Monthly funds focus: Biopharma Credit, The all-singing discount play, Thematic ETFs

Welcome to my quick monthly round-up of interesting, listed funds, be they investment trusts (or closed funds, as they are sometimes called) or index tracking exchange traded funds (ETFs). To repeat earlier articles for SharePad, I’m still fairly bearish about prospects for global equity markets but I am starting to see some opportunities start to emerge, especially amongst deeply discounted investment trust funds. I’m also starting to think through the likely ETFs I’d use if, and when, markets do recover their mojo. So, on this score, I have a bevvy of defensive ideas plus two thematic ETFs that are primed for the next bull market recovery.

For the defensive investor – Biopharma Credit

Biopharma Credit first listed on the London market in spring 2017. It operates in an obscure part of the market but in reality, its pitch is simple. It lends to pharmaceutical and biotech companies, most of which are listed, through senior secured notes. Many of the firms it lends to use the debt as a way of funding growth or acquisitions. In good times, when investors are bullish about life sciences firm, borrowers pile into convertible stock, which BioPharma tends to avoid. In bearish times, converts dry up and borrowers need to switch to senior secured loans. The challenge is that many conventional lenders don’t really understand life sciences stocks: lots of hard-to-measure IP, and strange-sounding products. BioPharma by contrast has many decades of experience of lending specifically to these businesses and has run multiple private funds in this space before listing its London fund. As an aside, it continues to run a parallel private fund alongside the London listed fund. Crucially BioPharma has a track record of getting its money back. In fact by and large, BioPharma is repaid BEFORE the maturity of its loans – either because the borrower is purchased (see recent transactions) or because the borrower refinances on better terms. All bar one of its loans have been redeemed early and this triggers fees and extra payments which flow through to shareholders. Crucially there have been no defaults to my knowledge and the NAV has remained steady while the income has been paid out. In sum, exactly what a lending fund should be doing i.e lending at a decent rate, paying out that income and then getting repaid at the end plus a few extra fees for early repayment. For investors that means you get a current net yield of around 7.35% and a steady NAV which has very marginally increased over the years. There’s also the possibility of extra special distributions, which can add to the yield.

Key fund facts

• Share price: $0.95/$0.96
• NAV per share $1.02
• Discount to NAV – 6.36%
• Average discount last 12 months – -2.4%
• Average discount/premium since launch is estimated as a premium of ~1.6%
• Dividend yield based on share price 7.35%
• Dividends paid every year 7c
• Managers: Pharmakon / Pedro Gonzalez de Cosio / Pablo Legorreta / Martin Friedman / Currently manages BioPharma Credit Investments V (“BioPharma-V”), a private fund with $1.3 billion in commitments
• Target total net return on NAV of 8-9% per annum over the medium term
• BPCR’s portfolio is primarily composed of senior secured loans to listed companies

Talking to the fund manager, its clear that because of recent transactions, the fund’s dividend is already well and truly covered – cash cover excluding repayment fees – is already running at an annualised rate of 8.9c per share versus a dividend of 7c. That means I think there is a high likelihood that there will be an extra distribution in the coming 12 months, maybe in the 1 to 2c range.

On top of this, you’ll pick up the 7c a share dividend, paid in quarterly instalments. Last but by no means least I think the discount will narrow when the market wakes up to those extra payments. Currently, it’s running at just above 6% whereas over the last year that discount has averaged around 2.5% according to fund analysts at Numis. I think we could see a narrowing of the discount to around 3%. I would also point out that according to the managers, since inception the fund has averaged a premium of over 1% so that discount could, potentially, even vanish entirely although I think that unlikely in the next 12 months.

So, we can add up the potential upside for the next 12 to 15 months. There’s the 7c dividends, the possibility of a 1 to 2c extra payment plus a 3c tightening in the discount. That adds up to a potential upside of 11 to 12c based on a share price around $0.95/6. In my view, a total return of over 12% in the next year and a bit is well worth locking away.

