A new wave of lending

Duke was set up in 2015 to provide royalty finance, a flexible, revenue-based, long-term form of finance. Royalty finance originated in Canada in the 1980s in the mining sector and in the 1990s in the pharmaceutical sector and has since been replicated in other sectors. Duke Royalty estimates that royalty finance is now worth US$50bn in the US and growing. In the UK and Europe, this is a nascent sector and Duke is the market leader, with an investment portfolio close to £80m. The team behind Duke Royalty is an experienced financial services team with a CIO who was a pioneer in drug royalty finance in the early 1990s in Canada.

Royalty financing involves an upfront, one-off payment in exchange for a revenue stream for a long-term or sometimes perpetual period. Duke typically receives an initial 13.5% pa (which includes principal repayment and interest) over a 30-year period. Payments are paid monthly, but reset annually linked to the change in sales revenue of the invested company or partner. Annual resets on a cash basis have a ±6% cap and floor, which limits the movement in payment from one year to another. The royalty partners can prepay the investment, but there is a prepayment penalty designed to protect Duke from the time lag in reinvesting the money, as well the internal rate of return (IRR) of the project.

Royalty partners are typically unlisted or privately-owned companies that do not want to issue expensive equity or loans with significant repayments in the first three to five years. In addition, they are not usually looking for the exit strategies or additional board influence that private equity and venture capital partners require. Royalty finance appeals to owners looking to stay in control without needing to sell their company.

Duke is looking for companies with a long track record and demonstrable strong competitive positions. A good growth profile is desired, but not start-ups. Duke also eschews particularly volatile sectors such as biotech, oil and gas and mining. It uses third parties to help with due diligence, employing consultants such as Oliver Wyman and McKinsey, which it pays on a success-only basis, typically c 3% of the revenue paid throughout the term of the contract. Although Duke’s focus is on the UK and Europe, it will also consider deals from North America.

Duke had raised £80m in equity and invested a similar amount in 12 different royalty partners prior to its announced £16.1m placing this week. These investments include the acquisition of competitor Capital Step in February 2019 for £10m plus £11.6m in debt, which brought on board a portfolio with six companies, some equity positions and an experienced UK-based team. Management believes it has a scalable, relatively fixed-cost infrastructure to support £250m in deals comfortably and its aim is to add five to seven new deals worth about £45–100m a year. The growth will be largely equity funded. Duke expects to expand its debt facility to lower its cost of capital, and for the loan to value (LTV) not to exceed 30%. The use of debt helps Duke to better manage its investment pipeline and avoid cash drag.

Duke has just announced a successful equity offering of £16.1m at a price of 44p per share. This will give it £45m in capital to deploy by end of FY20 (financial year-end 31 March). This assumes a net debt to capital ratio (or loan to value) of close to 30%, which is the limit that the company sets itself for gearing. Assuming £25m in investments would take the portfolio to £105m by end of FY20. We are then pencilling in £45m in new investments in 2021 and £50m in 2022. To fund this, we assume that £50m is raised in equity at a price of 59p in FY21 and debt funded during FY22 by drawing the line of credit to 30% LTV at the end of FY22. The issue price involves rolling forward our valuation midpoint (53.2p) by one year, ie increasing it by our assumption of Duke’s cost of equity, 9.5% pa. This will keep the debt to capital ratio close to the 15% range. We see this as a very cash-generative business. We forecast that the free cash flow yield will be 8.0% in FY20, climb to 11.6% in FY21 and then reach 14.9% in FY22. The company expects to distribute 65–90% of earnings as dividends, towards the upper end of the range in the short term (we are modelling close to 85%).

We value Duke on a cash flow basis and our starting point is the expected average IRR of Duke’s royalty investments. We estimate this to be 16.1% to 17.1%, assuming a 13.5% average yield at inception and 3% average growth in the payment. We flex the assumptions regarding the average investment term (from seven years to 30 years). The early payment penalty clauses mitigate the impact on the investment IRRs and these are relatively stable across the various terms.

We think this 16–17% IRR range (with a midpoint of 16.3%) indicates that a sustainable ROE close to 14% for Duke Royalty seems reasonable. Translating the investment IRR to the company ROE requires us to make adjustments for (1) operating costs, (2) forecast average leverage and (3) taxes.

