The role of royalties in portfolios of wealthy clients

Royalties – high-yield income investments that have characteristics of bonds and stocks, but are often decorrelated from both asset classes – are an increasingly attractive addition to wealthy Canadians’ portfolios.

And beyond the traditional oil and gas and mining royalty plays, many are now looking for royalties from more diversified sources, which can include the music and biotech industries.

“Royalty investing has really expanded over time,” says David MacNaughtan, partner and head of Sagard Healthcare, a pharmaceutical royalty fund of alternative asset manager and Desmarais family co-founded Sagard, based in Montreal, whose investors include family offices.

“The amount of capital that has been invested in the space is now in the billions of dollars, but it still remains largely overlooked because a lot of people don’t quite understand the model.”

Pharmaceutical royalties

That model of purchasing the present discounted value of a royalty in exchange for a portion of the future top-line revenues from an asset for several years may be less familiar than other income investment strategies.

Yet many family offices are allocating capital into the space, including pharmaceutical royalties, like the ones that Sagard manages in its fund, he adds.

“One big upside is they can participate in the topline growth of the pharmaceutical industry innovation without all of the risks associated with venture capital.”

Royalties have come to play a pivotal role in the research and development drug pipeline, MacNaughtan further notes.

In exchange for rights to a promising drug poised for late-stage trials, big pharmaceutical and biotech companies will pay less up-front to early-stage developers – like researchers at universities or small biotech companies – while promising them a share of revenues in the future, should these drugs come to market and generate revenues.

Usually, these are new therapies that have just completed Phase 2 clinical trials, and large pharmaceutical companies then purchase the drug, taking it through costly large-scale, Phase 3 trials. If the therapy proves successful, and the drug generates revenues, a percentage of those sales is paid to the original developer as a royalty.

“The reason this chain exists is because the failure rates for new drugs is so high,” he explains.

Where investment firms like Sagard come into the picture is after a new drug is on the market generating sales. They approach early-stage developers, offering them a lump-sum based on the present-discounted-value of their royalty stream that can last up to 15 years.

“They’re happy to take some risk off the table, and not count on sales,” he says, noting the lump sum often allows many recipients to reinvest in more R&D to create new medications.

Music royalties

Music royalties are another lesser-known income investment, but with a potentially longer lifespan than patented pharmaceutical products.

“These have become more lucrative and consistent amid the growing use of music streaming subscriptions,” says David Vankka, president of ICM Asset Management and portfolio manager on the ICM Crescendo Music Royalty Fund in Toronto.

The fund owns 28 catalogues consisting of more than 4,200 songs, including Bye Bye Bye by the pop band NSYNC. The hit from the early 2000s was in the spotlight again recently, featured in the trailer for the summer blockbuster Deadpool and Wolverine, which led to a surge in streaming.

“It just shows how these things can go stratospheric out of the blue,” he says, adding the royalty rights are bought from artists themselves, song-writers and estates.

Income with equity-like exposure

Regardless of the asset, all royalties share the bond-like characteristic of reliable, regular income – given that asset owners are legally obligated to pay them.

And they offer equity-like exposure because the underlying asset can see higher sales increasing the royalty while increasing the capital value of the income stream itself can rise and fall over time.

Yet royalty yields generally outpace those of fixed income and dividend equities.

Vankka notes the yield for the Crescendo fund last year, for example, was about 11 per cent, though a portion consists of modest appreciation of the royalties’ overall value.

Pharmaceutical royalties are potentially even more lucrative with the Sagard portfolio holdings generating “mid-teen percentage yields,” MacNaughtan says.

Among its dozen or so holdings is a royalty stream for the new GSK cancer drug, Jemperli, recently approved for treating endometrial cancer.

“It is like the flagship oncology drug for GSK, and they’re trying it for other types of cancer … seeing remarkable results,” he says.

Family office clients of wealth advisor Rob Tétrault in Winnipeg do not hold pharmaceutical royalties, but they do own the Crescendo Music Fund.

“You not only get a larger population of consumers streaming music, you get growing revenue from gaming and TikTok, which means growth in the value of those assets,” says the portfolio manager and head of Tétrault Wealth Advisory Group at Canaccord Genuity Wealth in Winnipeg.

The returns have been so attractive, he has had to temper many clients’ expectations.

Risks to consider

“Eventually we get the question, ‘Why don’t I own more of this?’ To which I have to tell them, it’s an asset class and just like everything else, it has risks.”

Among those are lower liquidity as a private market asset, and the yields – though high and often consistent – can fluctuate and even dry up if sales from the underlying assets fall or stop entirely.

Management of the royalty stream is another potential risk, says John Amonson, founder and president of Unbiased Financial Services Inc. in Calgary.

Some clients of the Calgary multi-family-office have owned royalties from single oil and gas plays, he adds.

“We have helped in managing those.” Yet he would be reluctant to again.

“I would say we were lucky to get out without any major consequences or mistakes.”

Single royalty plays

Single royalty plays are perilous, in his opinion, because of the specific expertise required to manage them properly.

“A royalty often sounds very straightforward at a high level,” he adds.

Yet each royalty stream has its own nuances and specific risks that call for expert oversight. That can prove challenging for advisors serving wealthy families with large investment portfolios.

One example of this, he notes, is when another company acquires the royalty producing asset. The new owner is obligated to pay the royalty, “but if you, as the manager of the royalty, let that drop off the table and they stop sending it to you, you’re on the hook.”

Still, he notes that royalties help diversify income sources for clients, but he would prefer families get exposure through a managed fund opposed to a family office trying to oversee several royalty streams on their own.

“If you’re a wealthy enough family that can afford to build a dedicated team, that’s great, but most offices aren’t that large to do that effectively.”

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