Last Wednesday (May 4), the Federal Reserve issued the US’s biggest interest rate hike in 22 years.
The following day, the UK’s Bank of England raised its own rates for the fourth time since December, as its Governor, Andrew Bailey, warned Brits of a “sharp economic slowdown” in 2022.
Just as all of that was going on, the music industry was showing its strength.
In the space of three days: Universal Music Group announced Q1 revenues up 16.5% YoY; Live Nation announced its “best first quarter ever”; Believe saw Q1 revenues jump 30.9% YoY; and HYBE, home of BTS, revealed a whopping 59.8% YoY rise in its Q1 turnover.
The bull case for music assets was robustly summed up by that spread of numbers.
The bear case, however, now incorporates the aforementioned interest rate rises.
After all, everything involving borrowing just got more expensive. That includes credit cards, mortgages… and buying music assets for megabucks prices (using debt).
Yet at least one music business company – right at the center of the modern catalog rights acquisition boom – isn’t breaking a sweat.
Nari Matsuura is Partner and co-leader of the Music Economics and Valuation Services practice (formerly Massarsky Consulting) at Citrin Cooperman.
As such, alongside Barry Massarsky, she leads a group that has been in the thick of valuing music biz deals involving Hipgnosis Songs, Round Hill, Primary Wave, Shamrock Capital, Reservoir and Lyric Capital among many others.
Last year alone, the New York-headquartered Massarsky/Matsuura practice valued music assets worth over $6.5 billion in total.
Massarsky and Matsuura’s practice has also become well known in industry circles as the ongoing valuer of Hipgnosis Songs Fund’s NAV [net asset value].
To understand Matsuura’s calculations on her team’s music biz valuations – and why interest rates don’t affect them as much as you might think – we first need to explain what a Discount Rate (DR) is.
A Discount Rate is a tool factored into valuations by practices like Citrin Cooperman during discounted cash flow (DCF) analysis. i.e. Calculating future pain points related to interest rates that may render an asset worth less than it first appears.
Matsuura is confident that, with a Discount Rate of ≈8.5% set in stone for some time, Citrin Cooperman has comfortably protected its clients, both past and future, from over-valuations – and from losing their shirts on interest rate rises.
As Matsuura confidently puts it: “We will not have to raise our Discount Rate again. And as a result, we are protecting all of our clients: valuations will not go down.”
Here, in an exclusive interview, Matsuura (pictured inset) explains precisely how Citrin Cooperman came to its Discount Rate decision, and why it spells good news for music funds keeping a watchful eye on the Fed…
Simple question to start: Why does the Discount Rate matter so much when you’re valuing assets in the current environment?
As you know, music valuations are trading at high multiples. And there’s a lot of investment money being poured into this asset class.
People are understandably asking a lot of questions, given the current rising interest rate environment. Will that have an impact on the Discount Rate? And in turn, what will that do to music valuations?
“Our Discount Rates do not change [in tandem with] a purchaser’s ability to buy… We remain completely agnostic to the buyer’s profile.”
Before we answer that, it’s important to make sure people know that [Citrin Cooperman] conducts market valuations. We need to provide an objective view of the market value of each asset.
As such, our Discount Rates do not change [in tandem with] a purchaser’s ability to buy, or if a purchaser has a lower rate of return – or a higher rate of return – required for their investors. We remain completely agnostic to the buyer’s profile.
There are two Discount Rate calculations you want to explain today, both of which have ended up approximately in the same place. The first is the simple one – the rough and ready one!
We represent a wide array of investors – anywhere from pension funds [i.e. long-term investors looking for a steady ROI] to private equity [i.e. shorter-term investors looking for a more spectacular ROI].
These two types of companies’ hurdle rates might be very different: 4% versus 14%, for example. [A ‘hurdle rate’ is the minimum rate of return required by an investor.]
We thought our [starting Discount Rate] should be the middle point of this range, so we arrived at about 9%. This obviously isn’t a technical calculation! We were simply looking at the range of the market and arriving at the midpoint.
“We decided to lower the discount rate by half a percent [to 8.5%]. We considered that to be a conservative adjustment.”
We were using 9% [as an average ROI rate for music investors] in 2019, into 2020… and then COVID hit. And in March 2020, that month we all remember, the Fed interest rate dropped to near 0%. They cut it by 1.5%.
We as a company want the music market – and the individual catalog [performance] – to guide valuations. How is it performing? Where’s the growth? What is taking place across these income streams?
But the question was raised: what do we do with our Discount Rate? And we decided to hold where we were [at 9%].
We didn’t know where things were going, and we didn’t want to just react for the sake of reacting – because every time you react with a new Discount Rate, you’re going to have a tremendous effect on valuations.
So we waited around six to nine months, before deciding to lower it by half a percent [to 8.5%].
That lowering [of 0.5%] was a third of what the Fed did to interest rates at that time (-1.5%). We considered that to be a conservative adjustment.
Meanwhile, we’re heading towards late 2020, and COVID is keeping us all indoors…
Yes. And we knew that in the long term, the Fed was not going to stick with a 0% interest rate forever.
So in the back of our minds, when the Fed started adjusting rates upward again – which we knew it would, eventually – we also knew we wouldn’t have to do the same thing to the Discount Rate.
If you end up increasing your Discount Rate [having prematurely/overly lowered it in the past], you’re going to lower your valuations [of music assets].
“We applied worst case scenarios, for all of the different inputs into the [calculation]. And we ended up in the same region.”
