Royalty investing is a profitable and significant form of alternative finance in North America. However, it is still a nascent industry in Europe and Duke Royalty was set up in 2015 by an experienced team to change this. Its current portfolio is now close to £80m and it aims to add £45–100m in deals a year in the coming years. Duke has just announced a fund-raising of up to £20m, of which £16.1m has already been placed in an institutional offering at 44p per share. This will allow it to invest another £45m in the next 12 months. We estimate a sustainable ROE of 14% for Duke and we see the current fair value range at 50–58p per share.
Although royalty finance has grown from its mining and pharmaceutical industry roots to become a US$50bn sector in North America, it is still a new asset class in Europe. Duke is the market leader in the UK in what is an open field for growth. Royalty finance provides flexible, long-term finance while allowing the business owners to retain control and reducing repayment risks by extending amortisations beyond the first three to five years. For investors like Duke, it provides an attractive yield, with potential for growth and a scalable business model. Investment income is reset annually and linked to the percentage change (with a 6% cap and floor) in the partner’s revenue. Terms are typically 30 years with no bullet repayment but a prepayment penalty.
After the acquisition of Capital Step, Duke is now more diversified and well positioned to grow. We see the portfolio growing from £80m to £105m by 31 March 2020. We then assume a further £95m of investments by 31 March 2022. It has an experienced origination and underwriting team and we believe there is a large potential market for this product, given sufficient marketing and as familiarisation grows. We expect the operating cash flow yield on Duke’s shares to climb from 5.4% in FY19 to 8.0% in FY20 and then reach 14.9% by FY22. The company has a 65–90% dividend payout policy.
We value Duke based on its cash flow generation. With yields at inception from 13.5% and the relatively low cost to manage projects, Duke is a cash-generative business. If we assume average gearing of 15%, we estimate the sustainable return on equity (ROE) to be around 14%. Flexing the 9.5% cost of equity (COE) by 50bp, we obtain a current fair value of 50–58p per share. There is further upside to our valuation from greater scaling, gearing or indeed growth assumptions (we use an average 3% annual reset).