We have therefore calculated our fair value range for Duke Royalty based on an ROE of 14% (Exhibit 5) and COE of 9.5%. Duke’s COE reflects its reduced gearing compared to most financial companies and the risk profile of its lending. We have used a conventional ROE-g/COE-g formula and have flexed the COE and ROE by 50bp to obtain the current fair value range of 50–58p, with 53.2p as the midpoint.

Duke Royalty is a Guernsey-domiciled financial services company providing long-term, revenue-based royalty finance to small and growing businesses, typically private companies. It may occasionally invest in other alternative asset classes and financing instruments that bear similar risk. Most of its investments are currently in the UK and Ireland, but the company has a geographic preference of Europe and North America. Duke Royalty was set up in 2015 and floated on AIM in 2017. It currently has a free float of 90% and its institutional investors include several large asset managers like BlackRock, AXA and Man GLG. Some of them find it useful that Duke Royalty can provide exposure to the private lending market, which is otherwise not always easy to access directly. Management and insiders own 10% of the company.

Royalty-based finance contracts typically involve a one-off, upfront payment from Duke Royalty in exchange for a specific yield at inception, which is then linked to growth in the revenue of the company, the royalty partner. The contract may be perpetual or for a fixed period (in Duke’s case, often 30 years). Unlike a typical loan or bond, there is no bullet repayment at the end of the term, so it can be viewed like a mortgage in this respect. The borrower is implicitly repaying both the principal and the interest. For example, in a 30-year contract, we can think of it as the partner effectively paying back 3.3% of the principal each year as part of the royalty payment. The 13.5% yield could therefore be envisaged as a 10.2% interest payment plus the 3.3% principal payment. However, unlike a mortgage, there is no formal amortisation of the loan in the sense that the mix of principal and interest changes over time.

Duke’s investment yields at inception typically start from 13.5% pa, and usually have a 6% cap and floor in the annual adjustment factor. This means annual changes in income received from a royalty investment can go up or down by no more than 6% annually, even if the partner’s sales movements are greater. These contracts provide Duke with a fairly stable long-term income stream. Although the contracts are more covenant-light than some lending, Duke Royalty normally secures loans on a senior basis to available assets. It usually tries to clear existing debt in a partner and roll all the loans into the royalty contract. Also, while the company does not demand seats on the board, it usually asks to attend all board meetings to help monitor the investment.

An important feature of Duke’s investment is that typically it wants the royalty payment to be less than 50% of a partner’s EBITDA. Along with the partner’s normally low or no debt and profitability track record, this helps control risk.

The royalty agreements have a buyback option, which is especially useful for partners whose sales revenue has climbed significantly. Early repayments are usually not possible in the first three years, due to Duke’s upfront costs and the time management puts into making investments. The contracts have prepayment penalties, typically a 20–30% premium over the initial investment. This not only protects Duke’s IRR from very early prepayments, but also provides compensation for the delay in redeploying the money.

Duke Royalty looks for businesses with a good track record of sustainable revenue growth and strong competitive position. A growth profile is also important for the uplift in yield, but a solid revenue base is just as important. As such, Duke does not invest in start-ups and also avoids sectors such as oil and gas, mining and biotech where revenue streams, profits and cash flow tend to be more volatile. Exhibit 1 details Duke Royalty’s criteria for its royalty partnerships.

The company now believes it has capacity to scale up investments from the current £80m to £250m in the next few years. Duke divides the ability to scale into four operational objectives: (1) origination capabilities; (2) deal execution; (3) portfolio monitoring; and (4) plc investor activities. In addition, Duke has eliminated its sole current UK competitor. The ability to scale up is one of the attractions of royalty financing. An extreme example of this is the market leader in the US, Franco-Nevada, with a market cap of C$21bn and only 29 employees.

Exhibit 2 below shows some details of the current portfolio. Duke is currently aiming to add c £50–100m pa with roughly five to seven deals a year (this includes increasing the size of the deals). It is now reasonably well diversified, but the aim is to take the current number of clients from 12 to least 20 companies to hit its diversification target.

