How Hipgnosis' accounting practices led to big problems at the Directory Fund

Accounting scandals may not get the same public attention as a Homeland Security raid, but questions about the quality of a publicly traded company's books are serious business. This week, an internal report released by Hipgnosis Songs Fund, the London-listed company that has been instrumental in turning music rights into a stable, attractive asset class, confirmed what some analysts and shareholders had long suspected.

At best, the 26-page report by Shot Tower Capital, the firm that hired the company's board after a shareholder revolt in October, details how the investment adviser, Merck MercuriadisHeaded by Hipgnosis Song Management (HSM), he made several mistakes in the accounting and financial projections of his massive music rights portfolio that includes music by the Red Hot Chili Peppers, Shakira and Journey. At worst, the report suggests the investment adviser chose accounting standards that overstated revenue, inflated portfolio valuation and — as a board of directors previously stated — led to higher fees paid to manage the portfolio. In any case, the information released Thursday paints an unflattering portrait of HSM and its inner workings.

For its part, HSM considers certain “aspects of the report … to be factually inaccurate and misleading,” the company he said in a statement on Thursday (March 28). HSM said it received the report the afternoon before its launch and would respond to the board “in due course”.

To be clear, Shot Tower did not specifically comment on the investment adviser's intent to use certain accounting practices. The data-rich report offers analysis, not guesswork. But the report, part of the board's bid to regain shareholder confidence, made clear that annual revenues were “substantially” overstated and provided several examples where the fund's numbers did not reflect the reality behind its assets.

Take, for example, something called a right to income (RTI), which are royalties paid to the buyer at the closing of an acquisition. (If the effective date of the acquisition is before the closing date, the rights received by the seller after the effective date are credited to the buyer.) Normally, the amount of RTI is deducted from the purchase price and is not included in the annual revenue figures. However, Shot Tower found that some RTI revenue from Hipgnosis acquisitions was calculated as annualized revenue rather than as an adjustment to the purchase price. As of the board of directors Update March 18 It is noted, including RTI revenue with annual revenue amounts to “double counting”. The RTI misclassification “significantly” increased the fund's income in 2021 and 2022, according to the report. In fiscal 2019 and 2020, zero and 5.3% of deals had RTI periods that extended more than one year. In fiscal 2021 and 2022, those numbers jumped to 43.9% and 60.0%.

RTI also got into the game with the proposed sale of part of the portfolio to Hipgnosis Songs Capital, a joint venture of HSM and investment firm Blackstone. The listing was presented to shareholders as having a net purchase price of $424.7 million (including RTI proceeds of $15.3 million). With pro-forma annual revenue (PFAR) of $24.1 million, HSM assigned a multiple of 17.6 times to the proposed sale. But Shot Tower believes the list multiple should have been 14.9x based on higher annual revenue of $28 million and believed the net sales price should have been $416.7 million. Shareholders voted down the proposed sale in October.

In fiscal 2022, the investment adviser changed the way it treated accrued income. The fund is required to make estimates of the income earned during the period, rather than recognizing income when the rights are collected. A new approach, called “usage increments,” calculated accruals “based on expected usage” rather than when revenue is “paid and processed by collection agencies, issuers and administrators.” Shot Tower noted that the adoption of accruals came “at a time when RTI revenues were declining and the Fund could no longer raise funds for ongoing acquisitions.” In other words, the lack of new funding halted acquisitions and reduced the amount of RTI revenue added to annual revenue. Without the change, Shot Tower believes the fund “would have breached lender covenants” and fiscal 2022 revenue would have been $36 million lower.

Accruals also caused problems with PFAR, a non-IFRS metric meant to show investors organic growth excluding accruals and RTI. However, Shot Tower found that the PFAR did include estimates of accruals expected to be included in the period, which “presents a picture of organic growth that is higher than the growth suggested by the statement figures,” according to the report. As such, Shot Tower cautioned investors not to rely on PFAR as a metric.

More issues arose in Shot Tower's due diligence investigations of how individual listings were valued. The entire portfolio, which stood at $2.8 billion as of March 31, 2023, stands at $1.95 billion, according to the report — a difference of about $850 million. Given the transparency of the fund's accounting practices, however, shareholders were not bothered by the downgrade. On Thursday, the Hipgnosis Song Fund share price jumped 8.3% to 69 pence, its highest closing price since January 31 and 30.4% above the 2024 low of 52.9 pence set on March 4. Whether the share price improves further could depend on how shareholders view the board's reaction to this report.