The Royalty Treatment

The idea: We invested in music royalties last year, and you can argue that the income you generate from music royalties is pretty independent of the business cycle. People will listen to “White Christmas” whether it’s a recession or a boom time.

The strategy: What’s fascinating to me is that music royalties are very tax-efficient. Music royalties are considered intangible assets, and, unlike real estate, are typically amortized over 10 years using a “straight line” method. You’re buying what’s considered a depreciating asset — a song or soundtrack is in style now, and it may be out of style at some point, so you can amortize your cost over 10 years.

Music royalties trade like fixed income — you have this cash flow you expect, and when rates/income from royalties goes down, you can discount them at a lower rate of present value. But unlike with high-yield bonds, the numerator of that bond is pretty consistent — people continue to listen to music. You really need to find someone who can find the right songs and work them — get them into commercials, movies.

We’re invested with a fund called Open On Sunday, and there are other music funds out there. When we bought — this was before the interest rate rise — we were penciling in a current cash return of around 8%. If the manager can work the tunes effectively, that could get to 13% or 13.5%. And when you get that 8% it’s more than offset by that 10% depreciation, so you’re owning something as boring as a building [in how it’s taxed] but as exciting as music. The additional 2% could be used to shelter income on other investments.

Music royalties have gotten popular, and I heard Sony paid a multiple of around 30 for Bruce Springsteen’s book. Sony was perfectly positioned — they have a music business, will put the music in movies, and for all we know Springsteen songs could wind up in video games.

Go Private

The idea: Private credit has really become interesting.  Banks have pulled away from lending due to regulation and that trend has been ongoing after the Great Financial Crisis. There’s been a decade-plus shift in who’s the lender to middle-market companies, which make up two-thirds of GDP in America.

The strategy: More recently, as banks continue to pull back on their balance sheet, there’s been more opportunities created for the private credit asset class. The strategies are mostly available to either accredited investors or qualified purchasers, so it’s not as broadly available as the stock and bond market. But it’s really a good time to look at income-based alternatives, and private credit is our leading idea in this space. Of course, you have to be careful here, but because we’re expecting a mild recession, we don’t expect default risk to go up materially. This is a really interesting space, especially on the senior side of the capital structure.

We expect high-single-digit to low-double-digit returns over time, with most of that coming from the interest rate on the loans. Today’s new loans are the highest we’ve seen in quite some time, around 11%. Returns will vary greatly based on leverage and where the loans are in the capital structure. The quality of underwriting is what matters most for loan success. Look for funds that have weathered economic downturns and assess their cumulative loss ratios to differentiate between managers.

International Diversification

The idea: I believe proper diversification includes not just companies varied by market cap or style, but also geographic representation. A common investor oversight is having little to no exposure to international companies. My view is that investors focusing chiefly on US firms are forgoing a lot of growth from companies domiciled abroad.

The strategy: There are structural benefits to international diversification. First, countries excel in different areas, for economic and cultural reasons. The largest five global luxury-goods public companies are based in France and Switzerland. Two of the most profitable automotive firms are Japanese, and the largest semiconductor manufacturer is Chinese.

At the end of the day, we invest in companies, not countries, and seek strong profits wherever they are. Secondly, US indexes are themselves overweight in certain sectors — the S&P 500 is, for example, over 25% technology as of today. So even in a broad index with hundreds of underlying holdings, you may be taking sector risk without realizing it.

When composing equity portfolios we are currently allocating between 30% to 40% in companies domiciled abroad. This includes firms in developed and emerging markets. We do use domestic indexes for their low-cost benefits, but when investing in emerging markets I prefer professionally managed mutual funds. US public companies undergo an elevated level of regulation, reporting and auditing, and for newer economies I want to leverage the insights of analysts who specialize in these markets.

Venture to Europe

The idea: The European venture capital market is at a compelling point in its lifecycle, and 2023 may be a particularly attractive vintage. Wilshire has had a front-row seat into this market’s development, including exponential growth in investment activity and €1 billion-plus exits over the past decade. This success has perpetuated a virtuous cycle of repeat founders, established top-tier investment firms and successful exits across emerging technology hubs from Stockholm to Barcelona.

The strategy: The combination of ecosystem acceleration, together with secular trends in areas such as fintech, e-commerce, artificial intelligence, cybersecurity and enterprise software, paints a compelling picture for expected investment return. Historically, European venture capital has delivered on this expectation, producing returns as good or better than venture capital funds in the US while diversifying portfolio risk vis-à-vis its complementary geographic exposure.

Despite these dynamics, Europe is a fundamentally less competitive market compared to its North American and Asian counterparts. While pricing is lower in general for similar deals with equivalent technology, management teams and institutional-class general partners, market dislocation has created a particularly compelling entry point as dry powder finds tomorrow’s breakout winners at even more attractive valuations.