NPEs: the second bounce of the ball

In a December 31 2015 article I analysed why the current responses of non-practising entities (NPEs) to the failure of their core strategy were ineffective. The reasons are simple:

• These approaches do not play to the real competence of the people or effectively utilise their own intellectual property,
• For the most part, they have no properly articulated business model (ie, how to make a relevant amount of money).
• There is no real scalable demand for the new services or products that they are offering

These failings are unsurprising, as they reflect the basic gating requirements for any new business or reboot of an old one, and are on the checklists of most venture capital and private equity investors. This gives an insight into how far removed from that world the NPE world really is. Intellectual property in the NPE world has nothing to do with innovation or building companies – which, to recap, is why clumsy attempts to rebrand around these activities will fail.

So what set of opportunities ticks the boxes for the basic requirements of any successful business strategy? I can think of only three:

• Consolidation – acquire the assets of a fragmented industry onto a platform that supports the cost base and revenue model reflecting today’s reality. IP monetisation has always been a supply-constrained industry, a fact that was masked by a bubble, but now the bubble has burst. So far, few NPEs have swallowed each other as management and shareholders cling to hope, but that is changing. RPX remains the natural consolidator for corporate assets. By adopting a different conflict resolution model (more like arbitration between members) they could defang the NPE world – vacuuming up the stragglers and perhaps even one of the remaining big guns.
• Patent busting – the one IP strategy that has been enhanced by patent reform. The inter partes review process has been empowered and the success rates are eye watering. But the key question is how to make money from this. Hayman Capital has found one way to monetise that reality: by shorting the stock of the afflicted company. This is one model, but there will be others based around the only NPE strategy whose edge has been sharpened. It is interesting to watch Article One Partners wander off down a blind alley as the inter partes review revolution happens, since crowdsourcing patent busting would seem to be a no-brainer as a business model. 'In the public interest' services to winnow out the thickets of invalid patents would be much in demand.
• Financing – using the NPE’s insight of actual IP value to lend to IP-rich technology companies on favourable terms. Lenders hate technology risk mostly because they do not understand it, and so they simply lump everything that they do not understand together and call it a risk.

This last strategy is golden because it operates at the intersection of intellectual property and the financial markets.  

The greatest value can always be found where Main Street and Wall Street diverge. The significant bid offer spread between companies or consultants valuing their intellectual property and financial investors doing the same thing gives investors literate in IP valuation a major advantage. By understanding where the real value lies, capital may be deployed to take advantage of this unprecedented discrepancy.

To put some colour around this, the US bond markets are worth almost $40 trillion, and within this huge number are hundreds of specialty debt products. While bank lending to companies has recovered since 2008 (growing 50% over the past five years to reach almost $2 trillion), the collateral value given to intellectual property in this market is close to zero.

Growth in the most lucrative areas of lending (private equity leveraged loans), combined with stricter regulation of bank balance sheets, has fuelled the expansion of unregulated specialty lenders or business development companies (BDCs). There are now dozens of public BDCs in operation with over $30 billion in market capitalisation. Many of the hungriest borrowers from this universe are tech companies whose patents are mission critical and therefore valuable. Hedge funds have also stepped into the gap, lending against patents for mid-teen returns on risk that is totally mispriced in favour of the lender.

Ironically, this is the area where NPEs should have a real edge based on the private experiential data sets that they hold about out-of-court settlements, real royalty rates and the market ecosystems for patents. Mainstream financial institutions have neither the skill nor the will to price or lend against patents, in part because they eschew working out complex collateral pools in the event of a default. Their exit strategy is to sell non-performing loans at a deep discount to hedge funds. A properly capitalised leading NPE could therefore add significant value as a specialty lender and risk manager of last resort to this ecosystem.

The skills to execute on this business strategy are a hybrid of credit, equity analysis and intellectual property. Certainly, the skillset requires significant upgrades to existing rosters, but this is a growing market and unlike other arbitrage-based approaches, contributes something positive to the world that spawned trolls.

In summary, if you are a public NPE you have only two assets to leverage into a new strategy: your public vehicle and your own intellectual property (which, at best, comprises a unique data set about patent valuation). The public markets are open to changes of direction, but only when the new strategy hangs together. There are some real opportunities out there for reinvention, but whatever the path taken, it requires the incumbents to take a long hard look in the mirror. Very few are capable of this objectivity.