Now there are risks of course. Perhaps the biggest one is that the fund is stuck with a great mountain of cash which it can’t reinvest – this in turn could hit the future dividend cover. Talking to the manager though I get the impression that they are not remotely worried by incoming demand for the loans pipeline and that there is a very high likelihood of that money being deployed in a timely fashion.

There’s also the risk of course that the shares could fall in value and that the discount could increase. I think that it’s unlikely as the shares aren’t especially volatile in pricing terms. And of course, there’s the ever-present risk that the current biotech/life sciences swoon downwards could intensify and a borrower could go bust. Again, that is possible but, in my view, unlikely. So, in sum, this looks like a decent bet for an adventurous investor who is nevertheless cautious about the state of the markets.

The all-singing discount play

I’ve been fairly reluctant to highlight the listed music funds (Hipgnosis and Roundhill) for a simple reason – I’ve been cautious about valuations. Put simply, the world of music rights is a small, closed one. It’s basically dominated by the two listed music funds plus a handful of big music labels. Sure, there are other players but basically, once you get to a portfolio worth say more than $20m there’s really probably only about 5 to 10 realistic buyers in town, or perhaps even less.

That poses a problem for an asset class where you need to put a number on private market valuations. Hipgnosis, like its peers, uses a private market valuation process – and valuer – in an attempt to get some marks on the market valuation. But this still leaves me with an uneasy feeling. These private valuation marks could of course be accurate, but they are usually based on difficult-to-disclose transactions amongst a small handful of players, who presumably all know each other very well. Now, to be fair, private equity funds have similar problems in that valuations are frequently based on market marks using recent transactions which frequently involve fellow PE funds. But the number of players in PE is infinitely greater than music rights, so at least there is some safety in numbers – though I’m not entirely sure that will be much of a safety net in the next few months.

Anyway, back to Hipgnosis. I’ve always been impressed by the quality of the portfolio, though a little skittish about the high prices paid for well-known music rights. I’ve also wondered aloud whether less well-known catalogs might represent better value but over time I’ve come to accept that Hipgnosis does have a first-class catalogue which is being ably augmented by a fast-growing sync music rights business. The CEO, Merck is basically rolling out an integrated music business without the risky A and R stuff which costs money – and that aggregated catalog will of course have some value to the right buyer.

Another reason for my caution has been the constant issuance of new equity, which has helped build up the portfolio scale. I know plenty of shareholders who have pushed back against this constant market tapping and it seems like Merck and the board have listened and seem to have slowed down the pace of new issuance.

It’s also worth saying that a few recent deals point to corporate diversification. I realize that Merck’s deal with PE giant Blackstone ruffled some feathers but it does show he has greater market traction and access to more firepower for bigger deals. He’s also just announced “plans to securitize 950 of the songs held within the Blackstone-backed Hipgnosis Songs Capital private fund via a bond issue. The songs are across five sub-catalogues, including those of Justin Timberlake, Nelly Furtado, and Leonard Cohen. The yet-to-be priced bonds have an anticipated repayment date of May 2027 and an advance rate of 65% (i.e., a principal balance of £222m versus an independent catalogue valuation of $341m)” according to Matt Hose at Jefferies.

As Matt says, I think this is a big advance because it could help improve the debt position of the fund ($600m) “which is via a relatively expensive (L+325) credit facility maturing in 2025. “ In sum, one can now see a pathway to securitizing large bits of the portfolio, which is another positive.

So, let’s recap where we are.

I have real concerns about valuations in the portfolio, but I think it has reached a critical mass in terms of scale.

• Recent trading has improved and the fund is obviously a net beneficiary of the rise of streaming – we have a strong BUY on Spotify.
• On a side note, Hipgnosis revealed that global streaming revenue grew by 24% in 2021 and the market is expected to reach $103bn by 2030, which would represent a 9% CAGR.
• Last but by no means least, new share issuance has slowed down and the fund has a way of improving its debt costs.
• Crucially though, the share price has also been weak recently. By my calculations using the net operational net asset value, the fund is trading at a discount of around 25%, although data on the Numis funds research website shows a discount of closer to 8%.

