13.1.1 Natural Resource Prices as a Driver of Operating Firm Performance

A key issue is the extent to which investments in operationally intensive firms that process natural resources provide reasonably similar risk and return characteristics to direct investments in the underlying natural resources. For example, are the returns of firms that explore, mine, or refine gold driven by the prices of refined gold?

In many industries, there would seem to be unclear links between the performance of an operating company and the price of the good that underlies the company's production. Thus, the price changes of the equities of manufacturers, technology firms, communications firms, and health-care firms tend to be only moderately correlated with the price changes of their products. For example, when airline ticket prices soar due to rising fuel costs, the stocks of airlines usually decline. The demand for airline tickets can be elastic, with higher prices reducing demand. In this example, the higher prices for tickets are driven by higher costs to the airline companies, not higher profits. In other cases, operating firms may hedge their exposures to commodities, such as in the case of large oil companies that use derivatives to hedge their commodity exposures to smooth their profits.

However, there are sound economic reasons to believe that the market prices of firms that provide goods and services related to the extraction and processing of natural resources should be substantially correlated with the prices of the natural resources themselves or the commodities that emanate from the processing. The reasoning is that a dramatic rise in the price of a commodity, such as a metal or an agricultural product, indicates that demand vastly exceeded supply at the previous price. The relatively high demand for a commodity should generally coincide with increased demand for the services of firms that process those commodities. Thus, for example, when a commodity price such as oil soars, the firms that explore for oil, drill for oil, and produce the oil should generally expect that their services will have much higher demand than during a period following a large decrease in price. Accordingly, absent hedging strategies, large price increases in a commodity should tend to drive anticipation of higher profits in the firms that provide goods and services in the production of that commodity. For example, soaring oil prices have clearly been a boon to the oil and gas development industry.

In theory, the correlations between the returns of firms and price changes for their associated goods are driven by three primary factors: the price elasticity of the demand for the good, the price elasticity of the supply of the good, and the extent to which an operating firm is exposed to or has hedged changes in its profits.

13.1.2 Evidence on Commodity Prices and the Equity Prices of Operating Firms

Empirical evidence can also provide insight into the relationship between commodity prices and the equity prices of operating firms. Let's examine an extreme 10-year price move in a major commodity. The price of gold in U.S. dollars soared roughly sixfold, from about $300 per ounce in 2002 to a peak of $1,800 per ounce in 2012. Did investors in the shares of gold mining firms realize similar profits? No. Roughly, the price of gold mining shares (as represented by the Dow Jones U.S. Gold Mining Index) experienced only a threefold increase. It would appear likely that much of the gain from rising gold prices went to the owners of gold bullion and gold reserves rather than to the firms that explore, develop, extract, and process the resource. But gold mining stocks outperformed the overall market, which rose about 50% from 2002 to 2012.

Now let's turn to a shorter-term example of gold price changes. In the turbulent economic times of October 2008, overall equity prices varied widely. The price of gold in U.S. dollars fluctuated roughly between $700 and $900 per ounce from early September 2008 to the end of November 2008. At the end of October, gold was down only about 10% from its value in early September. Over the entire three-month period, the price of gold was slightly up. Gold therefore provided protection to investors from the panic that devastated equity markets.

On the other hand, U.S. gold mining firms did not fare so well over the same period. The average price of these firms was quite volatile and generally moved downward. As represented by the Market Vectors Gold Miners ETF (which tracks the NYSE Arca Gold Miners Index), shares of gold mining firms dropped on average by almost half from early September to their low in October and recovered only partially by the end of November to a net decline of about one-third. Thus, in the short run, it appeared that the operationally intensive firms related to gold production were driven more by the volatility of the equity markets than by the volatility of gold prices.

Gold provides evidence that operationally intensive firms related to a commodity have short- and long-term performance that differs substantially from the price performance of the related commodity. The empirical evidence cited in this section substantiates the intuition that the share prices of operationally focused firms related to a commodity depend only partially on the value of the commodity.

13.1.3 Commodity Prices and Operating-Firm Equity Return Correlations

Let's turn to another commodity for a more formal analysis of correlations based on returns. From an economic perspective, energy is the largest sector of natural resources, and oil is the largest underlying resource within the energy sector. Oil prices vary between quality and location. Based on the private ownership of natural resources in the United States and data availability, we examined data on U.S. oil and equity prices. This analysis uses monthly calendar returns related to U.S. oil and ETF prices over the 96 months from July 2006 through June 2014.

