Revenue Royalty Structures for Private Equity Funds

The first private equity funds were created in the 1950s. However, there were few such formal structures, and they were mostly marketed to institutional investors rather than to individual investors.

A series of regulatory changes in the US and Europe enabled private investors to effectively access the funds but mostly these were very wealthy individuals. These favorable regulatory events together with the evolution of the limited partnership resulted in a spectacular growth of the private equity industry.

A hypothetical investment of USD 100 invested in five different financial instruments on  January 1, 1980, and assuming reinvestment of all proceeds provides a clear return comparison across asset classes. Private equity clearly shows the highest returns with an ending value of USD 27,024, equating to an annual time-weighted return of 15.0% – an outperformance of 5.5% and 4.3% over the MSCI World and S&P 500 indices, respectively.

However, as opposed to public equity investments where the investor is immediately fully invested, private equity managers usually call committed capital from their investors over time as they find investment opportunities and distribute principal and gains as investments are exited. For this reason, the timing and size of cash flows are more important than in traditional asset classes. Private equity practitioners do not typically report time-weighted returns but analyze and report performance in a money-weighted performance metric, the internal rate of return (IRR). The money-weighted mechanic of the IRR better reflects the timing and size of the underlying cash flows.

The Revenue Royalty Structure

What is a Royalty?

A royalty is a legally binding payment made to an individual or company for the ongoing use of their assets, including copyrighted works, franchises, and natural resources. An example of royalties would be payments received by musicians when their original songs are played on the radio or television, used in movies, performed at concerts, bars, and restaurants, or consumed via streaming services. In most cases, royalties are revenue generators specifically designed to compensate the owners of songs or property when they license out their assets for another party’s use.

Examples of Royalty Deals in Private Equity

A recent example of royalty deals was with a company called “Better Bath Better Body”, which is an all-natural bath salt business. When the private closed its first royalty deal with them, they were seeing roughly $1.5 Million in revenue annually. Since the deal, they’ve grown their revenue amount to approximately $3.5 Million over the last 2 years.

The fund up a structure where the fund received a 1.2x return on the investment via monthly wire transfer. Plus, it was agreed that the fund would own equity warrants in the company. When they sold the company, the fund would receive 16% of the sales price. And because it’s an equity warrant, the fund cannot get diluted by raising more capital.

This is a critical point. If you invest in an equity warrant that is structured to be activated at the exit and doesn’t have a termination date, then it doesn’t matter if they raise capital. If it’s written so that the fund can’t be diluted, you get a specified percentage of the company at the exit, it doesn’t matter if they have diluted someone else. The fund would still get its agreed-upon percentage at the exit.

If you are analyzing a company with a gross revenue royalty deal, the company may claim that its valuation is $4 Million for example. If you see that the company has only earned $2 million in revenue, then you may be hesitant to close the deal since the valuation doesn’t seem to accommodate their figures.

However, if the goal is just to invest for income, then you would want to discuss the gross revenue royalty after you understand what the company can afford cash flow-wise. After closing the deal, the fund will receive a payment each month based on the royalty percentage agreed.

For example, at a 5% royalty amount, the fund would receive $5 for every $100 in revenue until you get all investment and interest back and you have the bonus on the potential exit.

Alternatively, if you just buy equity and no dividends are coming out, then you’re just making money at the exit. This is something to keep in mind when investing in private equity.

About the Author
Dan Dobry was the founder of the Union of Financial Planners in Israel (UFPI), served as the first Chairman and President of UFPI. Dan was the Global Council Representative for Israel for the Global Community (FPSB) from 2012 - 2018 and from January 2019 is a member of the Committee for Standards and Qualifications for the European Union (SQC).
Related Topics
Related Posts