Traditionally when a company needs financing but wants to retain control of its fortunes there are limited options available to it. Bank loans are probably the most popular but high street banks are still cautious in lending small to medium size enterprises (SMEs) cash despite government initiatives aimed at boosting business.

Step in Duke Royalty (DUKE:AIM) which lends businesses money in return for a slice of the investees’ revenues. The terms of this agreement can be as long as 30-40 years and it doesn’t matter if the company goes through some tough times. As long as it’s still generating some sales, Duke Royalty gets paid. Companies can pay back the initial loan after several years with a fee although CEO Neil Johnson describes the deal as a ‘corporate mortgage’. Benefits of keeping the agreement running include extra financing when needed.

The company has an annual reset of the money it will take back as repayment that is reflective of the movement of the investees’ revenue in the last 12 months. The reset is restricted to plus or minus 6% of the original deal agreed between the two parties. Therefore, although the company is not impacted by the investee’s profit figure, it has the ability to help out when times are tough.

Johnson says it’s a ‘fundamental promise’ that companies retain control of their finances. There’s never a need to refinance debt as often happens when companies can no longer stick to their banking covenants.

Duke Royalty takes the annuity-like royalty income it receives from its investee companies and returns some of the cash to its shareholders in the form of dividends. Stockbroker Cenkos forecasts an attractive dividend yield of around 8% for 2019 and 2020 due in part to the low headcount and lean operating model of the business.

DUKE'S BACKGROUND

Relatively unknown in the UK, royalty financing has been used in Canada and the US for years with its roots in the commodity sector, especially mining. It has also been used in the biotech sector although neither area is of particular interest to Johnson.

He doesn’t want to invest in these types of businesses as they may have a finite lifespan. Mines will eventually run out of things to dig up and biotech companies will lose their patents on drugs after several years. In both these hypothetical situations a dramatic fall in earnings is implied.

FINDING THE WINNERS

When choosing a company, it’s vital that the right sort of business is found as Duke Royalty is exposed to equity risk. However, even in the worse-case scenario of a default or liquidation, Duke has senior security on assets so should be able to recoup some of its losses.

Further examples of types of businesses Johnson avoids  include the company behind mobile phone game Angry Birds, Rovio Entertainment. Any hint that the product is a fad and not going to be around for the foreseeable future means that it won’t receive investment from Duke Royalty.

‘We avoid high obsolescence companies that run the risk of becoming outdated or obsolete and those with high customer concentration,’ says Johnson.

Duke Royalty also has a comprehensive checklist of investee criteria which includes the company having an established track record with
at least 10 years of predictable and visible revenue.

It prefers to come on board with an existing management team with a track record of delivering. It also likes businesses with little or no debt; in some cases Duke Royalty will replace the existing debt with its own financing.

Examples of companies where Duke Royalty has made an investment include Dutch river cruise business Temarca. It invested €8m into a company that has been around for 20 years and has sold out the next two sailing seasons so has clear visibility of revenue.

Another of Duke Royalty’s investments is Trimite, a Birmingham-based specialist coatings manufacturer. It has committed £9m to Trimite to fund its ‘anticipated future organic sales growth’. Duke Royalty expects £1.2m annual royalty payments.

HOW DOES IT FIND OPPORTUNITIES?

To find potential targets, Duke Royalty is aided by an exclusive partnership with consultancy firm Oliver Wyman, which Johnson describes as an ‘expert in every field’. According to broker Mirabaud, Wyman adds ‘extensive expertise in due diligence’ to Duke Royalty’s target acquisition.

In total, Duke Royalty has three royalty investments and has signed non-binding terms on a fourth deal.

The company raised around £20m through issuing equity at the end of last year to ensure it has the firepower to make further deals. It has also used some of the funds to top up pre-existing loans, for instance investing a further £3m into Temarca. (DS)

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