Exhibit 13.1 lists the correlation coefficients between the returns of four investments: (1) the price of West Texas Intermediate light, sweet crude oil, as represented by United States Oil ETF (ticker USO); (2) the value of the SPDR S&P Oil & Gas Equipment & Services ETF (ticker XES); (3) the value of the SPDR S&P Oil & Gas Exploration & Production ETF (ticker XOP); and (4) the value of the SPDR S&P 500 (ticker SPY).

Are the returns of oil-industry-related equities related more to oil prices or to stock prices? In Exhibit 13.1, the first column depicts correlations of two oil industry ETFs (XES and XOP) with oil prices (USO). The second column depicts correlations of the same ETFs with general U.S. equity prices (SPY, which proxies the S&P 500).

The results indicate relatively high and positive return correlations that are rather uniform. The ETFs of firms related to oil production (XES and XOP) had reasonably high correlations with oil prices but also had reasonably high correlations with U.S. equity prices. XES focuses on publicly traded oil equipment and services firms, such as Schlumberger and Halliburton. XOP focuses on publicly traded oil exploration and production firms, such as Goodrich Petroleum Corporation.

The correlation between the monthly returns of USO and SPY over the same period was only 0.51 (not shown). Thus, the relatively high return correlations between the ETFs of the oil firms and the U.S. equity market indicate that much of the return variation in oil-related industries is driven by overall equity valuations and general economic conditions rather than as a pure play on the price of oil.

The empirical analysis summarized in Exhibit 13.1 reinforces the intuition that investments in operationally focused firms are not pure plays on the returns of the real assets related to the firm's industry. Rather than the returns of these firms being driven entirely by the contemporaneous prices of related commodities, they are presumably also driven by the market's anticipation of dynamic supply and demand factors more related to the long-term profitability of the goods and services directly offered by those firms. To the extent that the returns of firms within the ETFs in Exhibit 13.1 are driven substantially by operational issues, the investments will serve more as traditional equity investments rather than as diversifiers or any other type of alternative investment vehicle.

13.2.1 Structure of MLPs and the MLP Sector

MLPs are simply limited partnerships in which the limited partnership ownership units are listed (publicly traded). Limited partners of MLPs are unit holders. MLPs receive tax treatment predicated on adhering to regulations, including that at least 90% of the entities' revenues come from specified businesses, such as energy.

Although MLPs have existed in the United States since 1981, they have thrived more recently. With energy prices at historically high levels, MLPs generated stellar returns from 2009 to 2011. There are now more than 100 MLPs in the United States with an aggregate market value of very roughly $500 billion.

MLPs are typically traded on major exchanges, such as the NYSE, in the same manner as are corporate operating firms. MLPs are not shares in the equity of taxable corporations; they are limited partnership units representing direct ownership of a firm. Many publicly traded securities are described as investments in natural resources, but a closer look indicates that the investment is subjected to substantial development, extraction, and processing operational risks.

Most MLPs are involved in the energy sector, although some MLPs invest in real estate, timber, or other assets as permitted by regulations. The oil and gas sector is divided into upstream, midstream, and downstream operations. Upstream operations focus on exploration and production; midstream operations focus on storing and transporting the oil and gas; and downstream operations focus on refining, distributing, and marketing the oil and gas. Midstream operations and midstream MLPs—the largest of the three segments—process, store, and transport energy and tend to have little or no commodity price risk. For example, a gas pipeline is paid a transportation fee for the quantity of oil or gas transported without regard for the value of the product being transported. Similar to infrastructure investments, midstream MLPs have been called a toll road for energy.

13.2.2 Tax Characteristics of MLPs

MLPs have a distinct ownership structure from most traditional investments. Exhibit 13.2 highlights three major types of entities: taxable corporations (C corporations), untaxed corporations (investment companies), and limited partnerships.

Exhibit 13.2 highlights the critical issue of how income is taxed. Investors in the equity of traditional operating corporations in the United States experience double taxation. Double taxation is the application of income taxes twice: taxation of profits at the corporate income tax level and taxation of distributions at the individual income tax level. Most investment companies in the United States, including mutual funds and REITs, can avoid paying corporate income taxes if they distribute almost all of their profits to the corporation's shareholders—a practice generally followed. The distributions are taxed at the individual income tax level.

