Hipgnosis Songs Fund (LSE:SONG) now has potential grounds to part ways with fund manager Hipgnosis Song Management (HSM) – and without paying too large a settlement fee, analysts suggested.
The investment trust, which owns portfolios of music rights from artists ranging from Blondie and Red Hot Chili Peppers to Shakira and 50 Cent, today said it had discovered a double-counting error which caused net asset value to be overstated.
It has published an updated NAV of 85p per share, a reduction of 7.6% from earlier in the month.
Hipgnosis said HSM has now notified the board that they agree with the board's updated view, "contrary to previous advice".
Stifel analyst Sachin Saggar said it was "an unexpected and disappointing announcement" and had spoken to both the board and HSM to understand how the error had arisen.
This led him to believe that the error "should have been caught much earlier" by HSM, the previous board that was ousted after October's failed continuation vote, and previous auditor PwC.
"At some stage you have to ask whether the state of the vehicle can be put down to poor governance alone and not something else.
"Our base case is now that the manager will be terminated for cause given the costs that have been borne by shareholders from essentially publishing incorrect NAVs since IPO," said Stifel in a note to clients.
"That should at least limit any financial settlement in terms of removing the manager."
How the double counting arose
Since floating in July 2018, Hipgnosis has reported both an operative NAV and an IFRS NAV for each accounting period.
The valuation methodology used by the company's valuers assumes the transfer of rights to all future cash receipts including any income accrued by the song rights at the date of sale, with Hipgnosis saying operative NAV should therefore deduct accrued income to avoid double counting.
It said the error relates to the adjustment made to the IFRS NAV to produce the operative NAV, which is prepared by the investment adviser, and does not relate to the valuation methodology used by the company's valuer.
Having talked to both sides, Stifel observed that "there is typically a high portion of accrued income at any reporting date given the inherent delay in receiving cash in the music sector".
As an example, if a valuation was conducted on 31 March, the purchaser of a portfolio of song rights would typically have the right to receive all cash income related to the songs from 31 December or earlier – "i.e. the transfer date of cash income is backdated as accounting methodology is not relevant".
Hence, it said when calculating a NAV, "accrued income should be reversed out as it would not be received".
Saggar noted that the rival Round Hill Music royalty fund, which was acquired last year, followed the approach of reversing out this income.
"If this occurrence was in isolation we could be swayed into thinking that the reversal of accrued income was akin to a transaction cost which is not typically included in a NAV i.e. it is just a difference in methodology and not an 'error'.
"However, given what has happened to date, we think the calculation has more likely been intentionally designed to reflect as high a NAV as possible.
"The manager was acutely attuned to the mechanics of 'right to income' at IPO by backdating transaction dates by more than a year, and the reversing of accrued income effectively represents the counter opposite of the trade i.e they are having their cake and eating it."
He said the Stifel team still maintain the view that selling the portfolio now would be "the wrong step", but added that these announcements increase the likelihood of a sale in the next 18 to 24 months once the portfolio has been "cleaned" by a new manager and interest rates cuts have started.