Hipgnosis has sold some songs to itself, and that’s not even the odd bit

In 2018, Hipgnosis was the future. The music management group had floated a royalties fund in London with a tricksy corporate structure and an asset class that might be considered cool, at least relative to peers. Founder-manager Merck Mercuriadis would turn up in places not typically associated with closed-end investment trusts, such as the cover of Billboard magazine and backstage at the MTV Music Awards.

Several hundred catalogue acquisition press releases later, Hipgnosis Songs Fund might be liquidated.

HSF shareholders will vote later this month on whether to persist with a fund that has tended to trade at a ~50 per cent discount to its published net asset value. Turns out the cool asset class involves recondite valuation methods, and that income funds are quite sensitive to stuff like interest rates and cashflow visibility; see Alphaville passim.

HSF shareholders have been pushing for an incentive to vote for another five years of worrying about whether The Chainsmokers and Shawn Mendes have staying power. Today, they got one: a share buyback programme of up to $180mn and lower advisory fees for Hipgnosis Song Management, the investment advisor formerly called The Family that literally employs Mercuridas’s family.

There are some peculiarities to the proposal.

HSF is funding the cash return by selling 19 per cent of its portfolio to Blackstone for $465mn, which is a related party transaction. Blackstone bought a majority stake in Hipgnosis Song Management in 2021 on undisclosed terms and pledged $1bn to Mercuriadis so he could build its own private fund.

Shareholders of the listed entity accepted this at the time, in the hope that the involvement of Blackstone would add some professionalism to operations, even though it created an obvious conflict. Having already been tapped nine times since IPO, they had recently extracted a promise from HSF that it wouldn’t raise more acquisition capital for at least a year.

The suspicion was that Mercuriadis was finding an different outlet for his hoarder tendencies. Blackstone built a private portfolio including songbooks from Justin Bieber, Nelly Furtado and music festival fixture Nile Rodgers, a co-founder of HSF, while the listed fund mouldered. Whatever professionalism the relationship had encouraged within Hipgnosis wasn’t apparent in the share price.

Today’s deal will see the Blackstone-owned fund buy some songs from HSF. The catalogue for disposal (known as first portfolio) averages a bit newer than the retained portfolio, which according to HSF’s statement will improve its proportion of “culturally important and successful songs”. The explainer also mentions that, with no change of manager, artists should remain happy — though being put in the culturally unimportant disposal group may not help relations with the likes of Barry Manilow and the Kaiser Chiefs.

HSF says it has “put in place appropriate governance arrangements and information barriers” between Hipgnosis (PLC), Hipgnosis (Blackstone) and Hipgnosis (management group). Liberum Capital calls this “a boilerplate statement”:

In our view these are standard measures of good governance, but it leaves us with the question of where the really good investment team members at the investment advisor are going to sit. Are they going to be on the team that advises the company or on the team that advises [Blackstone-owned] Hipgnosis Song Capital? Furthermore, are the two teams at the investment advisor going to use the same models to value catalogues? If so, it will be of no surprise to anyone that even with Chinese walls in place, the two teams will think alike and not be independent in their assessment of the value of the catalogues.

Wouldn’t it have been cleaner to sell a simple percentage share of the whole songbook to Blackstone? Do the above assets have better or worse than the portfolio average? Do New Rules by Dua Lipa and Yeah! by Usher (both in the disposal group) have superior or inferior DCFs to Whatever it Takes by Imagine Dragons or Chop Suey! by System of a Down (both retained by HSF)?

Who knows? Who could possibly know?

“The primary goal of this transaction was to provide comfort over the NAV and provide a re-rating to the share price. The complex nature of the deal suggests that it is hard to say the NAV has been validated,” writes Stifel analyst Sachin Saggar. “Perhaps it lends itself to our view of skepticism of the valuation agent.”

HSF outsources catalogue valuation to Massarsky Consulting, owned since 2022 by Citrin Cooperman. In May 2022, Nari Matsuura of Citrin Cooperman gave a fascinating interview to Music Business Worldwide on how “when interest rates go up, we will not have to raise our discount rate,” and how “we are protecting all of our clients: valuations will not go down.” When an independent valuation agent says stuff like this, some skepticism is perhaps merited.

The songbooks are being sold at a headline 17.5 per cent discount to the fair value given on March 31, 2023. That’s slightly weird, not least because it compares rather poorly to Round Hill, HSF’s only peer in the London market, which last week received a take-private at an 11.5 per cent discount to NAV. Also, it’s a headline discount because it doesn’t take into account bonuses, earn-outs and other contingent payments that will be paid by HSF rather than Blackstone up to a cap of $30mn. The actual discount might be in the low to mid 20 per cent range.

Valuation also has to be considered on headline and underlying levels. Blackstone has agreed to pay 18.3 times the catalogue historical net publisher share, which is quite high by industry standards for a b-grade portfolio — but royalties etc are backdated to the start of the year. There’s already $15.3mn of backdated payments accrued, so if the deal completes by the end of the year that’s 5 per cent or thereabouts off the purchase price.

Unusually for a UK transaction there’s a go-shop clause that gives other interested parties 40 days to come up with a better proposal. But they’ll have to pay a $6.6mn termination fee to the management company, Hipgnosis Songs Capital, and factor in the cul-de-sac risk that their offer will be matched. As it says in the small print:

If Hipgnosis Songs Capital matches the superior proposal, such transaction will be final and binding and the company will not be permitted to have any further discussions or negotiations relating to a superior Proposal or other alternative transaction with any person.

Among the other sweeteners, there’s a $250mn paydown of HSF’s revolving credit facility to address interest cost, which for obvious reasons have gone stratospheric in recent years, and reduced management fees if the market cap stays around current levels. The concession on fees brings to light the possible conflicts of interest within the group, as Liberum explains:

Is the investment advisor in the end going to make more money out of managing the first portfolio inside Hipgnosis Songs Capital that it outweighs the loss of income from the [HSF] investment advisory fees? If so, what impact do these incentives have on the proposed transaction? And what are the incentives of Merck Mercuriadis after the transaction? We do not intend to accuse the investment advisor of cherry-picking or rigging the disposal in its favour, but we wish there was more transparency about the transaction and  the incentive structures of all parties involved.

Overall, we cannot shake off the impression that the company has received a lot of feedback from investors that the continuation vote may fail and that last week’s announcement by Round Hill Music Royalty Fund to sell its entire portfolio may have forced the board’s hand to sell some of the family silver. Whether this will calm investors depends, in our view, very much on reassuring them that the carrying NAV of the remaining portfolio is not overstated and that governance concerns are properly addressed and incentives are truly aligned with shareholders so that the investment advisor provides the best service to the company rather than Hipgnosis Songs Capital.

Stifel offers a more terse summary:

It’s unclear how any shareholder can assess the transaction as a good or bad deal given the structuring involved and that may prove to be an obstacle.

An eventual Blackstone buyout is the only clean solution for shareholders, so has become a big part of the HSF investment case in spite of being entirely hypothetical. The Blackstone-owned fund is also the most likely buyer of the assets in liquidation, of course, and has set just set a low valuation benchmark.

Ahead of the AGM vote Mercuridas is offering shareholders the chance to keep hope alive for another five years, but has also shown once again why his company is ill suited to public markets.

“We would not be surprised to see votes split by a relatively fine margin,” says Winterflood Securities. Ditto.

Further reading:
— Yield-crazed investors should not put too much faith in Hipgnosis (FT, 2020)
— Stifel is worried that Hipgnosis Songs Fund is slipping out of tune (2021)
— The music keeps on playing at Hipgnosis (FTAV, 2021)