Follow the Money! Big Capital in the Music Rights Market – Part 4: The Business Model of Private Equity Firms
- Peter Tschmuck
- Jul 21
- 10 min read
Updated: Oct 21
In part 1 of this blog series, we provided a brief history of the music rights sales boom and demonstrated that private equity firms are the main investors in music catalogues. In part 2, we introduced the key players, including major private equity firms such as Blackstone, KKR, the Carlyle Group, and Apollo Global Management. In part 3, we provided an initial insight into how private equity projects work, using Shamrock Capital Advisors as an example. This fourth part will examine the business model of private equity firms in more detail, providing a clearer understanding of the motivation behind the billion-dollar music rights business.
Follow the Money! Big Capital in the Music Rights Market – Part 4: The Business Model of Private Equity Firms*
The Concept of Leveraged Buyout
At the core of the private equity business model is the concept of the leveraged buyout, which means that an investment is financed not only with equity but also with debt. The debt component then acts as a lever that not only enables a higher investment volume to be achieved, but also increases the return on investment (ROI). You may be familiar with the principle of financing a house not only with your own funds, but also with bank loans. Imagine that you financed your purchase of a house for US $500,000, with 20 per cent of your own funds, i.e. US $100,000. Then you borrow the remaining US $400,000 from your bank on favourable terms. If you do not live in the house yourself but rent it out, you can pay the ongoing loan costs from the rental income. If you sell the house after five years because the market value has risen to US $600,000, you will make a profit of US $200,000. Your equity of US $100,000 would therefore have doubled, which would not have been the case if you had paid the entire purchase price yourself.
With this example, we are quite close to the concept of a leveraged buyout. However, we are not buying houses and apartments, but companies and other investment properties. The core business model of private equity firms is to buy companies or parts of companies that the purchaser believes are poorly managed and therefore undervalued. Private equity companies use between 10 and 40 per cent of their own funds, with the remainder financed with debt. The more debt that is used, the better the return prospects, but the higher the risk. The investment property must be able to service the debt with the cash flow generated. If the debt is too high, there is a risk of default and the company may go bankrupt. Debt is also structured, which means that in the event of default, there is an order of priority for debt repayment. First, senior debt, usually traditional bank loans, is repaid, followed by subordinated debt, also known as mezzanine debt, which pays a higher interest rate. Third are the junk bonds, which pay even higher interest rates because of the high risk of default. Next comes equity, which can also be structured. For example, preference shares with no voting rights at general meetings are serviced first before ordinary shareholders are paid. Holders of preference shares are also prioritized in dividend payments. Finally, there are convertible bonds, which are actually debt but can be converted into equity. The structuring of debt and equity in private equity buyouts is relevant because it also involves a corresponding level of risk, which is reflected in the interest rates that the investment property has to earn.
The 3 Phases of a Private Equity Project: Fundraising – Investment – Exit
So, who are the investors in private equity? They are primarily institutional investors, such as pension funds, endowments, foundations, insurance companies and sovereign wealth funds, but also high-net-worth individuals (HNWI), who have large financial resources and are attracted by the prospect of higher returns than in traditional investments, but who are also risk takers.
Fundraising Phase
A private equity project begins with the fundraising phase, which can take up to five years. It begins with the creation of an investment fund by the private equity group (PEG), which raises capital for the subsequent purchase of a target company. The Private Equity Group (PEG) acts as the general partner, managing the fund, while the investors serve as limited partners. Legally, these arrangements are typically structured as limited partnerships, with the PEG as the fully liable general partner and the investors as limited partners, liable only up to the amount of their contributed capital. The internal relationship is governed by a limited partnership agreement, which outlines the rights, obligations, and exit scenarios for both parties. These companies are set up for a limited period, usually ten years, with an option to extend for one to three years. During this period, investors cannot withdraw their capital from the fund, but after this period the PEG must repay their investment with a targeted profit.