Although the portfolio is still quite new, we note that investments are typically achieving 6% resets, including Temarca, Lynx and United Glass Group (UGG). Although we model Duke on an average 3% annual reset on investments, we think it is likely that in the first years, many investments will be hitting the 6% cap and, conceivably, this should be a good source of newsflow.

Sometimes the money raised from Duke is for management or shareholder buyout purposes (eg with Berkeley, Brightwater, BHPC and Trimite), but often it is used as growth capital, which of course directly benefits Duke by generating more revenue. Examples of growth capital funding by royalty partners include InterHealth, UGG and Temarca. In the case of Temarca, Duke helped it fund a third vessel (Temarca runs river boat cruises on the Danube). The Lynx and Welltel deals are examples of acquisition capital. Typically, these companies have been competitive and in business for some time, as this is one of Duke’s investment criteria. For example, Duke’s last major single company investment, Miriad, has been operating for more than 40 years as a spares and accessories specialist for the caravans and motor homes market and is now the market leader.

After two equity issues in 2017 (£35m), Duke Royalty raised £44m in additional equity (at 44p per share) in August 2018 with the aim of supporting further growth and diversification of the portfolio. As part of this strategy, Duke acquired Capital Step in February 2019 for £10m in cash plus £11.65m in debt. Capital Step added £16.5m in investments, plus equity positions estimated at £1.2m and increased the number of royalty partners from five to 11 (we include the various Lynx group of companies as one client in this respect).

It is worth noting that the Capital Step royalty model had some differences from Duke’s. The royalty adjustments are carried out on a monthly basis and fixed as a percentage of revenue with a floor and cap ranging from 14% to 30%. Capital Step also has some senior conventional loans (on three- to five-year terms) as part of a ‘unitranche’ product to three of its six royalty partners. Duke’s existing practices should be the most common in new deals, but management expects to keep an open mind in terms of royalty finance formats. We note that soon after the acquisition, Duke made some changes to the investment. For example, Pearl & Dean changed to a perpetual investment from one amortising by 50% over a three-year term, and the terms of the loan components in the Welltel and Xtremepush investments were extended by two years (to 2024). The Pearl & Dean investment was subsequently moved to its parent investment company (Step Investments), which has several investments in the media and hospitality & leisure sectors (Pearl & Dean is focused on cinema advertising). The Capital Step debt is in the form of an £11.65m revolving credit, which costs Libor + 9.5% with Honeycomb Investment Trust. On 10 September 2019, Duke announced it had refinanced this with a lower rate (Libor + 7.25%) and increased the credit facility from £15m to £30m. The new terms also include an accordion facility that could provide a further £20m if certain LTV thresholds are maintained.

Duke has high yielding assets and expects to pay a generous dividend. It targets a 65–90% earnings payout ratio (likely to be closer to the upper end of the range in the near term). The forecast yield for FY20 is 6.4%, the company has delivered three dividend increases in the last two years and we are assuming a further increase from 0.75p to 0.80p in the last quarter of FY20.

Management expects to continue to use a limited amount of gearing as working capital. However, it does not expect the net debt to capital (or LTV) to exceed 30%. In our forecasts, we assume an average LTV of 15%, although in the short to medium term we are forecasting it to reach 30.1% by 31 March 2022 (FY22).

We are factoring in the £16.1m just announced in fresh equity capital. We forecast that Duke will deploy £22m in the second half of FY20 and the net debt to capital ratio will be 14% in FY20. These investments are expected to be one new partner and some follow-on from existing clients. The increase in gearing to 30.1% assumes investments of £95m over 2021 and 2022 and the assumption of a £50m equity raise in FY21, as we detail later.

Duke does not hedge its FX position because it is relatively small (essentially it is just the Temarca investment, a European river boat cruise company) and because its high operating margins make tight FX control unnecessary. However, it may review the situation if its FX positions grow considerably.

Royalty financing started in the mining sector in North America in the 1980s as a useful alternative to equity and bond funding. It began with smaller players, then large mining companies such as Vale, BHP and Glencore started to use it and it has also now spread to other players in that sector, notably with Franco-Nevada. Pharmaceutical royalties became an asset class in the 1990s and this is now a multibillion-dollar sector.