Limited partnerships in general and MLPs in particular are not directly subject to income taxes at the partnership level. The revenues, expenses, and profits of the partnerships flow directly through the partnerships and into the tax forms of the partners. The limited partners are subject to tax on profits that flow from the partnership, whether or not the profits are distributed to them. Thus, Exhibit 13.2 indicates that partnership distributions, per se, are not taxed at the individual level.

Energy development enterprises in the United States tend to have opportunities to enjoy substantial tax benefits, including credits and accelerated expensing. MLP structures allow tax benefits to pass through the firm level directly to the tax forms of the limited partners. These benefits manifest themselves in the ability of limited investors to enjoy large tax-free distributions, because it is income that is taxed, not distributions. Many of the large distributions from MLPs are sheltered in the short run as return of capital due to generous rules regarding the expensing of costs. Return of capital distributions are tax free when received. Distributions that represent return of capital serve to lower the tax basis of the MLP investment to the investor. Upon the sale of the MLP, the lowered tax basis tends to cause more of the sales proceeds to be taxable. The recaptured gains attributable to the distributions tend to be taxed at full rates rather than preferred capital gain rates. Thus, the tax-free distributions of MLPs are likely to serve as tax deferrals.

The potential tax benefits of MLPs to U.S. investors need to be weighed against three potential drawbacks. First, MLPs report income on K-1 forms rather than 1099s, which may add substantial complexities and delays to federal tax filing. Second, MLP income is usually subject to income taxation in the states in which the MLPs operate, which means that limited partners with moderate to large holdings may be required to file numerous state income tax returns. Finally, MLPs can cause unrelated business income tax for some pension plans and not-for-profit corporations in the United States.

13.2.3 MLP Valuations and Distribution Rates

There has been controversy regarding the prospective risks and returns of the MLP sector in general and MLPs with high distribution rates in particular. As noted earlier, MLP investors are taxed on income, not distributions, from MLPs. The MLP structures themselves are not required to pay income taxes. Whereas mutual funds and REITs generally set distributions to be approximately equal to their income, MLPs are free to make distributions as high as their cash flows allow. As previously noted, these distributions are tax-free and are attractive to investors focused on cash income.

Some MLPs are alleged to be making distributions at rates that are not sustainable based on the MLPs' current and prospective income. It is further alleged that the market prices of the MLPs are inflated by high demand from brokers and investors who are drawn to the high tax-free distributions and who overestimate the sustainability of the distribution rates.

The controversy over MLP distribution rates may be discussed relative to two valuation theories: a PVGO valuation theory and a Ponzi-like valuation theory (although no allegation is being suggested that any MLP is engaged in fraud or is literally a Ponzi scheme):

1. PVGO VALUATION THEORY: In corporate finance, present value of growth opportunities (PVGO) describes a high value assigned to an investment based on the idea that the underlying assets offer exceptional future income. Thus, a growth stock might sell for a much higher value than is justified by its past and current income based on its PVGO.
2. PONZI-LIKE VALUATION THEORY: A Ponzi scheme is an overpriced and fraudulent operation in which cash inflows from new investors are distributed to old investors with the false description that they emanate from the current and past success of the underlying investments. The fraud can be perpetuated as long as investors can be deceived into believing that the distributions are emanating from true profits.

It is sometimes argued that enthusiastic investors inflate asset prices to Ponzi-like valuation levels even when no fraud is taking place. In the United States, the SEC requires substantial public financial disclosure of the details of new offerings, including the planned use of the proceeds from those offerings. MLPs file prospectuses containing highly detailed information on past and planned transactions regarding both financing and investments.

Proponents of the high valuations of MLPs with high distribution rates argue that the high rates are reasonable and sustainable due to the highly profitable transactions and operations underlying the MLPs. New acquisitions are often financed by issuing new partnership units at high market valuations, which enable attractive future cash flow projections. Exceptional prospects for success can be captured as the present value of exceptional growth opportunities.

Analysts who say that MLPs are overpriced often argue that the high cash flows are being driven by proceeds from the secondary offerings of the MLP units and that eventually the distributions will have to be cut when new financings and acquisitions end. Can the proceeds from secondary offerings buy and develop new capacity that will lead to growing cash flows that can support higher levels of cash distributions? While required by law to be factually correct, prospectuses often indicate intricate and complicated arrangements between affiliated entities that make analysis exceedingly complex relative to many traditional investments.

