IP finance: the asset class that fell to earth
In 1997 David Bowie made history by securitising $55 million of royalties from his back catalogue in what became a milestone in IP finance. I often wonder whether this insightful financial decision was in any way influenced by one of his early film roles as Jerome Newton, the billionaire owner of patents in his 1976 movie classic The Man Who Fell To Earth. Whatever Bowie’s motivation, many other musical artists followed Bowie's example with custom bond issues created by the pioneering and idiosyncratic David Pullman, and for a while musical royalties became the new hot asset class to own.
Six years after Bowie’s issue, Royalty Pharma achieved an Aaa rating from Moodys on a $225 million portfolio of drug royalties generated by Genentech, Amgen, Celgene and Centocor Inc. The pharmaceutical business, like music, proved itself a perfect industry for IP investors, since pure-play exposure to IP revenue was possible, stripping out the systemic market risks of owning company stock.
Mainstream businesses as prosaic as Domino’s Pizza, Quizno’s, Sears and Dunkin Donuts followed the trend with trademark finance deals that raised hundreds of millions of dollars and provided investors with alternative exposure to their value. Then, 12 years after Bowie kickstarted IP investing, the global credit crunch closed the door on IP structured finance deals with Vertex Pharma’s $240 million securitisation of Hepatitus C blockbuster drug Telaprevir – the last deal to leave the station.
Since 2009 IP lending (because that is what securitisation is) has been the province of a handful of specialised funds, which have increasingly explored more structured deals to avoid an auction market and seen yields progressively shrinking due primarily to supply/demand factors. This situation is ironic, because in theory IP lending is one of the largest and most profitable areas of banking activity with its true potential yet to be exploited.
For the last 25 years the world economy has relentlessly migrated from asset-heavy industries to asset-light, and the value of most companies now resides primarily in their intellectual property. This includes 'hard' intellectual property such as patents and copyrights, and powerful soft intellectual property like data, trade secrets and know-how. Given this context, lending against intellectual property would seem to be a 'no brainer' – but of course, there is a catch.
Intellectual property is hard to value and, moreover, the most significant value driver for any intellectual property is contextual. That means that the market price or strategic market value of intellectual property at any particular moment in time is a multiplier for traditional net present value or replacement value techniques. It also means that for investors or lenders, trying to value intellectual property as collateral for an investment or loan is challenging at best. Collateral management in intellectual property is in its infancy, there are questions about ability to perfect a security interest and few banks want to end up in another 'loan to own' situation with assets that they have no idea how to exit. However, notwithstanding these significant hurdles there is now real growth in IP-based investment and lending.
Three factors are driving this.
In the last decade the dramatic rise of IP value as a percentage of corporate value has occurred in tandem with the contraction of the banking sector and the availability of financing for growth. Since growth companies are particularly asset light, they are most affected by this phenomenon. This is not confined to technology businesses, but includes hotel groups, airlines, software companies, media companies, fabless semiconductor manufacturers and genetic engineering companies. Many of these companies are constrained in their access to traditional banking or debt financing, and so for them IP finance is an obvious solution.
Banks in the United States and Europe have been criticised for not lending to small and medium-sized enterprises. However, high-growth, IP-rich companies do not possess suitable collateral on their balance sheets for financing from a capital adequacy perspective (intellectual property is a 100% risk-weighted asset).
Non-bank lenders have stepped into the funding gap and myriad forms of equity or mezzanine are evolving to provide an alternative funding route. In this context, recourse IP loans may provide a competitive solution for many growing companies, since a loan is not dilutive (unlike private equity) and operationally relatively easy to implement. The first movers into the market were hedge funds offering very expensive capital (mid-teens rates plus payment-in-kind notes). These yields reflect the lack of default statistics and minimal competition for deals. However, as portfolios grow interest rates should fall, additional competition will rise and a secondary/collateralised debt obligation market should evolve.
The mainstream financial press is growing more aware of the value of intellectual property. Numerous high-profile IP investment stories have gripped the financial press over the past few years and some of the key points have crossed over from Wall Street to Main Street. Aside from the Nortel, Motorola and Kodak sagas, these include:
- Carl Icahn’s much-publicised fight over MGM;
- AOL’s sale of its patents for $1 billion;
- Nokia’s sale of its mobile telephony business;
- Tesla’s decision to open-source its battery patents;
- the collapse of software patent value in the United States;
- Pfizer’s audacious bid to acquire Astra Zeneca;
- Caesars Palace battle over its gambling data; and
- Jana Partners' attempt to pressure Qualcomm to separate its profitable licensing business from the chip unit.
For corporate activists, risk arbitrageurs, distressed debt funds, raiders and vulture funds, intellectual property is now high on their agenda. Intellectual property is a value driver in both private and public deals, as Kyle Bass’s Hayman Capital has discovered in its systematic activist strategy predicated on invalidating critical pharmaceutical patents while shorting the stock of the company.
The obvious next step is for an investor to create a specialty lending business focused on IP collateralised loans. There is a huge market waiting and a number of emergent insurance products searching for a reason to exist (IP monoline insurance for lenders would be a better product than IP infringement insurance). The re-engagement of the ratings agencies and bond markets into IP value or quality is another next logical step thereafter.
Another possible outcome is a peer-to-peer lending situation backed by cash-rich treasury units of global technology companies that have the ability to value, manage and liquidate IP collateral in the event of a default (or even acquire the borrower). One could see a Microsoft, an Apple, a Nokia, a Qualcomm, an IBM or even a Google finance such a role.
IP lending or the intermediation of it is the obvious sustainable business model for non-practising entities whose experience in valuation, litigation and licensing makes them well positioned to 'own' this sector and create some shareholder value at the same time. The market is huge, scalable and sustainable, unlike the 'litigation first' model, whose time has clearly passed.
For all the talk about a traded market in patents and various quixotic efforts to build IP exchanges, the reality is that the market that is actually poised to take off is the debt market, where the contribution of intellectual property to balance sheet strength and credit quality bears proper analysis by investors, lenders and boards of companies alike.
Unlike many newfangled business models in 2015, IP lending is not a solution looking for a problem – it is a solution to a problem whose time has finally come. For those of us whose personal experience spans the intellectual property and finance sectors, the opportunity is mouthwatering. An industry is waiting to be built that provides banking and finance for the 21st century, serving growth companies and monetising the IP assets that underpin the future of the world economy.
This is an Insight article, written by a selected partner as part of IAM's co-published content. Read more on Insight
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