Royalty finance is an attractive option for borrowers that want to avoid expensive equity dilution, but also do not want covenant-heavy debt, often with bullet payments in the first three to five years that can bring refinancing risk. Some business owners prefer venture capital/private equity money, and the expertise, or even exit strategies it brings. However, if a business owner is not interested in these features, royalty finance is less disruptive. It is likely to appeal to business owners who want to grow the company while retaining control and also to those who do not want to be tempted to make overly ambitious promises of future growth to investors, which might bring problems later on. We also note that, like debt, royalty funding is more tax efficient than equity.

There is some benefit in reducing interest payments when sales go down, but we would regard this as of relatively minor importance in terms of helping the company cope with business downturn. Royalty funding should also be quicker to arrange on average. Covenants tend to be more straightforward and it is usually easier to price the investment than equity finance, for example.

Royalty funding typically has buyback clauses (always the case for Duke) and this flexibility further adds appeal to this type of long-term funding.

There are some drawbacks, including a higher cost of borrowing than straight debt and the administrative cost of the payments (especially on monthly resets), while royalty financing is not suitable for lower-margin or lower-revenue businesses. In addition, there may be inter-creditor issues if the company already has senior debt.

The attraction for royalty investors such as Duke is that borrowers are willing to pay a higher return for flexibility, the long-term nature and other features of royalty finance. Furthermore, royalty investments provide some room for income growth, but with less work than would typically be involved in a venture capital investment, for example. The procyclic pricing helps asset quality, without having to formally restructure loans. A portfolio can be diversified and is relatively easy to manage. Finally, there is a stronger bias/incentive to choose winners compared with some other types of debt finance such as distressed lending.

The process of origination at Duke Royalty includes business contacts, professional services companies (accountants, lawyers, etc), as well as the use of third parties. In the case of third parties, finder’s fees are usually applicable. Typically, Duke will pay 0.5% if a deal is more than £20m and 1% if less than £20m (which has been the case of all the deals so far). Duke also expects follow-on business opportunities from existing clients.

Duke’s investment committee currently consists of five executives: Neil Johnson (CEO), Jim Webster (CIO), Justin Cochrane (president of Cobalt 27), Andrew Carragher, (a founder and managing partner of DW Healthcare Partners, a private equity firm founded in 2002 with over $1.25bn under management) and John Romeo (Oliver Wyman global executive committee member).

The investment committee reviews the pipelines and proposals, gives advice on royalty terms, manages conflicts of interest, assesses capital requirements, and reviews the performance and outlook of the portfolio. It also makes investment recommendations to the board, but these are non-binding. All final investment decisions are made by the board. If the board favours an opportunity, a non-binding terms of trade or letter is sent and due diligence is completed before the final contract is agreed. Duke Royalty had an exclusive agreement with Oliver Wyman, but works with a variety of third-party experts, including global management consultant McKinsey, to obtain expertise. These often obtain a percentage of revenue (typically 2–3%) if the deal goes ahead. However, there is no payment if the deal is rejected. The guiding investment criteria are as described on page 4 and shown in Exhibit 1. As mentioned above, sustainability of revenue is of paramount importance due to the nature of the investment. We also note that Duke requires the operating cash flow of a royalty partner to be at least twice the royalty payment where practicable.

Duke has two management incentive schemes. These are divided into short-term (STIP) and long-term (LTIP) incentive plans. The STIP is limited up to 100% salary, annual, based on performance and limited to 15% of each year’s increase in free cash flow versus the previous year. There are also share option schemes. The LTIP is limited up to 200% of salary and is 50% based on total shareholder return and 50% based on total cash flow per share available for distribution. Both metrics have to be positive for shareholders.

Nigel Norman Birrell – non-executive chairman: works with the executive directors on deal origination and structuring and has extensive public company experience and expertise in the gaming, media and financial services sectors. He is the CEO of Lottoland, Gibraltar, a regulated gaming group, and was previously an executive director at bwin.party, a global online gaming business, where he was responsible for mergers and acquisitions, business development and management of its portfolio of investments. Before that he was a director of HIT Entertainment (formerly a FTSE 250 company). He was also an investment banker at Donaldson, Lufkin & Jenrette and Dresdner Kleinwort Benson. He is a qualified solicitor of the Supreme Court.