The fundraising phase also determines the amount of capital committed and how it is structured. The PEG usually also provides a share of 1 per cent of the fund’s assets “to have the skin in the game”. The distribution rules for potential profits are also agreed. A common model is the ‘2 & 20’ model, whereby the PEG receives 2 per cent of the management fees from the investment capital and 20 per cent of the sales profit each year. With a fund volume of US $1 billion, the private equity firm receives US $20 million in management fees each year during the investment phase, which can last up to ten years. If the private equity project is then successfully completed with the sale of the investment property, the PEG receives a carried interest of 20 per cent of the net profit. If the investors’ capital contribution has doubled from US $1 billion to US $2 billion as a result of the profit realisation, PEG will receive a further US $200 million in addition to the US$200 million management fee. That is, it will earn US $400 million from the private equity deal. As the PEG is also a shareholder in the acquired company, it is also entitled to an annual dividend payment. The private equity firm therefore benefits in three ways from the purchase of the investment property, provided it can earn the corresponding funds.
Investment Phase
During the fundraising phase, investors do not know which investment properties will be purchased. This decision is made during the investment phase, which lasts at least five years. This involves a detailed analysis of which investment properties are suitable for purchase. Detailed due diligence must be carried out to determine the potential for increasing the value and the financial strength that is required to carry the debt. Only when the ideal investment has been found, a special purpose vehicle (SPV) is set up, to bring in the equity of the investment fund, the bank debts and money from other lenders, to purchase the investment target and, if it is a company, to merge with it. The new company is then added to the private equity firm’s portfolio. The takeover of a company does not necessarily have to be with the consent of the management, but can also consist of a so-called hostile takeover, in which shareholders are offered an attractive price for their shares, which can be far higher than the current share price. This was the case with the famous takeover of RJR Nabisco by KKR in 1988/89.
During the investment period, the management team of the private equity firm must ensure that the value of the investment property increases. This can be achieved by increasing revenues and/or reducing costs. The benchmark used is the internal rate of return (IRR), which reflects the return on invested capital. The IRR depends on the balance between equity and debt, the cost of debt and the cash flow generated. It tells investors whether their capital is well invested, and it tells lenders what the risk of lending is. Of course, other metrics play an important role in performance analysis, but the IRR also provides information on when the desired profitability target has been reached, and the investment can be exited. This is triggered when a pre-defined minimum value of the investment property is reached.
Exit Phase
This marks the beginning of the exit phase, which can last several years. The exit may take the form of selling the asset, which has increased in value, to a strategic buyer. This is usually a company in the same sector. Another option is to recapitalise the investment, either by bringing in another private equity firm, or by attracting other investors. If the investment is in a company, it can be listed on the stock market for a profit. However, if the anticipated increase in value is not achieved and the company cannot sustain the cost of its debt, it may need to be liquidated, with proceeds distributed based on its capital structure. This would be the worst possible outcome of a private equity project, in which the asset is devalued and the investors and lenders suffer losses.
This is where the criticism of private equity comes in. As the aim is to maximise the return on investment (ROI), the long-term value of the investment is sacrificed for short-term profit skimming. Cost-cutting can also lead to job losses, leaving workers in the acquired companies worse off. Finally, a private equity buyout may result in the company or asset being broken up to sell the parts more lucratively.
Private equity firms are therefore not long-term, strategic investors; such firms aim to realise a rapid increase in value and then sell the investment property. Their primary obligation is to their investors, who have been promised an above-market return. The means by which this return is generated is of secondary importance. If the increase in value cannot be realised as expected, a private equity firm will not wait until the situation improves in the long term but will liquidate the investment property and realise it commercially to save at least part of the invested capital. In addition, debt financing in the private equity business carries a significant risk. There is a risk that excessive borrowing costs will be imposed on the investment property that cannot be paid from the cash flow. These costs become particularly problematic when borrowing rates rise, as is currently the case at the time of writing as we are in an inflationary economic environment. The result is a liquidity squeeze that must be resolved by rescheduling or liquidating the investment property.