I prefer to use the bigger number and for me, that discount is enough to assuage my concerns about valuations. I would not have been a buyer of the fund when it traded at a premium but everything has changed – the fund is at scale, with improving cashflows. A 25% discount strikes me as a reasonable margin of safety. In addition, I think that during the next market upswing (2023 or 24), Hipgnosis will be big enough and integrated enough to be attractive to a big media buyer.

Basic fund facts

·         Ticker – SONG £

·         Share price SONG = £1.1276

·         Alternative SOND = $1.35

·         Net assets £1.5 billion

·         Yield 4.6%

·         Net debt 25%

·         Operative NAV of $1.84 = £1.52

·         Discount 25.8%

·         Website – https://www.hipgnosissongs.com/

·         Founder and CEO: Merck Mercuriadis

My bottom line? Ideally, if you could buy in at below 110p I’d wait around for the right entry price but I’d be a buyer at anything below 113p. I’ll happily take the 4.5% yield plus I think we could see the share price back above 125p/130p within the next year to 18 months. What to watch in terms of risk? Keep a wary eye on cash flow and arrears, and also hope that streaming growth comes through as predicted. It would also be nice to retire some of that expensive debt.

Feeling adventurous? Thematic ETFs

You’ll have noticed that there is a new kid on the block when it comes to tech fund investing. The traditional choice was an actively managed fund, with investment trusts such as Ben Rogoff’s Polar Capital Technology trust amongst the top choices. Over the last decade index tracking sector ETFs have also had a big impact, largely because the tech leviathans have come to dominate tech sector returns – be that narrow tech in the case of the IT sector or more broad sectors that include communication services which include outfits such as Meta. If I’m honest, precisely because returns to the FAANGs (and other similar acronyms featuring the tech giants) have been so skewed to the mega large caps, active fund managers have had a tough time.

In recent years though a new option has opened up – thematic funds. These take either a small bit of the sector – say robotics – or widen out to firms that straddle different sectors – say the meta verse – to build a more concentrated basket of stocks based around a theme or trend. By and large these thematic funds – nearly all of which are ETFs – proved very popular until last year when the wheels fell off the tech growth boom.

The profusion of thematic funds for every imaginable trend, theme or niche has got so out of hand that many investors have struggled to get a handle on the choices. There’s also the not inconsiderable challenge that some themes or niches are so narrow, that supposedly ‘diverse’ portfolios actually comprise less than 50 stocks, many of which are small caps. That makes them the very definition of volatile.

But two thematic-focused ETF issuers have launched an interesting alternative which is multi-thematic ETFs. Both HANetf and LGIM have launched fund of funds which combine different themes in one fund structure. The L&G Global Thematics invests in the issuers existing range of nine L&G thematic funds, ranging from robotics and automation, through to clean energy and logistics stocks. The LGIM team decide how to allocate between the existing range of nine funds using an in-house system. This is described as followed: ‘The thematic ETFs are weighted using a quantitative allocation model that seeks to ensure each theme contributes approximately the same amount of risk to the fund. This means that if the volatility of companies in a theme rises, the fund’s allocation to that theme would be decreased to continue providing a similar risk contribution, while still benefiting from each theme’s potential growth.’ Each theme is assigned a cap of 20% and a floor of 5%, and there are some limits on turnover.

HANetf also has its own multi-megatrend fund, called the HAN-GINS Tech Megatrend Equal Weight UCITS ETF (ticker ITEK) with a total expense ratio of 0.59% (very close to the L&G ETF). This allocates equally to the following subthemes: robotics and automation; cloud computing and big data; cybersecurity; future cars; genomics; social media; blockchain; and digital entertainment. Year-to-date, it’s down 33.5% versus a 22% decline for the Nasdaq Composite.

Obviously, these multi-theme funds are about as popular as a republican at a royal funeral at the moment. As I expect more pain to come for the tech space I’m not optimistic about these funds in the short term, but sooner or later the tech growth bulls will recover their mojo and when they do these funds with their meme-heavy investments in mid to small caps will become popular again. That means they’ll suffer from elevated volatility, but the upside could be great.