] . For illustration purposes if pharmaceutical royalties captured just 4% of that market, their total market size would go up 4.5x[10] .

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Royalty business models are scalable

Slide8-4Royalty firms themselves are highly scalable. This is evidenced by their high margins and outstanding sales per employee metrics, outstripping mining companies as well as large tech firms.

A key driver of this is operating leverage. As revenues expand driven by rising underlying asset revenues and acquisition of new royalty streams, costs typically don’t increase as much, leading to potential for a substantial increase in operating cash flows. For example, Royal Gold over the last 20 years has seen a 64x increase in revenues but only less than a 20x increase in costs (as they have invested to expand) which means operating cash flows have gone up nearly 100x [11] Slide9-3

Exploring investment opportunities in Royalties

Investing directly in royalties is very difficult for investors as these are hard to access private assets. It is possible to buy royalties for music, on venues like Royalty Exchange, but doing so is very risky as it requires considerable expertise. The other approach is to invest directly in royalty company equities, but this carries all the risks associated with single stock investing.

Is there a Royalties ETF?

The Tema Global Royalties ETF (ROYA) is the first of its kind in the United States, offering exposure to royalty companies across the commodities, music, and pharmaceutical sectors. ROYA focuses on identifying royalty companies that have limited leverage and management track records of investing in successful royalties.

Why should I consider investing in Royalties ETF in the current environment?

Companies need alternative financing sources

Royalties are first and foremost an alternative source of financing for companies. In the current environment, traditional sources of financing have become very expensive, raising the attractiveness of more creative sources. This increased demand also allows royalty companies to be flexible and opportunistic in how they deploy their capital.

Inflation remains persistent

Royalty companies have the potential to benefit from inflationary environments. Inflation can lead to rising revenues across underlying assets and therefore rising revenues for royalty companies. The latter falls straight to bottom lines, as royalty companies don’t have the same rising operating costs. 

There is evidence of a commodity price updraft

The world could be entering what some have called a new “commodity super-cycle” – where commodity prices rise structurally. One sign of this is the lack of investment in new supply by extractive industries. This is best measured by the ratio of capital expenditure to depreciation within the mining and oil and gas industries. During the decade between 2005-2015, this ratio was high as mining companies expanded to accommodate the rising demand from China and the emerging world. This ultimately created over-supply in some commodities leading to falling prices in the late-2010s. What we have been seeing since then is a permanent downshift in capital expenditure, which could lead to restricted future supply. When combined with steadily growing demand there is potential for longer-term, structurally higher commodity prices. Slide10-3

What are the risks of investing in royalties?

Investing in royalty companies involves several risks:

       Leverage – Royalties are contractual cash flows meaning they can support higher debt loads. This financial leverage can pose risks should something go wrong. Balance sheet analysis is one of Tema’s four pillars of security selection, and we try to avoid situations where excessive leverage could impair future equity value.

       Jurisdiction risk – For commodity royalties, there is a risk of asset expropriation in certain less developed jurisdictions.

       Counter party risk – Since royalties are a contract requiring the underlying asset owner to pay a stream of cash flows in the future, there is a risk that the owner might break the contract and not pay.

Bottom line

Royalties are a differentiated, efficient asset offering financial exposure to commodities and other hard to access private assets. Their inflation-linked revenues and low operating and capital risks mean they can offer a real contractual income for investors.

Footnotes

[1] See Total Shareholder return comparison of Royalties, S&P/TSX Global Mining index, and Bloomberg commodities index over a 1-Y, 3-Y, 5-Y & 10-Y period on page 4 of this blog.

[2] Source: Republic of Mining, 2008, ”The Northern Miner’s 1997 ‘Mining Man of the Year’ Pierre Lassonde and Seymour Schulich”.

[3] Source: Texas Pacific Land Corporation investor presentation, February 2023.

[4] Source: Royalty Pharma website.

[5] S&P/TSX Global mining index: tracks equity securities of major companies in the North American mining industry. Bloomberg commodity index: Index made up of 23 exchange-traded futures on physical commodities, representing 21 commodities which are weighted to account for economic significance and market liquidity.

[6] Source: Universal Music Group investor presentation, Full-year results 2022.

[7] Source: Bloomberg as of June 2023.

[8] Source: Wheaton Precious Metals corporate presentation, June 2023.

[9] S&P 500: The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. Solactive Global Royalties Index: representation of firms earning royalties by licensing their intellectual property or tangible assets or earning revenues through royalty finance or royalty streaming.

[10] Source: Royalty Pharma corporate presentation, 2021.

[11] Source: Royal Gold Investor Presentation, Bloomberg.