So sure enough [in March 2022], the Fed announced its first increase. When that happened, we moved into phase two: a full blown technical analysis of our [music asset] Discount Rate, using all of the different inputs available to us.
We applied worst case scenarios, for all of the different inputs into the [calculation]. And we ended up in the same region [of 8.5%] we’d already decided upon.
Okay, this is part two: The technical analysis. What was that process?
Here’s where I nerd out a bit!
So to calculate a Discount Rate, the first step is to calculate the Cost of Equity. The Cost of Equity is composed of a few inputs: (i) the Risk Free Rate; (ii) the Beta; and (iii) the Equity Risk Premium.
- The Risk Free Rate is the average return of long term government bonds. 2.5% is considered to be a very basic way of viewing long term government bonds.
- The Beta is the volatility of a group of stocks against the overall stock market. [An index for music-specific stocks] is harder to calculate because there aren’t that many public music companies. The closest that we could get to for music was entertainment, using the Kroll Cost of Capital Navigator. Kroll suggested that the Beta for entertainment should be 0.89. Anything less than 1.0 suggests lower volatility than the overall stock market, which means that entertainment is less volatile than the overall stock market. That’s an easy thing to understand, of course: the demand is generally always there for entertainment regardless of the state of the economy;
- And then we have the Equity Risk Premium. This is the excess return that investing in the stock market provides over a risk-free rate. So the risk free rate is 2.5%. And then you add another couple of percent for the Equity Risk Premium. And that Equity Risk Premium, via the Kroll Cost of Capital Navigator, came out at 5.5%.
So if you then just roll through those numbers (2.5% + 0.89 X 5.5%) the Cost of Equity becomes 7.4%.
Then we put the Cost of Equity into the Weighted Average Cost of Capital (WACC). And then we added a cost of debt, the source of which was Professor Damodaran of NYU, who is kind of the guru on Discount Rates.
And then [to calculate the Discount Rate] we assumed an aggressive proportion of financing [in acquisition funding] of equity versus debt at 75% / 25%. And of course, we put in taxes.
That’s a lot of calculations. Where did you come out?
We came to a Discount Rate of 6.2%. That sounds really nice and low, right? [Remember, the lower the discount rate, the higher the music asset valuations.]
But a rate can’t just take the present into account, it has to take the future into account too.
By this point, Goldman Sachs had already raised its forecast [i.e. a prediction of how much the Fed would increase future interest rates] to include eight to ten rate hikes of 25 basis points each.
That’s a total [projected interest rate rise for the Fed] of 2% to 2.5%.
“If you take the Discount Rate that we calculated (6.2%), and you add the average of Goldman’s forecast – 2.25% – you get to an approximate Discount Rate of 8.45%. And that’s what we’re using.”
[Basis points are a common unit of measurement for interest rates: one basis point is equal to 1/100th of 1%. So a 1% change = 100 basis points.]
So if you take the Discount Rate that we just calculated (6.2%), and you add the average of Goldman’s forecast – 2.25% – you get to an approximate Discount Rate of 8.45%.
And that’s what we’re using.
[To explain further: In her rough, quick-math version, Matsuura got to a Discount Rate of ≈8.5%. And in her let’s-just-check-that, long-math, everything-calculated-fastidiously version, she got to 8.45%.]
So what does this actually… mean?
It means that when interest rates go up, we will not have to raise our Discount Rate. It’s that simple.
You mean when interest rates go up from this point onwards?
Yes. And as a result, we are protecting all of our clients: valuations will not go down.
But What if interest rates go even higher than Goldman predicted?
Remember, we put in a really conservative debt-to-equity profile in our calculation of 75% / 25%.
If we shift that to something that resembles more like what the market [typically uses to fund acquisitions] that’s 50% / 50% [i.e. 50% debt and 50% cash].
Debt to equity in certain deals might be 35% / 65%; it might even flip the other way around. But let’s just say 50% / 50% for the time being.
From there, we started to play around: We played around with the Beta, we played around with the Equity Risk Premium, and we played around with the Cost of Debt.
“So again, we just feel that we’re on a very, very secure footing with these funds, with the long term outlook.”
For the Risk Free Rate, we put in 5% instead of 2.5%. For the Cost of Debt, we put in 8.5% instead of 3.5%. That’s a really, really high cost!
We really didn’t think we needed to put the Beta at more than 1, because we don’t believe that music is more volatile than the [overall] stock market. We’ve seen that already, during COVID: when everything else was falling, Hipgnosis was standing strong. Consumers are not as sensitive to price changes in music; in a recession, people won’t buy cars but they will pay for their Spotify.
And then we built in an Equity Risk Premium of 6%. And I’ll just say right off the bat: the equity risk premium has risen above 6% only three times since 1960.
But even when you put all of this together, you come out at a Discount Rate of 8.6%.
So again, we just feel that we’re on a very, very secure footing with these funds, with the long term outlook.
Valuations are being lifted by the growth in the music industry, which is just continuing to barrel through.
In essence, you took a conservative view when COVID hit because of the uncertainty. and it turns out, effectively, the finger in the air estimate you had there has now been backed up by evidence, based on what’s happening with the Fed’s rate rises?
Everybody asks what’s going to happen in a rising interest rate environment. Is that going to lower the values of these catalogs? In the end, will investors start to pull out?
We think that we have positioned these catalogs – using the Discount Rate that we did – such that none of that will come to pass.Music Business Worldwide