John Tamisiea, McDermott, Will & Emery

	By Jeffrey Jung and John Tamisiea, McDermott, Will & Emery

In the span of just over 10 years, specialized investment funds which initially purchased interests in royalty streams from out-licensed pharmaceutical intellectual property assets have evolved to offer successively larger and more sophisticated alternative sources of non-dilutive capital to the owners of developing and developed biotech and pharmaceutical assets. These firms have increased in number and in the size and complexity of transactions in which they engage. Additionally, the size and scope of their counterparties have recently grown beyond traditional small pharma and biotech licensors and university technology transfer offices to include larger, established pharmaceutical and biotech companies and their affiliates, which have increasingly taken on an international flavor.

	The annual volume of these transactions increased from two publicly reported transactions in 2000 to 27 reported transactions in 2007-8 (anecdotal evidence suggests, not surprisingly, a dip in deal activity in 2009 but we anticipate the overall growth trend will continue.) Over the same period the average size of the reported transactions increased from $72.5 million to $122 million (i.e., aggregate reported deal volume increased from $145 million in 2000 to approximately $3.3 billion in 2007-2008). As a result of the increase in the number of transactions and in overall deal volume, the number of participating investment funds has increased but it remains relatively small. Capital Royalty, Cowen Healthcare Royalty Partners, DRI Capital, Paul Capital Healthcare and Royalty Pharma are among the leading market participants. Twenty-two of the 27 transactions reported in 2007-8 were completed by nine distinct participants (including these firms) and the remaining five transactions were completed on a multiple investor basis.

	Broadly speaking, royalty investing began with the straightforward monetization of payment streams arising under existing out-licenses of primarily domestic (i.e., US) biotech or pharmaceutical intellectual property assets (a “royalty interest” transaction) developed by either a small pharma or biotech development company, or a university-based research facility. The earliest and simplest transactions involved the exchange of cash for an interest in the payment stream generated by an existing license of already commercialized intellectual property. The licensor, whether a small company or university research arm, had developed or acquired initial or latter-stage intellectual property (usually by undertaking basic R&D or through strategic acquisition) which it out-licensed to a third party licensee which was better positioned to expand and commercially exploit those assets. In exchange, the licensor received a royalty stream, often tied to the remaining useful life of the intellectual property it was licensing.

	While these arrangements are economically beneficial to the licensor, they typically deliver their value in increments over a long period of time, which is problematic for many licensors in immediate need of capital to fund their business. Additionally, the value of these arrangements to the licensor was subject to event risk (e.g., a change in strategic focus of the licensee, development of competing commercial products, and successful legal attacks on either the base intellectual property or its application in the commercialized products). These factors presented an opportunity for specialized funds that were able to more clearly analyze the intellectual property in question and the related regulatory and commercial competitive landscapes and make investments in these payment streams at yields that were attractive to their investors. From the licensor’s perspective these investments have been attractive because they have accelerated the cash value of the payment stream, allowing the licensor to invest the proceeds in other development efforts and minimized or substantially eliminated the uncertainty that value would be fully realized for that asset. These results were not generally available to the licensor from traditional sources of liquidity (e.g., these assets have generally not been sufficient to support a traditional secured line of credit, with its emphasis on inventory and receivables.)

	Put simply, the intellectual property in question and the regulatory and competitive commercial landscape in which its value is determined require a framework of technical, regulatory, commercial and legal expertise which traditional liquidity sources either did not possess or were unable or unwilling to marshal. It is precisely the concentration of this expertise in specialized investment funds that enabled these funds to assign a sufficient value to the assets to make the transactions attractive to the licensor community. Conversely, these investments have proven attractive to the funds’ investors for at least three distinct reasons:

	The underlying assets and their return features are not correlated to the broader market (i.e., as a non-correlated asset class this investment category presents excellent diversification opportunities).

	The investment yields current, periodic, distributions of cash flow (as distinguished from most traditional private equity funds where distributions are dependent on irregular and somewhat unpredictable liquidity events).

	Their targeted yields are consistent with more traditional private equity vehicles.

	As the number of transactions has increased, funds have made increasingly sophisticated types of investments. They have expanded beyond royalty financing transaction and have entered into transactions with the licensor where there is no pre-existing out-license or royalty stream. In these investments (referred to as “revenue interest” or “synthetic royalty” transactions), the licensor typically anticipates undertaking the commercialization of the underlying intellectual property and is either at or reasonably close to commercial launch of the resultant product/device. The fund exchanges cash for an undivided interest in the revenue stream anticipated to be derived from an identified product and related intellectual property.

	Since the product may be in a pre-commercialization phase or in the nascent stages of commercialization, oftentimes these transactions will include milestones tied to achievement of regulatory (e.g., final approval in a particular jurisdiction) or commercial (e.g., commercial launch) hurdles. Milestones allow the investor to stage their investment—generally an unnecessary step when doing a traditional royalty transaction with an existing out-license, unless the out-license itself is subject to a pending milestone regime. Further, the counterparty will have an incentive to push for timely completion of regulatory and commercial objectives.

