In the next few months I will be speaking at a number of conferences. The topic I am most often asked to address is intellectual property as an asset class.
This is something that I have been talking about for the past five years and, despite my initial enthusiasm for the notion, I am coming to the conclusion that the premise is false. Intellectual property is not an asset class for three main reasons:
- Intellectual property is not standardised and thus does not exhibit similar characteristics even within subcategories (eg, trademarks versus patents);
- Intellectual property does not behave similarly in the marketplace (the most significant value driver of intellectual property is situation-specific value); and
- Intellectual property is not subject to similar laws and regulations (its disposition is case law driven, with marked anomalies such as the treatment of software).
This statement may disappoint many, but I am driven to accept what the data tells me and no amount of semantic gymnastics – such as lectures entitled “Intellectual property as an emerging asset class” – will square the circle. Intellectual property simply does not exhibit the qualities necessary to qualify as a distinct asset class.
Taking a different perspective
This does not mean that intellectual property is less valuable or does not represent a compelling scalable investment opportunity for private and institutional investors; but the perspective from the asset allocation/portfolio management standpoint needs to be a little different.
Intellectual property is a valuable enhancer of value in all asset classes (including alternative assets) that can dramatically increase the risk-return profile. In this way, it is a significant contributor to the massive dispersion of returns seen at the level of security selection and should therefore comprise a critical part of all security analysis and valuation, particularly in IP-rich environments. These include technology, media and telecoms, pharmaceuticals, automotive, entertainment, publishing, branded products and luxury goods.
Intellectual property exhibits characteristics that are no-brainers in terms of their importance for influencing security selection:
- Intellectual property often confers pricing power, strategic positioning and sustainable competitive advantage – this drives outperformance when properly managed.
- Intellectual property has value in bankruptcy – this provides credit enhancement to lenders. Recent analysis of US lending markets found intellectual property as valuable collateral in 21% of corporate loans.
- Intellectual property entitles the owner to exclude competitors from their market or generate high-value earnings before interest, taxes, depreciation and amortisation from licensing – this provides additional profits without significant additional operating expense.
These factors provide the straightforward answer to investors who, on attending an investment seminar extolling the virtues of intellectual property as an investment, ask, “So how do I deploy capital into the market?” The answer is, of course, “You already are but without understanding what you are doing.”
My first message to investors this conference season, therefore, is to take another look at the security selection in their portfolios, but this time using an IP prism to evaluate the quality of the assets.
Outside of security selection and focused IP investment strategies such as litigation finance, royalty investing and certain venture capital opportunities, there is one market in its infancy where intellectual property does stand the chance to become a true asset class: insurance.
IP insurance includes highly specific risk coverage, such as the open-source insurance product provided through Lloyd's of London, and more general risk coverage offered by defensive patent groups such as RPX. In each case the insurer is underwriting for the insured the costs of litigation in the event of an infringement lawsuit.
Unlike intellectual property itself, as a derivative risk IP insurance contracts may be standardised, are highly scalable and can operate within a well-established common framework of regulation and law. While risks in any particular company or industry may be correlated, by underwriting a broad spectrum of companies and industries a non-correlated portfolio may be created. This is the approach typically taken by property and casualty insurers, particularly those underwriting catastrophic risks. For many companies, particularly in the small and medium-sized enterprise (SME) space, an IP infringement lawsuit constitutes a similar catastrophic event that can result in share price collapse, employee exodus or a drop-off in sales. It is an imperfect analogy, but a reasonable one.
What is most compelling for me about the potential of the IP insurance market is that it is data rich. Despite the risks inherent in underwriting any particular counterparty, there is a vast amount of data on patent filings, litigation, the statistical reality of what goes to court and the financial consequence of these events. This is the type of data that actuaries love. Careful analysis of this data is almost certain to show that the market is mispriced.
Profiting from this
In property and casualty insurance, investors may buy insurance-linked securities (ILS) that provide standardised tradable bonds representing diversified pools of risk. The market is small (around $150 billion in outstanding bonds), but new issuance has been growing at more than 40% for the past decade since these bonds were pioneered by Winterthur.
The driving force for ILS growth has been speculated as including global warming (causing peak events such as Hurricane Katrina), better contract standardisation, development of catastrophe derivatives and a catastrophe risk exchange and yield hunger among investors. In the IP world we have certainly experienced a storm of patent filings, a hurricane of non-practising entity lawsuits and an avalanche of yield-hungry investors.
So my closing statement for conference attendees this year is that in the next three years, I expect the IP insurance and ILS markets to develop rapidly as investors recognise the opportunity to acquire mispriced insurance risks. The risk profile will be substantially lower than litigation finance, but given the asymmetric impact of lawsuits for SMEs in particular, the profitability should be high. Intellectual property may not be an asset class, but IP insurance very well could be.
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