J.P. Morgan just wrote a glowing endorsement of Hipgnosis Songs Fund. Here’s why. – Music Business Worldwide

MBW Reacts is a series of short comment pieces from the MBW team. They are our ‘quick take’ reactions – through a music biz lens – to major entertainment news stories.

J.P. Morgan issued a glowing research note on UK-listed Hipgnosis Songs Fund on Monday (September 19).

“Given the long-term growth potential of the asset class, and the higher quality (in our view) portfolio relative to [Round Hill Music], we believe SONG offers compelling value,” said J.P. Morgan, maintaining its ‘overweight’ rating on HSF’s stock.

J.P. Morgan’s research note on Hipgnosis Songs Fund was a thundering vote of confidence in HSF’s business, following a recent flurry of business media scrutiny.

In particular, a run of three similar recent articles in the Financial Times on HSF each questioned aspects of Hipgnosis Songs Fund, including:

• The fact HSF hasn’t bought a catalog in the past 12 months;
• The fact that it’s refusing to raise new funds;
• The impact of current macro-economic pressures on HSF’s value, and its finances.

We’ll get to some important detail behind all three of those shortly, and what J.P. Morgan has to say about them.

But first things first: Said coverage of HSF has led to some follow-up reporting, which in turn has led to the wonky conclusion in some quarters that ‘Hipgnosis has burned through its cash’.

As much as that idea might bring glee to those with the knives out for Merck Mercuriadis’ company, in reality it’s flat-out wrong.

That’s because Hipgnosis Songs Fund is not Hipgnosis; it is one part of a three-pronged Hipgnosis group.

That group has already spent approximately $300 million on music catalogs in 2022. Sources suggest that the current plan for this Hipgnosis group is to spend another $300 million by the end of the year.

In short: Hipgnosis, the group, has access to all capital it needs to do every conceivable artist/songwriter copyright acquisition in music.

It remains to be seen, however, how a rising rate environment might complicate this picture, with interest rates now at their highest point since 2008 in the US and UK.

Understanding Hipgnosis

To understand the Hipgnosis group – and why it still has a potential pipeline of billions of dollars in its M&A arsenal – we first need to refresh our memories of the three Hipgnosis-branded companies:

• Hipgnosis Songs Fund (HSF): a UK-listed FTSE 250 company that has acquired over $2 billion in catalogs to date, which have collectively been given an independent valuation of $2.7 billion;
• Hipgnosis Songs Capital (HSC): a private fund, fully-funded by Blackstone, that has spent around $300 million acquiring copyrights in 2022 alone, from the likes of Justin Timberlake, Kenny Chesney and the Leonard Cohen estate;
• Hipgnosis Song Management (HSM): a ‘song management’ and Investment Management company that advises on the investments of HSF and HSC, and manages the assets of both.

In essence, company (iii) – Hipgnosis Song Management – chooses which catalogs to spend HSF’s and HSC’s money on.

Over three years (2018-2021), HSM built up a portfolio for Hipgnosis Songs Fund of ≈65,000 copyrights from writers such as Mark Ronson, Red Hot Chili Peppers, Neil Young, Lindsey Buckingham, Tricky Stewart and many others.

However, last summer, HSM confirmed that its primary source of capital for deals had effectively switched to company (iii): Hipgnosis Songs Capital.

The initial commitment to HSC from Blackstone was a billion dollars (a mix of equity and debt). Sources suggest this commitment is still expected to multiply over the next few years.

It’s this fund (HSC) that has spent $300 million on music rights in 2022 so far via HSM – and which is expected to spend somewhere near that again in the remainder of the year.

Rising interest rates, however, are likely to put a cap on the multiples any music company is willing to pay for copyright buyouts in the current environment.

Unless prospective sellers are willing to drop their desired multiple to this level, we may see something of a cool-down in the music M&A space in the months ahead.

(There is a flip-side to this situation: Some artists and songwriters may indeed be willing to sell at a lower multiple than their peers achieved in recent years – because once they have money in the bank, high-interest rates and a battered stock market arguably create an investment market where said money can quickly gain in value.)

Why is Hipgnosis Song Fund not raising money?

For casual observers of Hipgnosis Songs Fund (HSF) – which has spent over USD $2 billion on catalogs since being founded in 2018 – the current halt in its spending activity may come as a surprise.

Yet for HSF investors, and those more closely watching the company, it’s not exactly unexpected.

Hipgnosis Songs Fund told its shareholders when it raised $215 million last July that it was putting a stop on further raises until Q2 2022 at the earliest.

The following month, in August 2021, HSF told investors that it was “fully invested”, following acquisitions of several catalogs (using that $215m) including music by the Red Hot Chili Peppers and Christine McVie of Fleetwood Mac.

