Skip to content 
Article by Stephen Otter, Head of Private Markets Royalties at Partners Group, as published in Insight/Out magazine #37.
Introduction
Private markets have become an essential component of the modern global investment landscape, offering investors an opportunity for diversification and attractive returns.
At the same time, the range of strategies within the space has expanded significantly. Investors today can diversify their portfolios across a wide range of asset classes, such as Private Equity, Private Credit, Infrastructure, Commodities, Real Estate and Venture Capital – each of which is further segmented into distinct sub-strategies.
As private markets expand and become increasingly competitive and institutionalized, new asset classes are emerging. One such asset class that has garnered increased attention and popularity is royalties. With an estimated total market size exceeding USD 2 trillion, this strategy encompasses both established and emerging, high growth sectors with global diversification.
The mechanics of royalties
In its simplest form, a royalty investor receives a percentage of revenue generated by an underlying asset. The asset can include rights to intellectual property (IP), such as patents, trademarks or copyrights, as well as exclusive rights over natural resources like gas or minerals.
The terms of a royalty contract are negotiated between the owner of the asset and the operating company. The contract grants the operating company the right to use the asset, and, in exchange for this, the owner receives a royalty payment (i.e. a percentage of the revenue).
Examples of this include the revenue generated from the sale of a pharmaceutical product, the use of a musician’s song catalogue, or the sale of gas from a producing gas reserve. These rights, or simply, these royalties, can then be sold to third party investors.
A truly differentiated asset class that offers income and inflation mitigation
Royalties possess traits that set them apart from traditional investment strategies.
- Low correlation to the broader economy: The performance of royalty investments tends to be less tied to the direction of the broader economy and the markets than many traditional asset classes. This can offer potential non-cyclical economic exposure that can enhance diversification across an investor’s portfolio.
- Stable income streams and inflation hedge: Royalties have historically served as an effective hedge against inflation, as payments rise in line with price and the royalty investor is not exposed to cost inflation. Royalty investors are not responsible for funding asset costs such as operating and capital expenditures, and therefore, not sensitive to cost inflation or profit margins.
- Self-liquidating with attractive cash yields: Royalty investments generate ongoing cash yields that can help meet investors’ income needs. They are largely self liquidating, meaning they are not reliant on an exit to meet target returns, which can substantially help reduce their risk profile. Royalty investments also have potential to be sold, offering additional sources of upside for investors.
Framing the asset class
The structured nature of many royalty investments provides clarity and control over payment terms and durations, akin to private credit instruments. However, unlike private credit, royalties also offer potential upside driven by the underlying asset’s performance. This places the risk-return profile of royalty investments between that of Private Credit and Private Equity.
Moreover, royalty investments are typically cash yielding from day one as the investor receives a portion of the asset’s revenue stream. This increases the multiple on invested capital (MOIC) over the holding period. In cases where royalty investments have long-term IP exposure (such as music) or sub-surface ownership, there is also the potential for long-term NAV accretion to complement the yield generated by the royalty investment.
In contrast, a typical Private equity buyout often sees most of its value creation after two-to-three years of implementing operational initiatives, followed by a sale that ultimately realizes the value. This places the return profile of royalties closer to that of Private Credit. Yet, the royalty investment’s initial and final internal rate of return (IRR) are expected to be higher over the long term.
Identifying the potential key risks
As with any asset class, it is essential to recognize the potential risks associated with royalties. Specific sector-related risks, including regulatory changes, technological advancements, and shifts in consumer behavior must be carefully considered and addressed through prudent underwriting and sector selection.
Additionally, counterparty risk, legal and regulatory risks, and lack of diversification are important factors to be aware of and actively managed when investing in royalties.
At the investment level, factors such as asset impairment, operational issues within the operating company, unexpected leadership changes, and other specific risks can all impact performance and returns.
While it is challenging to completely avoid these risks, steps can be taken to mitigate them to the greatest extent possible. Protection mechanisms can include economic structures that have “step-up” or “step-down” features to protect the investor once certain IRR or MOIC hurdles have been achieved.
It is important to note that the stage of an asset’s life cycle in which a royalty investor chooses to invest will significantly impact the investment’s risk profile. It is crucial for investors to conduct thorough due diligence, negotiate favorable terms, and diversify their investments across multiple transactions and sectors to help mitigate these risks.
Portfolio construction
When contemplating an allocation to royalties, investors must carefully consider their preferred risk return profile. As their desire for capital protection and stable yield in their portfolio increases, royalties become increasingly suitable. Conversely, for investors focused on maximizing return potential, royalty investments may not align with their objectives. Prior to employing any portfolio optimization models, investors should have a holistic understanding of the benefits royalties may add to an existing portfolio. For instance, music streaming demonstrates somewhat non-cyclical characteristics. While not all sectors may demonstrate the same non-cyclical qualities, having a multi-industry approach to royalties can provide investors with the means to reduce their exposure to market cycles.
Within the private markets space, investors have typically tapped into royalties through closed-end, commingled fund structures, like those used in Private Equity and Private Credit. While these structures have their benefits, their standard 10-12-year fund life often does not match the typical duration of royalty investments.
This misalignment can bring about challenges and undesirable outcomes, such as funds being forced to sell off investments prematurely or having limited flexibility in allocating across different sectors. For investors seeking to align the lifetime of their investments with the underlying assets, evergreen fund structures may offer a viable solution.
These funds are not restricted in their investment horizon, or tied to a fund-end date, more easily matching the duration of the underlying investment portfolio. Additionally, they often offer regular liquidity events (typically quarterly), allowing investors to adjust their exposure to the asset class
Royalties present an attractive investment opportunity, blending potential for equity-like returns with increased stability and downside protection. A multi-sector royalty approach, across music/media, pharma and energy transition, can further enhance risk/return characteristics, as these sectors are inherently uncorrelated. Thoughtful integration into a diversified portfolio strategy, can make royalties advantageous for long term investors seeking capital protection and yield.
