Partners Group wants to take royalties into the private markets mainstream. It sees a USD 2tn addressable market lurking behind a niche and esoteric profile, with enough growth to justify becoming the firm’s fifth asset class, alongside private equity, private credit, infrastructure, and real estate.

At its heart, this strategy is about tapping cash flows from intellectual property (IP) and natural resources. The goal is to bind together multiple verticals, balancing growth and downside protection – holding in perpetuity but not entering before the asset is proven, targeting stable revenue streams while relying on diversification to ride out volatility in individual verticals.

Pharmaceuticals, music, green metals, and US natural gas are the mature domains; carbon offsets, sports, and brands are the up-and-comers. Stephen Otter, head of private markets royalties at Partners Group, is open-minded as to where this might lead.

“Long term, we want to take royalties beyond the established sectors. A lot of areas are IP-related – film and TV, books, sports, brands, even the franchise model pays royalties,” he said. “Some areas are more suitable than others, but if it’s long-dated, stable and has relatively predictable cash flow, we can do it. That’s why the opportunity set is so large.”

Building a multi-specialty platform in an industry of single specialists is one challenge. Partners Group must also ensure its target verticals deliver sufficient large-cap deal flow and mobilise institutional capital into an area that sits between traditional LP comfort zones of private equity and private credit.

It is not alone in this mission. Partners Group is seeking low teens returns from exposure that is long-dated, yield-generative and lacks correlation to financial markets. To other investors, from Apollo Global Management to Blackstone to KKR, this is one part of a strategy that invests up and down the capital structure in commercial and consumer activity-linked asset pools with recurring cash flows.

Asset-backed finance (ABF) is so broadly interpreted that it seems to defy classification and projection. According to David Ross, head of private credit at Northleaf Capital, ABF is the only asset class where size assessments range from USD 10tn to USD 30tn. And yet capital formation still trails demand.

“The ABF market on the institutional side – for the more opportunistic deals, higher returning-type transactions – feels like direct lending in 2017-2019,” added Daniel Pietrzak, a partner and global head of private credit at KKR.

“Plenty of investors are in the early days, doing their work on the space, but we are seeing more interest and are helping to educate them. ABF is a large topic with many of our current investors today.”

Size matters

This kind of institutionalisation happens once an asset class has navigated its nascent stages. Royalties have been available in pharma, mining and oil and gas for decades, long enough for large, listed platforms to co-exist with private investors. For the most part, it is North America-centric.

That’s where Otter got a taste, working as an energy-focused investment banker. He moved to Switzerland in 2014, hoping to launch the strategy in Europe. This led to a dialogue with the family office of Partners Group’s founders, which was interested in royalties, and the formation of a partnership in 2020. A total of 22 investments followed, with third-party co-investors brought in selectively.

Last year, the family office took the unprecedented step of transferring the business to Partners Group. All the positions rolled over, and the co-investors followed. With 11 additional investments made from the Partners Group balance sheet, these will help seed a new line of royalties-focused evergreen vehicles.

Partners Group has already launched two vehicles for ex-US investors. In March, the firm announced a joint venture with Lincoln Financial to bring royalties to the US retail market.

The transition was partly driven by a recognition that size matters in royalties. “Bigger assets are typically better – you get higher quality operators and less competition. In healthcare, transactions can be USD 500m to USD 2bn, which is too big for a family office,” Otter observed.

Moreover, there was an ambition to do it across several verticals. This holistic approach was seen as unique five years ago, and Otter believes it remains largely true today. Even global firms investing in royalties under ABF strategies tend to pick and choose their areas of focus.

KKR, which launched ABF in 2016, hasn’t spent much time on energy or pharma royalties, according to Pietrzak. It focused on music, notably post-pandemic, when the trifecta of track record, diversification – thousands of line items, taking in different artists and genres – and robust growth outlook emerged.

“We need to believe that the asset has scalability. We have a large team, but human capital is not infinite,” Pietrzak explained. “With music, we saw during COVID that artists were not making money from live shows, so several started selling catalogues, and it became a proper asset class. We bought a fair amount, using bank and public markets to finance it.”

Northleaf, which invests in royalties as part of a multi-sub-vertical asset-based specialty finance strategy, has also restricted itself to music despite exploring different areas.

Making noise

Music is arguably the most visible demonstration of private markets-led transformation. David Bowie pioneered the notion in 1997, issuing bonds backed by future music royalties. However, this form of securitisation took a beating during the global financial crisis and then became more closely regulated.