Perhaps one thing is certain: MLP investing, like many other forms of alternative investing, is skill based. Even a broad indexation strategy in which an MLP ETF, an MLP exchange-traded note, or a representative basket of individual MLPs is purchased requires the skillful evaluation of whether the entire MLP sector is fairly valued.

13.3.1 Seven Elements That Help Identify Investable Infrastructure

Defining investable infrastructure is challenging. Some market participants define investable infrastructure based on having risks and returns that are distinct from those of traditional investments and that require specialized tools of analysis. Other market participants focus on the extent to which the investments are financial claims on infrastructure assets. For our purposes, investable infrastructure is typically differentiated from other assets with seven primary characteristics: (1) public use, (2) monopolistic power, (3) government related, (4) essential, (5) cash generating, (6) conducive to privatization of control, and (7) capital intensive with long-term horizons.

1. Public use refers to the idea that the associated economic activity is accessed by a large segment of the population or is viewed as serving the general welfare of a society.
2. Monopolistic power refers to the extent to which services are offered by a single provider or are offered such that the provider can set prices relatively free from competition.
3. Government related refers to the extent to which the underlying assets are typically created by, owned by, managed by, or heavily regulated by government.
4. Infrastructure assets tend to provide essential goods or services, such as electricity distribution. Hence, the demand for the goods or services is usually price inelastic, and cash inflows tend to be stable and inflation-protected.
5. Investable infrastructure tends to be focused on assets that directly generate cash, such as toll roads, rather than similar assets that are supported by general tax revenues, such as highways other than toll roads.
6. Investable infrastructure may possess attributes that make the underlying assets and systems relatively conducive to privatization of managerial control.
7. Investable infrastructure is usually capital intensive, with underlying assets that are long-term in nature.

To the extent that these elements are satisfied, an asset is more likely to be considered an investable infrastructure asset. However, no single element is necessary or sufficient. For example, a municipal bond backed by revenues from a toll road would generally not be considered investable infrastructure even though it may satisfy almost all of the aspects found in investable infrastructure discussed here. In the case of a municipal bond, there is no privatization of the toll road or change in managerial control if the toll road remains under the full authority of a governmental organization. The equity of a firm that manufactures a common and essential vaccine may satisfy all of the listed aspects of investable infrastructure except that such equity is not traditionally governmentally owned. Fortunately, the major types of investable infrastructure are reasonably well defined, as shown in Exhibit 13.3.

Investable infrastructure can originate as a new, yet-to-be-constructed project, referred to as a greenfield project, that was designed to be investable. Investable infrastructure can also be an existing project, or brownfield project, that has a history of operations and may have converted from a government asset into something privately investable. New projects may be funded by private capital rather than through government control and financing in order to promote efficiency and enable construction without straining government resources. Existing projects are converted to investable infrastructure primarily to raise capital for government and to earn cash flow for private investors.

The critical distinction between investable infrastructure and traditional investments is in the nature of the revenues. Investable infrastructure generates a cash flow stream in a monopolistic environment rather than in a competitive environment. An investment in infrastructure generally relies on the purchase or long-term lease of a facility that generates stable cash flows, ideally growing with the rate of inflation.

13.3.2 Types of Infrastructure

As shown in Exhibit 13.3, Mansour and Nadji (2006) separate infrastructure investments into the two broad categories of economic and social infrastructure. Notice how these infrastructure categories fit the previous discussion, as transportation or utility assets often have the characteristics of a natural or regulated monopoly, in which users have a low price elasticity of demand. When necessary services are provided, users do not typically reduce their usage substantially as a result of price increases; this means that the service providers have pricing power, which allows price increases to result in revenue increases.

13.3.3 Governmental Influence on Infrastructure Investments

Investors in infrastructure need to be keenly aware of governmental issues related to their investments, which can be either positive or negative. The scope and quality of a nation's infrastructure can influence its economic growth, with weaker infrastructure often blamed for reducing the economic growth potential of a nation. One positive aspect of governmental issues on the infrastructure sector is the vast need for new or improved infrastructure assets combined with the constrained fiscal budgets of governments. In developed economies, infrastructure is aging and needs to be repaired, replaced, or improved. In developing economies, especially those with rapid population and income growth, there is a substantial demand for the creation of new infrastructure. In most countries, the scale of infrastructure needs far outstrips the ability of the government to fund the investment. Governments can use the proceeds from infrastructure leases or sales to fund other infrastructure projects or divert them to other fiscal needs. However, some governmental entities use those proceeds for spending or debt reduction, neither of which directly and immediately enhances the quality or availability of the infrastructure in an economy.