Q2 2022 has now been and gone, which means HSF is free from its self-imposed moratorium on raising money. But market conditions don’t look like they did last summer.

In particular, with the dual shocks of a steep rise in inflation plus the war in Ukraine, public share prices across the board have been hit hard.

Publicly traded music compares have not been immune to this trend: Hipgnosis Songs Fund is down 20% YTD in 2022; Universal Music Group is down 27%; Reservoir is down 33%; Warner Music Group is down 42%; Spotify is down 50%; Believe is down 58%.

It’s therefore unlikely that companies like these would choose to raise new equity (via share issues) at current stock prices as it would damage the holdings of existing shareholders. In accordance, HSF has opted not to do so.

Another barrier to Hipgnosis raising money right now: those rising interest rates.

HSF currently has a debt stack of $600 million. The cost of servicing that debt increases with every interest rate rise.

That being said, HSF confirmed to shareholders this week that it has now secured a new debt refinancing package. J.P. Morgan was impressed with this news, saying this refi is “expected to lower [HSF’s] facility cost and increase its size”.

As MBW explained in November, HSF – so long as it has the funds available – can opt to acquire a 20% stake alongside HSC (via the latter’s billion-dollar-plus pot of Blackstone money) in any catalog buyout proposed by HSM.

Why is Hipgnosis Songs Fund’s Pro-forma revenue declining?

One major topic raised by financial media outlets in recent weeks: The ‘Pro-forma’ revenue (PFAR) of Hipgnosis Songs Fund declined YoY in HSF’s FY 2022 (to end of March 2022).

On the surface of it, this certainly looks troubling: ‘Pro-forma’ revenue (PFAR), which HSF voluntarily publishes, shows the royalty revenue earned by catalogs in a calendar year based on royalty statements received, irrespective of whether the songs were owned by the company over the period analyzed. It is a ‘pure’ like-for-like reflection of how catalogs are performing.

You’d expect a certain amount of decline each year in ‘Pro-forma’ revenue at a company like Hipgnosis Songs Fund due to newer catalogs; i.e. catalogs that are still ‘leveling off’ from their commercial peak before they hit a long-tail plateau.

In turn, you’d expect these declines to be offset by a rise in income from older catalogs that have already hit that plateau.

For example, within HSF’s catalog of songs, you’d expect Shape Of You (released in 2017) to still be on a strong decay curve, but you’d expect classics from Neil Young, Lindsey Buckingham, Bon Jovi etc. to be increasing annual revenue as they ride streaming’s growth.

So what went awry within HSF’s ‘Pro-forma’ revenue in FY 2022? In a word: Covid.

Performing rights societies across the globe typically account to publishing rights-holders 12 to 18 months behind the moment of consumption. Within HSF’s numbers right now, that lag is crucial.

If you go back 12 to 18 months from the end of HSF’s latest fiscal year (March 2022), you land at the heart of the greatest level of negative impact that COVID lockdowns had on all businesses.

Thus, there’s a substantial amount of performance revenues from around the world – music being played in bars, restaurants, shops, nightclubs, and all of the live performances by artists – that would have been there in ‘normal’ conditions but are not reflected in HSF’s numbers.

“We expect a very strong bounce back in [Hipgnosis songs Fund’s] performance income.”

J.P. Morgan

This Covid-driven revenue deficit is arguably more pronounced for companies like HSF than it is for the major music companies, because HSF is purely in the catalog business; it does not have a streaming cash bump from new frontline hits to offset the negative impact from Covid lockdowns.

J.P. Morgan this week noted why it was unworried by the ‘Pro-forma’ decline in Hipgnosis Songs Fund’s numbers for FY 2022, stating: “We expect a very strong bounce back in [HSF’s] performance income (ex the performance element of streaming, which is classified by SONG as ‘streaming’ but in reality is a combination of mechanical and performance), which was late to show up in the PFAR numbers, but also late to recover given the lag vs UMG and WMG.”

The early signs of that recovery were actually already there within HSF’s FY 2022 numbers:

• For the full calendar year 2021, HSF’s PFAR was indeed down 5.3% YoY;
• But in the second half of 2021 alone (July- December), HSF’s PFAR was up (vs the first half of 2021) by double digits (+11.6%, see below)

(How much HSF investors really care about the PFAR vs. the company’s ability to pay its expected dividends is another matter. At its AGM this week, Hipgnosis confirmed it would pay its interim 2022 dividend in October at the expected price, and reiterated it was on course to pay its full-year dividend, also at the expected price, in March 2023. J.P. Morgan seemed pleased by this news.)

Hipgnosis Song Management x Blackstone

Another question mark raised by recent reporting points specifically to Hipgnosis Song Management (HSM) and Blackstone’s level of involvement in the company.