From Buyouts to Royalty Funds
Originally, the investment targets of private equity firms were undervalued companies that were acquired in a leveraged buyout, increased in value and then sold again. However, with the onset of the financial and global economic crisis in 2008, the traditional private equity business came to a standstill and PE groups began to diversify. In addition to traditional buyouts, other business areas such as the purchase and commercial realisation of real estate, infrastructure investments, investments in existing PE funds (“fund of funds”) and distressed debt were developed. The basic concept is the same in all cases: The investment properties are acquired with a mix of equity and debt capital, increased in value and sold at a profit. A huge secondary market for private equity investments has emerged, on which existing investment obligations of investors are traded. The sellers are pension funds, foundations and other institutional investors, who are matched by sovereign wealth funds or special secondary private equity funds. The advantage for buyers on the secondary market is that they know the investment portfolio and do not have to invest blindly. This market, which had a volume of US $11 billion in 2009, has grown to US $130 billion by 2021. This demonstrates the continued popularity of private equity and the hope of above-average returns.
This is also the hope of investors in so-called ‘royalty funds’. Such investors buy into income streams that stem from the exploitation of licences. The income from oil and gas extraction and the exploitation of other natural resources is an example. Special funds, also known as royalty income trusts, are set up for this purpose, in which investors can invest their capital, which can then be used, for example, to develop new deposits. The income from the exploitation of the mineral resources then flows back into the trust. The advantage for investors is that the profits flowing out of the trust are not taxed at the company level, but only when the recipients pay income tax. Intellectual Property (IP) funds are a special type of fund that invests in royalty income from the commercial exploitation of intellectual property. One example is patent royalties paid by pharmaceutical companies to patent holders such as other companies, universities or even individual researchers, which the funds buy into. However, IP funds can also tap into income streams from the exploitation of franchises, trademarks, brands and entertainment products and services. And that brings us to music rights, which generate royalty streams in which funds and their investors want to participate. Which brings us full circle and back to part 1 of this blog series, where we took a closer look at PE projects related to music rights.
All parts of the series “Follow the Money! Big Capital in the Music Rights Market”
Endnotes
Steven N. Kaplan and Per Stromberg, 2009, “Leveraged Buyouts and Private Equity”, Journal of Economic Perspectives, vol 23(1), p 124.
Wentworth, M. C., 2023, The Hidden Trillion Dollar Industry of Private Equity, 11:59 Publishing, p 53.
Ibid.
Ibid., p 59.
Ibid., p 71.
Josh Lerner, Antoinette Schoar and Wan Wongsunwai, 2007, “Smart Institutions. Foolish Choices: The Limited Partner Performance Puzzle”, The Journal of Finance, vol 62(2), pp 731-764.
Wentworth, 2023, p 29.
Kaplan and Stromberg, 2009, p 122.
Ibid., p 123.
Wentworth, 2023, p 123.
Ingo Stoff and Reiner Braun, 2014, “The Evolution of Private Equity Fund Terms Beyond 2 and 20”, Journal of Applied Corporate Finance, vol 26(1), pp 65-75.
Wentworth, 2023, p 122.
Other fees, such as a monitoring fee, may also be charged. An overview of the fee structure for private equity deals can be found in Andrew Metrick and Ayako Yasuda, 2010, “The Economics of Private Equity Funds”, The Review of Financial Studies, vol 23(6), pp 2303-2341.
Wentworth, 2023, pp 61-66.
Ibid., p 68.
Ibid.
Ibid., p 69.
Ibid., pp 96-99.
Ibid., pp 75-76.
Ibid., pp 101-102.
Investopia, “Royalty Income Trust: Meaning, Benefits, Risks”, November 22, 2021, accessed: 2024-01-25.
* This blog post is based on the report IP Finance in the Music Industry, which was commissioned by the World Intellectual Property Rights Organization (WIPO).
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