Royalty Companies and Cost of Capital & Overhead

Royalty companies are at their core a kind of specialty finance.  Like a bank they have a cost for the money they use to acquire or originate royalties.  

Imagine two theoretical simplified royalty companies, F and E.  F is large with lots of assets many of which produce a steady stream of cash.  F can also borrow money incredibly cheaply because it has lots of assets and cashflow so lenders know they are a safe bet to pay their loans on time.  E meanwhile is small with just a few assets.  If they borrow money it is at very high rates to compensate lenders for the risk.

Company F Company E
asset value $10 billion $50 million
royalty revenue $1 billion $5 million
borrowing cost 3% 15%
return on investments 10% 10%
company overhead $20 million $10 million

Company F is in an enviable position.  Despite having twice the company overhead as Company E after paying its overhead it has $980 million cashflow a year to reinvest.  Its biggest problem will be finding enough deals to reinvest in and deciding how much of its leftover cash to return to shareholders via buybacks and dividends.  If it does manage to find more good deals than it can fund from its own cashflow it can easily borrow money and still make a very tidy profit borrowing at 3% and investing at 10%.

Company E however is still bootstrapping a new royalty business.  Despite its lower company overhead, after paying its overhead it has to go raise another $10 million every year just to keep the doors open, diluting existing shareholders.  With no cash leftover from its royalty revenue it also has to borrow money to fund purchase or originating new royalties.  But because its borrowing costs are higher than its returns it has to issue even more shares to pay the loan.  

The hope of company E is that eventually they can increase their asset value and the resulting royalty revenue.  If they can get big enough they can cover their company overhead from their royalty revenue.  If they get bigger still they can have some royalty revenue to reinvest.  If they get bigger still their borrowing costs might get below their return on investments.  In other words, if they are successful someday they might become company F.

But it's far from certain if company E can pull it off.  If they can continue to find investors to issue shares to without making their current shares worth too little.  If they can continue to scale up out of the cash burning hole they started in.  If they can pull themselves up by their bootstraps.

Two questions I ask about any royalty company I look at investing in.  Is their borrowing costs below their investment returns?  Can they fund their overhead out of their revenue?  If the answers to both of those are yes then I start looking at valuation.  If the answer to either is no I don't look at valuation at all and instead start looking at what their plan is to make the answer to both of those questions a yes.

This is the framework through which I read this press release that came out three days before Christmas.