Many existing infrastructure assets were built with public funds and then sold into the private sector. When a governmental entity sells a public asset to a private operator, this is termed privatization. While some argue that the private sector operates assets more efficiently, others argue that privatization is unfair to public-sector workers or otherwise contrary to the public interest. Although many privatizations take the form of the outright sale of an asset, in other cases, the governmental entity retains a stake in the asset. A public-private partnership (PPP) occurs when a private-sector party is retained to design, build, operate, or maintain a public building (e.g., a hospital), often for a lease payment for a prespecified period of time. Popular are leases or concessions wherein the government leases an asset to a private operator for 20 to 99 years, with the full equity interest in the facility reverting to public ownership at the end of the concession term.

There can be regulatory risk in a transaction. Regulatory risk is the economic dispersion to an investor from uncertainty regarding governmental regulatory actions. Regulatory risk includes uncertainty regarding the initiation of a project or its operation. In some circumstances, a sale to investors may need to be approved by voters or a governing body, and therefore the consummation of a purchase is uncertain until all approvals have been obtained. Even after the completion of a purchase, investors in many infrastructure assets continue to find operations being regulated. Governmental entities, especially in the transport or utility sectors, are often involved in monitoring service quality and regulating prices or profit margins. Although regulating prices or margins may reduce profit potential, the right to run a monopoly business often leads to relatively stable cash flows. When assets are leased, the governmental entity may retain the right to revoke the lease if the service and maintenance of the assets do not meet the stated standards.

13.3.4 Infrastructure Investment Vehicles

Infrastructure investments can be accessed indirectly through a number of vehicles: listed stocks, listed funds, open-end funds, and closed-end unlisted funds. Open-end funds permit further investment or withdrawal of funds by investors, whereas closed-end funds have a fixed size.

Estimates of total global listed infrastructure assets vary around $3 trillion. In 2014, the S&P Global Infrastructure Index (S&P GII) comprised over $1 trillion of publicly traded stocks, with approximate weights of 40% utilities, 40% industrials, and 20% energy firms by asset size.¹

Infrastructure stocks are generally regarded as having higher dividend yields and lower volatility than stocks from other sectors. The higher dividend yields can reflect, for example, the relatively inelastic demand for infrastructure services or the generally reduced growth potential for infrastructure assets compared to overall equities. The lower volatility can be attributed to the monopolistic and regulated nature of infrastructure assets, as well as the price-inelastic demand for the goods and services generated by many infrastructure assets.

Investing in listed infrastructure stocks or funds of infrastructure stocks over unlisted funds has the advantages of greater liquidity and a clearer valuation process. However, these funds have exhibited higher volatility and a greater correlation to equity markets than unlisted infrastructure funds. Jacobius has estimated that the unlisted infrastructure fund universe had global assets under management of $132 billion in 2010.²

Closed-end infrastructure funds are typically structured like private equity funds. The life of a closed-end infrastructure fund is typically 10 to 15 years. Investors commit capital, which is drawn down over a stated investment period of four to five years. Management fees typically range from 1% to 2% annually, in addition to carried interest of 10% to 20% over a preferred return of 8% paid at the exit of the fund or liquidation of specific investments. These unlisted funds have experienced lower volatility and lower correlation to equity markets than listed funds. However, this may be due to the appraisal-based nature of the valuation and the illiquid nature of the fund. While listed funds may use 30% to 40% leverage, unlisted funds can reach 60% to 90% leverage when financing markets allow that level of borrowing. Due to the short track record and the private nature of unlisted funds, reliable benchmark index data have not yet been disseminated or studied.

Unlisted open-end funds, also called evergreen funds, allow investors to subscribe to or redeem from these funds on a regular basis. This provision of liquidity works only when investor redemption demands match the underlying liquidity of the fund's assets. To fund net investor redemptions, an open-end fund must have the ability to liquidate assets, attract new investors, borrow on a line of credit, or draw down cash balances. Should the demand of investors to redeem exceed these resources, gates may form. Gates are fund restrictions on investor withdrawals. Infrastructure funds may erect gates, especially during difficult markets, requiring that investor shares be redeemed over time rather than on an as-requested basis.