Private market investors have filled the void in recent years, but the combination of low interest rates, aggressive financing, and the post-COVID-19 boom led to an ultimately unsustainable run-up in valuations. Hipgnosis, which operated a UK-listed music royalties investment trust, was arguably the highest-profile casualty. An investor revolt ultimately led to an acquisition by Blackstone last year.

Some investors are surprised the correction hasn’t been sharper, citing deals in which music portfolios have sold for 15x-25x cash flow, up from single digits 10 years ago. It’s possible the market has become more selective, with only quality assets transacting. Alternatively, the segment might be maturing. “Now, selling your music catalogue is the equivalent of getting a mortgage,” said one investor.

Pricing transparency is underpinned by familiarity with the spike in revenue on release and the profile of the subsequent decay curve, and how it varies by artist and genre. Capital markets have developed as well, with financing available for diversified portfolios at 50%-60% loan-to-value.

“The US market offers opportunities for long-term, consistent and structural growth, driven by ARPU [average revenue per user] growth and continued streaming penetration. Additionally, you benefit from leverage and value-added opportunities,” said Eve Lee, a managing director in Bain Capital’s special situations team in Asia.

Investors also have greater clarity as to the role they want to play – owner or lender. Another option is to shuttle between the two, putting forward debt-based solutions if the equity underwriting doesn’t stack up. Those choosing to act as owners may draw additional comfort by not going it alone.

Bain, which invests in royalties alongside other contracted cash flow assets under its special situations strategy, recently formed a joint venture with Warner Music Group to buy up to USD 1.2bn of recorded music and music publishing catalogues. Warner will handle marketing, distribution, and administration.

There are echoes of a similar partnership, with Tiger Media Holdings, through which Bain entered India several years earlier. In what likely represents Asia’s first music royalty investment of meaningful size, they formed Ivy Entertainment to acquire content in a highly fragmented, producer-led market and package it up for consumption by streamers and broadcasters.

Ivy Entertainment now owns more than 30,000 pieces of music and 1,500 films, having executed a lateral expansion. It is being primed for a domestic IPO within three years. Lee highlights both the huge growth upside – India’s music industry is 40x smaller than the US – and the importance of working with strong partners that can get access to content in less proven markets.

“The local knowledge and relationships element is especially important in the Ivy deal because India is so opaque: there are no published transactions and valuations, none of the long-term data around the trajectory of listenership and royalties over time that typically give investors confidence,” she said.

Barriers to growth

The partnership approach is reminiscent of private debt, where global managers have plugged existing teams into their platforms or recruited domain experts as the foundation stones of new builds.

Indeed, one of the obstacles to being a multi-vertical player in royalties is bandwidth and the availability of talent. While there might be similarities in terms of financial modelling, deal origination and understanding the underlying ecosystem are contingent on specialist knowledge. This typically means having dedicated teams for each vertical.

Australia-based Regal Funds Management raised its first open-ended mining and energy royalties fund five years ago. The firm has grown from AUD 70m (USD 46m) to AUD 300m in fund size across several vintages, but early plans to expand into pharma and music never materialised. “These are completely different skillsets, and we don’t have them,” said Simon Klimt, a portfolio manager at Regal.

It’s the same story in pharma. Asher Rubin, a partner and co-head of the global technology and life sciences transactions practice at Sidley, observes that most of the royalty talent originated from a handful of early movers and it remains relatively concentrated. While the number of active investors has increased, they tend to come from specialist biotech backgrounds.

“I don’t think you’d want to be a dabbler in pharma royalties unless you had real domain expertise. One wrong move could eliminate your royalty. I don’t think you can build this organically, you hire the right people,” said Rubin. Blackstone is arguably the standout example, having gained some royalty exposure through the 2018 acquisition of life sciences investor Clarus and then recruiting industry specialists.

Another obstacle, as KKR’s Pietrzak suggested, is scale. For KKR, that means an average cheque size of at least USD 200m. Partners Group is open to aggregation strategies where the first cheque is USD 10m and sees a path to USD 100m-plus, but once the evergreen vehicles are up and running, it expects to operate in the USD 50m-USD 300m transaction range.

Cloverlay invests in royalties as part of a twin-pronged strategy focused on tangible and intangible assets, looking to get in ahead of market trends. Each of its three funds looks markedly different because once a segment matures and institutional capital floods in, the firm has moved on. Pharma and music royalties, for example, largely sit in the past.

Several key filters are applied to new investments: the extent to which there is correlation; whether Cloverlay can grow a royalty stream from misunderstood or overlooked assets; and how large a segment must become to create a frothy exit environment several years down the line, where the buyers might be large-scale financial investors looking for stable and mature royalty portfolios.