Neil Allan Johnson, CFA – chief executive officer: responsible for Duke’s overall strategic direction and performance, he leads all deal origination, due diligence and structuring. Mr Johnson has over 25 years’ experience in investment banking, merchant banking, and research analysis in both the Canadian and UK capital markets. In 2012, he co-founded and became CEO of Difference Capital Financial, a Canadian publicly listed alternative financing company, which raised c £100m in its first two years of operations from institutional investors. Previously, he held various senior positions at Canaccord, spearheaded the firm’s diversification into the technology industry and led Canaccord’s initiative to encourage North American firms to list in London, which resulted in Canaccord becoming AIM’s largest broker by its clients’ market capitalisation and raising more than £3bn in aggregate for North America-based, UK-listed companies.

Charles (Charlie) Cannon Brookes – executive director: works alongside the CEO on deal origination, due diligence and structuring. In addition, he is responsible for Duke’s liaison with UK institutions and advisors and has oversight of the company’s corporate governance and compliance with AIM Rules. Mr Cannon Brookes has over 20 years’ investment experience, working for Arlington, Jupiter Asset Management, ABN Amro and Barclays de Zoete Wedd. He has advised and sat on the board of a number of different funds, trusts and other operating public companies.

Justin Cochrane – non-executive director: works with the executive directors on deal origination and structuring, and is a member of the investment committee. He is president and COO of Cobalt 27 Capital Corp. Mr Cochrane was executive VP of Duke Royalty from 2015 to 2018 as he transitioned into the executive role at Cobalt 27. He was previously executive VP of corporate development for Sandstorm Gold, where was a key part Sandstorm’s team as it grew into one of the largest royalty and stream financing companies in Canada. Prior to Sandstorm, he was a VP at National Bank Financial.

Matthew Wrigley – non-executive director: works with the executive directors on structuring and all legal matters. Mr Wrigley is a partner at asset management advisory firm MJ Hudson. In his 15 years in alternative assets, he has gained experience through a mix of legal and commercial roles, including serving as general counsel for a listed Australian fund management company, COO of a Singapore-listed investment trust and with a global law firm, Baker McKenzie. He also sits on several fund and general partner boards, with strategies spanning private equity, infrastructure and real estate.

Mark Le Tissier – non-executive director: responsible for the oversight of the company’s corporate obligations in Guernsey. He is the European regional director of Trident Trust, overseeing five offices, as well as the managing director of Trident Trust Company (Guernsey), having worked for Trident for over 20 years. He has extensive board-level experience and has in-depth knowledge of Guernsey and corporate and investment regulation in other jurisdictions.

James (Jim) Webster – chief investment officer: has a long experience in royalty finance dating back to 1993 when he started Drug Royalty Corporation in Canada. He was the company’s president and CEO from 1999 to 2002 and held the positions of chair of the corporation’s investment committee and CFO. He was the managing partner of Capital Royalty Partners, a private equity investment firm in Houston, Texas, for six years from 2003 to 2009, and conducted independent advisory work for pharmaceutical and biotech clients before joining Duke Royalty.

We believe the key risks to Duke’s income and earnings are as follows:

In our view, the best way to appreciate Duke’s value creation is, first of all, to look at the expected average internal rate of return (IRR) of its royalty investments. We estimate this to be 16.1% to 17.1% assuming a 13.5% average yield at inception and 3% average growth in the payment. We flex the assumptions regarding the average investment term (from seven years to 30 years). The early payment penalty clauses mitigate the impact on the investment IRRs and these are relatively stable across the various terms. In Exhibit 4, we also show the IRRs with other levels of annual revenue growth (-3% to 6%) with different investment terms.

We think this 16.1–17.1% IRR range (with a mid-point of 16.3%) indicates that a sustainable ROE close to 14% for Duke Royalty seems reasonable. Translating the investment IRR to the company ROE requires us to make adjustments for (1) operating costs, (2) forecast average leverage and (3) taxes.