Almost a year ago, Hipgnosis announced its partnership with Blackstone, with the investment giant fully funding Hipgnosis Songs Capital (HSC), while making an undisclosed investment into Hipgnosis Song Management (HSM).

MBW has done some digging, and understands that Blackstone owns 51% of HSM, with Mercuriadis and his family owning 35% and long-standing Hipgnosis allies, including Nile Rodgers, owning the remainder. As CEO, Mercuriadis runs the company.

Critics of this model might suggest that Blackstone’s majority (51%) ownership of HSM could give the private, Blackstone-funded Hipgnosis fund (HSC) unfair preference within the Hipgnosis group (the public fund, HSF, is owned by many other outside investors, including the Church of England).

On a more positive note, Hipgnosis’ strategic importance to Blackstone is surely highlighted by virtue of the controlling stake that Blackstone decided to acquire in HSM. (Plus, as mentioned, HSF – so long as it can find the money – has blanket co-investment rights on everything HSM sources and seeks to acquire.)

Regardless of the Hipgnosis group structure, the significance of having Blackstone as a committed investor in music rights should not be underestimated.

Blackstone had $881 billion in total assets under management (AUM) in FY 2021, and will likely have somewhere close to a trillion dollars in total assets under management by the end of FY 2022.

As mentioned earlier: Hipgnosis’ access to piles upon piles of private capital is not in question.

A controversial discount rate – and some very timely headwinds

Another aspect picked up in recent reporting from the Financial Times and others was the way in which Hipgnosis Songs Fund (the UK-listed company) is independently valued every six months.

To value HSF, the company turns to a group of music industry experts within Citrin Cooperman. This group previously operated as Massarsky Consulting before being acquired by Citrin Cooperman earlier this year.

Questions have been raised over Citrin Cooperman’s insistence that an 8.5% ‘discount rate’ remains sufficient for music valuations despite rapidly rising interest rates in the US, UK and elsewhere.

To keep it simple: If this discount rate was to be increased by Citrin, it would lower the value of Hipgnosis Songs Fund on a NAV (Net Asset Value) basis.

J.P. Morgan, though, says it continues to be satisfied with the 8.5% discount rate, and sees no need for adjustment.

The investment company said in its research note this week: “We actually think an 8.5% discount rate looked hugely conservative earlier in the year until US long rates started to rise… now we believe it looks reasonable given the still-big risk premium and lower beta of music as it has become a subscription-based utility annuity stream.”

Of course, with heavy inflation, a dwindling stock market, and the Fed ratcheting up those interest rates, companies like Hipgnosis Songs Fund are having to tackle some substantial macroeconomic headwinds today.

Yet J.P. Morgan notes that there is also a widespread number of ‘tail-winds’ helping boost the future prospects for HSF (and the wider Hipgnosis group).

The J.P. Morgan research note this week, penned by Christopher Brown and Adam Kelly, noted the recent ‘CRB III’ decision, which upheld better mechanical rates for songwriters and publishers in the US for the years 2018-2022.

As a result, the likes of Spotify, Amazon Music and other streamers are having to pay one-time money to publishers in order to satisfy retrospective rates in this period: Warner Music Group, for example, recently reported a $17 million windfall from the CRB III catch-up process in calendar Q2.

J.P. Morgan also likes the look of the recently-inked ‘CRB IV’ agreement between publishers and streaming services in the States, which would set the mechanical headline rate paid to pubcos at 15.35% of each streamer’s US revenue.

“We are optimistic about revenue [at Hipgnosis Songs Fund] over the coming year, with [many] positive drivers.”

J.P. Morgan

If ratified by the Copyright Royalty Board judges in the US, this will slightly increase the mechanical rate paid to publishers from 2023-2027 in the US as a result of CRB III.

What’s more, the historic strength of the US dollar vs. the British pound works in Hipgnosis Songs Fund’s favor when it comes to paying its UK dividends (the majority of the company’s revenues are generated in the US).

Combined with HSF’s debt refinancing, this run of news has put J.P. Morgan in a buoyant mood.

The investment firm’s note this week said it was “optimistic about revenue [at HSF] over the coming year, with [many] positive drivers”, including an expected increase in streaming subscription revenue and potential price rises on services like Spotify.

J.P. Morgan is also keen on the impact that the Mechanical Licensing Collective (MLC) is having in the States, forecasting that it “should lead to higher payouts from US streaming [to HSF], with more efficient, commission-free collections from DSPs”.

Furthermore, J.P. Morgan suggests that HSF will benefit from some “first time contributions to come from emerging digital platforms, not hitherto in SONG’s proforma annual revenue”.Music Business Worldwide