“As more capital comes in, it becomes harder for investors to maintain reasonable pricing and maintain the integrity of the initial structure of those transactions,” Jeff Collins, a managing partner at the firm, noted. “At the same time, there are some incredible assets that just can’t scale.”

Far and wide

Cloverlay has considered royalties involving legacy video games and printed editions of literary classics, the former for their enduring appeal after initial popularity and the latter for being fixtures on high school reading lists. It is already chasing patent families for mechanical IP – like components for smart home devices – often held in the vaults of technology companies now focused on other endeavours.

Brands are another area of interest, exemplified by Cloverlay’s acquisition of the commercial rights to the Care Bears. This was viewed as durable yet undermanaged IP with a broad range of royalty streams, from movies and TV to books and merchandise. Partners Group is also keen on brands, citing the same scope for monetisation as well as potential value creation angles.

“Once you own a pharma royalty, you are passively receiving a percentage of revenue – you aren’t dictating to big pharma how to sell the product,” said Otter. “With brands, you own the IP and you set the strategy, working out what the brand should be doing, how many stores, how many people. There’s a lot of strategic involvement, which means it’s closer to private equity than most royalties.”

Asked what cannot scale, Collins questioned the wisdom of investing in emerging sports, where there is no guarantee of blockbuster broadcasting rights, and name, image, and likeness (NIL) opportunities involving athletes, highlighting the instability of royalty streams tied to players who might flame out.

It is unclear whether, or how quickly, new verticals can become accessible for large-cap investors. A more likely near-term scenario is that existing sectors expand. In mainstream sports, attention has already shifted from broadcasting and merchandising rights to transfer fee receivables and even infrastructure finance, with stadium renovation costs covered by borrowing against future ticket sales.

In music, rather than simply focusing on publishing and recording royalties, investors are looking at whole artist exploitation rights, according to Adam Craig, a partner in the global financial markets practice at Clifford Chance. While there are similarities to NIL, the ecosystem is better understood.

The bigger picture development, in Craig’s view, isn’t just a widening of the target revenue streams, but an evolution in financing channels. “In music, they started out with corporate loans, went into securitisation until that dropped off, then it was back to corporate loans again, and now that has been replaced by royalty-type finance because they find the pricing is better,” he said.

Bucket talk

A deeper pool of private capital strategies is enabling this transition, but this would happen faster if more LPs could be persuaded to come on the journey. For all the talk of how royalties are a good fit for the likes of insurers and pension plans, relatively few allocate to the space.

Family offices and high net worth investors have historically been most readily associated with the strategy, partly because, unlike their institutional brethren, they aren’t beholden to asset allocation models. Australia-based wealth management platforms Koda Capital and Escala Partners, for example, have both previously told AVCJ of their appetite for niche, uncorrelated assets.

Regal’s entire investor base fits this profile. “I would prefer to beat my head against a wall than go after superannuation money,” said Klimt. “Fees are one issue, but it’s more a case of where do they put it? In the alternatives bucket, or are we not big enough for that? Is it a yield strategy? Is it mining?”

This classification dilemma extends from royalties through broader special situations and ABF strategies. Cloverlay has received capital via equity and real assets allocations; Bain usually ends up having meetings with the private equity vertical or the private credit vertical; others tell similar stories.

A new bucket aimed at this middle ground is seen as inevitable, at least for more sophisticated institutional investors – they want diversification without having to squander returns or take unnecessary risk under an existing allocation. This happened with private credit over a decade ago, and Northleaf’s Ross believes ABF is the most likely next candidate.

“Less than one-third of investors we deal with have an ABF allocation. Many put private credit and ABF in one basket, but I think these will split quickly. Each is large enough to justify a 2%-5% allocation,” he said. “And the moment investors establish that basket, you see huge scale. We saw it with private credit; suddenly everyone wanted it because they had a 5%-10% basket to fill.”

Most industry participants doubt that royalties will ultimately become a distinct allocation. Rather, it will sit within ABF, and LPs can choose whether to back a single solution provider or build a portfolio of specialist managers focusing on different kinds of contracted cash flows.

Introducing more institutional capital to private markets royalties will likely turbocharge the more established verticals. Amid intensifying competition and tighter pricing, investors will be tempted to take on more risk in pursuit of their target return. According to Collins of Cloverlay, this means a broader interpretation of what qualifies as a royalty and increased utilisation of financing.

“The way royalty segments expand is providers of financing moving further out on the risk curve while saying this is still a mineral right or a music right,” he explained.

“It used to be Michael Jackson’s catalogue. Now you are talking about a lot of different things, a lot of different technologies, including financial technologies, to access that underlying asset – even though the asset is the same as it was 15 years ago. Things get treated differently with more eyes on them.”