Based on the view that with a £2.5–3.0m operating cost structure Duke could grow investments to more than £250m, we believe it is realistic to assume 100–150bp operating costs (with bonuses). Further scaling benefits are possible. If we assume a 700bp spread on financing and 15% gearing to capital, this should add 105bp to the total return on equity before taxes. The beneficial impact of leverage greatly offsets Duke’s relatively low costs. The effective tax rate of 10% brings down the ROE to around 14% with these assumptions.

We have therefore calculated our fair value range for Duke Royalty based on an ROE of 14% (Exhibit 5) and COE of 9.5%. Duke’s COE reflects its reduced gearing compared to most financial companies and the risk profile of its lending. We have used a conventional ROE-g/COE-g formula and have flexed the COE and ROE by 50bp to obtain the valuation range of 50–58p, with 53.2p as the midpoint.

As a check and for completeness, Exhibit 6 shows Duke’s market multiples compared with some royalty company peers. As noted above, we do not believe this is the best way to value the company, given the different profiles/exposures of these companies and the relatively low visibility of the non-cash fair value adjustments.

We expect Duke Royalty to grow its business significantly over the coming years. Management has indicated that it would like to add £45–100m pa in the next few years. The £16.1m in equity that Duke has raised will enable it to increase its investment portfolio from the current estimated £80m to about £105m by end FY20 and a forecast net debt to capital (or LTV) of 14%.

The company has indicated that it expects to pay dividends of 65–90% of earnings and we have modelled this at close to 85% on average. Although we forecast that Duke will remain a very cash-generative company, we expect it to keep raising equity to fund this growth.

Our positive outlook in terms of share price is predicated by the potential for the company to finance growth with equity issuance at rising prices as portfolio returns and scale benefits generate higher EPS and hence dividend growth. In the table below, we show the impact of any future potential capital raising and growth in scale of the company on both EPS and DPS, together with the attractive yields on the prices assumed. In our model we assume that £50m in equity will be raised at FY21. This will help fund our forecast £45m investment in FY21 and £50m in FY22. These assumptions mean that the number of shares would increase from the current 236m (with 36.6m new shares from the £16.1m issue) to 321m by the end of FY22.

This will allow the company to continue to grow and keep its gearing at no more than 30% (it will hit this level, as discussed above, at end of FY22. As previously mentioned, Duke has capped its gearing at 30% and uses it to manage its investment pipeline without having a cash drag, rather than to leverage results.

Exhibits 8 and 9 show the impact of greater scale on Duke’s profitability. We forecast that the royalty income as a percentage of average investments will reach almost 15% by FY21. As Duke gains scale, we expect the cost to income ratio to decline significantly and by FY22 to be close to 12%, including unreimbursed transaction costs. The pre-tax margin mirrors this and under our assumptions rises from an estimated 31% in FY19 to 71% in FY22.

We expect Duke Royalty to generate an ROE of 7.7% in FY20, and for this to rise to 9.1% in FY21 and to 12.3% by FY22. Further increases in scale and gearing could increase this ROE. Although most of Duke’s revenue is royalty revenue received, there is also a non-cash component driven by changes in the fair value assessment of the investment portfolio. In the income statement, this is classified as ‘unrealised changes’ in the net change in the fair value of financial assets and liabilities. This is driven by changes in assumptions regarding the annual reset of the revenue (capped at 6%) as well as the discount rates used (15.4–17.3% in the last annual report). In our model, we have assumed a sharp decline in this non-cash component from as high as 39% of total revenue in 2018 to 0% from FY20. It is possible that the ROE forecasts may be understated as a result, but at any rate we believe the operating cash flow yield is more important. We see this rising from 8.0% in FY20 to 11.6% in FY21 and to 14.9% in FY22.

On the cost side, we expect the company’s structural costs to climb to about £2.5m in 2020 and reach £3.0m in 2022. This figure excludes transaction costs that are not reimbursed (currently running at c 2.2% of new deals, which the company expects to drop to 1.0–1.5%), as well as royalty partnership fees. Regarding the latter, Duke employs third-party companies like McKinsey to help with the due diligence and pays them on a success-only basis if the investment goes ahead. Typically, these are 3% of revenue and capitalised upfront, but in terms of cash flow are paid throughout the length of the contract.