Some institutional investors have chosen to invest directly in infrastructure assets, in addition to or as a substitute for investing in unlisted infrastructure funds. This method of access has become increasingly popular over the past decade, especially among the larger institutions that have built in-house teams with the experience to source, analyze, structure, negotiate, and manage infrastructure assets. Direct infrastructure ownership by institutional investors was pioneered by large Canadian and Australian pension plans.

Infrastructure investments are global in nature, with approximately equal weights in the publicly listed companies of North America, Europe, and the rest of the world. Investors in a global fund accept currency risk, as the assets, debt, and cash flows of each project are typically denominated in the country where each asset is located. Investors in these funds have a risk that the value of the currency where the asset is located might depreciate relative to the value of the currency of the home country of the investor.

13.3.5 Risk, Reward, and Categorization of Infrastructure Investments

There is a debate about where infrastructure fits in an investor's asset allocation, as infrastructure has commonalities with fixed-income, real estate, and private equity investments. Exhibit 13.4 summarizes the four investments across several characteristics. Some investors consider infrastructure as a fixed-income investment due to its high current yield, steady cash flows, and long duration. Infrastructure is similar to real estate and physical assets in terms of generating cash flows. Social infrastructure may have more in common with real estate investments than energy or utility infrastructure. Investors considering infrastructure as a private equity investment focus on the control aspect of infrastructure operating companies and the ability to add value through financial engineering or operating improvements. A CFA Institute paper estimates that 34% of investors consider infrastructure as part of their private equity allocation, 16% place it in the real estate or real assets allocation, and 50% consider it a unique asset class.³

The risk of infrastructure investments can be ordered by geography, type, age, and the amount of development risk that the asset owner assumes. The least risky infrastructure investments are mature assets with a long history of stable cash flows, such as brownfield investments in developed markets. The riskiest projects are greenfield investments, especially those in emerging markets. Greenfield investments require investors to build or make substantial improvements to an asset. Investors developing greenfield investments do not know the exact costs and do not have a good estimate of future cash flows, both of which make greenfield investments substantially riskier than brownfield investments.

The values and risks of an infrastructure asset often depend on its exit strategy, the plan by which an investor intends to terminate ownership in the project. The most common exit strategies for infrastructure funds are to sell assets on the secondary market to other investors, seek co-investors, float an initial public offering, seek a sale to a strategic buyer, or securitize the cash flows.

13.4.1 Characteristics of IP

Unbundled IP may be acquired or financed at various stages in its development and exploitation. Initially, newly created IP may have widely varying value and use. Exploratory research, new film production, new music production, pending patents, and the like typically have widely uncertain value prior to production or implementation. These early-stage types of IP are like call options, with most instances failing to recapture initial costs; but in a small number of instances, they generate large return on investment. For example, De Vany reports that for a sample of more than 2,000 films, 6.3% of the films generated 80% of total profits.⁴

In contrast, mature IP typically has more certain value and more certain ability to generate licensing, royalties, or other income than do early-stage projects. To return to the example of film, Soloveichik argues that theatrical film should be considered a long-lived asset with a life span of 80 years.⁵ However, 50% of a film's value is lost in the first year after release, and 5% of the value depreciates in each subsequent year.

The duration of IP varies by type. Most forms of IP, such as patents and copyrights, are wasting assets—that is, assets with relatively large immediate benefits but with value that is expected to diminish through time. Intellectual property generally diminishes in value through time, as its productive advantages are displaced by new creativity or its excludability wanes (e.g., patents expire). However, Nakamura suggests that there is evidence that some IP offers substantial capital accumulation through time. Clearly, many instances of artwork and brand names have exhibited substantial long-term growth in value.⁶

13.4.2 Intellectual Property Returns and Financial Analysis

There does not appear to be substantial empirical work on the investment properties of institutional-quality unbundled IP. However, there is well-developed economic research literature in three areas: (1) visual works of art, (2) research and development (R&D) and patents, and (3) film production and distribution. Collectively, these three types of IP represent a wide range of qualities and a similarly wide range of investment strategies designed to exploit their value.

