Apple/Samsung: NPEs and the future of IP investing
The August 7 2014 decision of Apple and Samsung to settle all of their patent disputes outside the United States feels like an inflection point in the patent wars and the beginning of a more nuanced approach to managing intellectual property among multinational corporations.
Perhaps this is unsurprising since, like all wars, the strategic purpose (a struggle for supremacy between Apple and Android) was a subtext behind a series of casus belli that spiralled out of control. Proxy battles were fought, mergers and acquisitions executed and a patent bubble fuelled that enriched a few and spawned a plethora of companies whose primary business was enforcing patents.
Phases of evolution
Of course, patent wars are not new, particularly in the telecommunications industry. In fact, it would be reasonable to say that patent litigation has been an integral part of the industry since Alexander Graham Bell (allegedly) invented the telephone.
Since then, each decade has given birth to a unique flavour of patent conflict. In this context the proliferation of non-practising entities (NPEs) since 2000 has been a reflection as much of the state of the financial world as of the patent world. The evolution of patent monetisation as an investment strategy has followed a well-trodden trajectory pioneered by hedge funds, life settlements, catastrophe insurance, class actions and other alternative investments.
Initially, industry participants financed their own litigation to protect valuable intellectual property and to run strategic interference with their competitors. One result of this activity was the production of occasional outsized returns that attracted the attention of bankers and hedge funds.
The second phase involved third-party capital being attracted to finance these activities for a share of the profits that could be generated. As companies focused on IP cost management, they actively sought out such partners. However, the cost of capital and risk appetite were high, and in a permissive regulatory environment this drove aggressive actions that generated big pay-offs. In turn, this drove (unrealistic) expectations among patent owners of even higher returns.
The third phase involved enterprising individuals from either the legal or investment world establishing independent boutiques. Here, first-mover advantage was important for funding and gaining the best returns. These early movers, highlighting the opportunity and drawing additional players into the market, often generated spectacular results in attracting capital or acquiring patents. The emergence of patent auctions and the tacit support lent to some pioneers by operating companies facilitated their growth.
The fourth phase occurred when the public markets began to get excited about the strategy and/or when NPE management teams found raising additional capital from expert investors difficult. The result was a number of public listings. This enabled the raising of lower-cost capital than that provided by hedge funds and afforded the opportunity of reverse mergers or the repurposing of moribund operating companies or cash shells.
The fifth – and perhaps final – phase is arriving now. Institutional investors are starting to take a genuine interest in the strategy. A number of pension funds, major private equity houses and insurance companies have been active in royalty investing for some time. Indeed, this is partly the reason for the fall in yield in these strategies, as too much money is chasing too few deals. The contemporary attraction for patents is driven as much by portfolio metrics such as lack of correlation as by expectations of yield. Some investors such as Sterling and most recently Vector have simply acquired IP specialists; others have invested capital in independent boutiques that provide access to deal flow and technical excellence. But for now, most are on the sidelines doing their due diligence.
So what does the future of IP investment look like? To my mind, after 20 years of trying, intellectual property is struggling to make it as an asset class. However, it does form part of several other asset classes and investment strategies.
Patents are a critical factor underlying the asset class known as litigation finance. When looking at how litigation funds invest, the percentage of capital allocated to patents versus other cases is significant. I therefore think that this remains a sustainable investment strategy with good returns, but limited scalability.
Listed NPEs provide a backdrop for active volatility trading particularly around earnings dates. Arbitraging the stock price movements of this universe of securities is a profitable niche strategy. I have not yet seen a dedicated fund in this space, but many hedge funds are actively trading the stock and options, often to hedge a proprietary investment in the litigation strategy itself.
Patents increasingly form part of the value proposition for lenders to technology companies seeking additional collateral for credit exposures. Loan-to-value ratios vary depending on whether they are based on sale value or litigation value, but the explicit presence of intellectual property in collateral pools is welcome.
Patents and other IP rights such as trade secrets are growing in importance for venture capitalists and trade buyers when assessing their investments or in M&A discussions. However, investors in venture capital and private equity would do well to ask more questions about IP management in constituent portfolios. There is a lot of 'dead' value in undermanaged intellectual property here.
IP value is something that industry analysts have begun to identify as a major contributor to earnings per share and a catalyst for corporate events. The recent 50% share price fall in a $5 billion New Zealand listed technology company on recognition that it had no patents compared to its major US competitor with more than 500 is a textbook case in point.
What next for NPEs?
So does Apple’s decision to close out the patent war with Samsung auger the end of the road for traditional NPEs?
In light of these events I believe that NPEs (and particularly listed NPEs) should carefully consider their strategy. Contrary to the oft-repeated lament, the market does understand you. It just does not like your business model.
The end of Apple versus Samsung is a wake-up call for NPEs to broaden their business models and leverage their IP knowledge into a wider set of activities. An attractive and scalable market for IP investing is developing, but opportunistic litigation programmes with binary outcomes will not ensure a sustainable future, as Vringo and Parkervision investors have discovered. This is particularly true as potential vendors shun NPEs and instead establish their own privateers, exemplified by Nokia and perhaps Blackberry’s new patent entity BTS.
As the fifth phase of IP investing develops, institutional investors will demand higher degrees of transparency, better corporate governance, reliable earnings forecasts and tighter cost control, and will remain wary of the reputational risks associated with aggressive litigation strategies. Another inevitable consequence of significant institutional investment into this area will be that the weight of capital provided by such investors will tend to drive down returns, 'normalising' them and ultimately bifurcating the market into high risk/return/difficult to scale and moderate risk/return/scalable.
The firm that can build a business model that responds to these challenges represents the future of IP investment.
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