	“When determining milestone payments we will always balance the needs of the seller with the degree to which value remains uncertain,” says Todd Davis, managing director of Cowen Healthcare Royalty Partners. “For example, if there is a review underway for an expansion of indication for an already approved product, it may make sense for us to stage our investment pending the outcome of that review. The milestone enables both parties to account for the essentially ‘all-or-nothing’ nature of the review decision with capital deployed only if there is a positive outcome.”

	The growth in sophistication of these structures is being observed by the investment funds. Their experience suggests that recent events in the capital markets have increased the visibility and attractiveness of both traditional royalty interest and revenue interest structures.

	“We have seen an uptick in demand for royalty and revenue interest transactions,” says Michael Weinmann of Capital Royalty. “Non-dilutive traditional royalty financings are increasing in number as more CFOs become aware of these transactions and the cost of issuing equity continues to be prohibitive.”

	In addition to the presence or absence of an existing commercializing out-license, there are a number of other distinguishing characteristics between royalty interest and revenue interest transactions. In a royalty interest transaction, the licensor’s principal obligation vis a vis the investor is to ensure that any actions required from the licensor in order to keep the out-license in good standing are taken in a timely manner. Additionally, to the extent the licensor has enforcement rights under the out-license, the investor will want covenants requiring the licensor to take adequate steps to enforce those rights (typically the out-license will preclude a direct assignment of the out-license to the investor).

	This contrasts sharply with the counterparty’s obligations under a revenue interest transaction. In that case, the investor is dependent on the counterparty’s execution of the business plan which forms the basis for the investor’s revenue assumptions. For this reason, the counterparty is typically left with a meaningful right of participation in the future revenue stream. That is, rather than purchasing all or the lion’s share of the stream, as may happen in a royalty interest transaction, the investor may purchase a lesser percentage or may purchase a declining or staged percentage of revenues. This aligns the investor’s and the counterparty’s interests in maximizing the commercialization prospects for the product. The counterparty in a revenue interest transaction is also responsible for execution of the product business plan and is required and incentivized to execute the product business plan by the terms of the agreement between the parties (e.g., restricting the use of proceeds to implementation of the product business plans and reducing licensor’s pay-out in the event milestones are not met within the agreed upon timeframes.)

	Common structural elements for both royalty interest and revenue interest transactions include robust cash controls and back-stopping security interest arrangements in favor of the investor. While it is common for the investor to characterize the transaction, whether royalty interest or revenue interest, as a purchase transaction vis a vis the relevant revenue stream, prudent practice dictates that security arrangements be implemented to minimize adverse affects from a deterioration of the counterparty’s underlying business. While common to both forms of investment, the cash controls may be especially important in a royalty transaction where the licensee’s consent to the collateral assignment of the underlying license to the investor has not been obtained. The purchase characterization is important to the investor because, if respected, it substantially enhances the investor’s position should the licensor/counterparty encounter financial distress. However, to account for the possibility that this position could be directly or collaterally attacked (especially in an insolvency proceeding of the licensor/counterparty), the security interest and cash management arrangements act as fallback lines of protection for the investor’s initial investment and, hopefully, its return objectives.

	In addition, it is not uncommon for the counterparty to require, and the investor to accede to, limits on the return the investor may earn on the investment. This may take the form of an absolute return limit (generally between 2X and 2.5X of the initial investment), after which the investor’s undivided interest steps down substantially or disappears entirely. The aggregate limit on the investor’s return often forms a basis for establishing the parties’ negotiated value for the investment under various circumstances. These might include the buyout price for an early termination at the election of the counterparty, or the liquidated damages claim in the event of a material breach by the counterparty of the terms of the transaction.

	Not surprisingly, as the range and depth of experience of these transactions has broadened and increased, the character of market participants has also expanded. While transactions continue to have a significant US bent, international opportunities have been increasingly observed.

	“We have seen an increasing number of international royalty financing opportunities over the past few years. Two of our more recent transactions, LifeCycle Pharma in Denmark and Aeterna Zentaris in Canada and Germany (with participation by Merck Serono), have successfully demonstrated the viability of these platforms outside the US, and we anticipate further activity in Europe as companies continue to seek out alternative sources of capital to fuel their commercialization and development efforts,” says Davis.

	Given the complexity of the underlying assets and the various structural elements which are in play in negotiating the final documents, these are necessarily complicated transactions. Notwithstanding this complexity, they do present good opportunities for immediate value generation for licensors/counterparties who might otherwise be unable to monetize their assets while diminishing future event risk. PC

	Jeffrey A. Jung (left) and John P. Tamisiea are partners in the corporate department in McDermott Will & Emery LLP’s Chicago office. Together they head the firm’s Healthcare Royalty Sales practice group. Mr. Jung can be reached on (312) 984-6919, jjung@mwe.com and Mr. Tamisiea can be reached on (312) 984-6957, jtamisiea@mwe.com. 

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