Visual works of art such as paintings have a rich history of prices and returns. However, visual artwork is not a major component of institutional portfolios. Further, returns from previous centuries are probably not reflective of returns related to modern market conditions. It should be noted that art is a major component of some high-net-worth investor portfolios. The value of R&D is not commonly observed on a stand-alone basis, as most R&D investments are made as part of the regular operations of corporations.

Film production and distribution is a major business and it offers perhaps the best data available on which to analyze historic risks and returns. Film production and distribution is therefore the focus of this discussion.

Total annual revenues from film production (including exports of U.S.-produced films and U.S. revenues generated from non-U.S. films), including exhibition, licensing for home media and broadcast, and ancillary income, have been estimated to be over $35 billion.

To understand the opportunities for generating returns from film production and distribution, especially in a relatively dynamic period, it is helpful to know the life cycle of a film. Film production itself has several stages. First, the costs of producing the film are collectively called negative costs. Negative costs refer not to the sign of the values but to the fact that these are costs required to produce what was, in the predigital era, the film's negative image. These costs include story rights acquisition; preproduction (script development, set design, casting, crew selection, costume design, location scouting); principal photography and production (compensation of actors, producers, directors, writers, sound stage, wardrobe, set construction); and postproduction (film editing, scoring, titles and credits, dubbing, special effects). These costs are coupled with the substantial cost of prints and advertising, which is the cost of the film prints to be used in theaters, whether digital or physical, and a film's advertising and marketing costs.

Film revenues are generated almost exclusively by exhibition, which involves a standard sequence of stages, though not all films are licensed for exhibition in all forms. Exhibition forms include theatrical, home video, and TV. The expected size of the revenues, the starting time of the revenue streams, and the projected length of the revenue streams are aggregated to project the total revenues through time. Financing is done via some combination of equity, equity-like financing, and debt financing.

Translating revenue numbers into profits is typically impossible without direct knowledge of and participation in the production of particular film assets. However, there are regularities that arise in contracting that can be exploited to conduct an analysis and forecast cash flows. For example, empirical evidence indicates that sequels tend to generate more revenue at lower risk, and different film genres have different risk-return properties. To maximize the potential returns and portfolio benefits from investments in IP, investors should develop or retain analysts with expertise in the underlying assets of the IP.

13.4.3 A Simplified Model of Intellectual Property

Based on the generalized behavior of IP, a very simplified model of IP values may be constructed as the present value of expected future cash flows. Assume that the value of IP at its creation is the sum of the discounted expected cash flows generated by the property. Further assume that the property has two possible outcomes: the probability (p) of generating large positive cash flows and the probability (1 – p) of generating no positive cash flows. Denote the first-year cash flows of the project, if positive, as CF₁. Finally, assume that the cash flows in years 2 and beyond are equal to CF₁ adjusted annually by the rate g: CF_t = CF₁(1 + g)^{t − 1}. If the model is being used to value a wasting asset, then the rate g is a negative number that indicates the rate at which the cash flows are decaying through time as a result of obsolescence or other causes of diminished value. Using the perpetual growth model commonly used to value common stock (where g is typically positive), the value of the IP at time zero, V_ip,0, discounted at the rate r can be expressed as depicted in Equation 13.1:

(13.1)

Equation 13.1 is identical to the perpetual growth model used for common stocks except for the use of p × CF₁ to denote the expected cash flow in the first year and the idea that g is likely to be negative. Note that the present value of the future cash flows, V_ip,0, is positively related to p and g. Given estimates of p, CF₁, r, and g, a value may be estimated for V_ip,0.

The previous computation reflects the idea that investment in new IP may have risk similar to that of an out-of-the-money call option. To illustrate another perspective, Equation 13.1 can be rearranged to solve for the total annual rate of return, r, as shown in Equation 13.2:

(13.2)

The total rate of return is the expected cash flow in the first year expressed as a percentage of the value of the IP minus the rate of decay. The intuition of Equation 13.2 is that an investment in undeveloped IP is a chance (p) at a potential stream of income (CF₁) that is likely to diminish (g < 0) through time as the productivity of the IP wanes.

Financial analysis of IP requires specialized skills, including legal knowledge that should be accessed to reap potential benefits through return and diversification. The reason that legal knowledge is especially important in the case of IP is the tendency of property rights to be complex and dynamic for intangible assets.