Pharmaceutical Report Royalty Purchasing Industry. Thomas R. Wells

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1 Pharmaceutical Report Royalty Purchasing Industry Thomas R. Wells

2 Table of Contents Industry Overview 2 How Transactions Work 2 Advantages & Disadvantages for Inventors and Investors 4 Major Investors in the Industry 6 Future Outlook for the Industry 7 References 8 1 P a g e

3 The Royalty Purchasing Industry Overview The pharmaceutical industry is one of the most technologically advanced and profitable industries in the world. With $595 billion in worldwide sales across all segments in , and an industry profit margin well above average, this industry is one of the most attractive for companies to join. Accompanied by the high profit margin there is also a grueling and uncertain process of discovering drugs, patenting them and getting them onto the market. The process of drug discovery is extremely long, averaging between 7-10 years with a cost of approximately $802 million dollars 2. However, after companies endure this process and develop the drug, they are rewarded for their discovery by owning a patent on the drug. This patent prevents other companies, namely generic companies, from producing the drugs and competing with them. Inventors are then able to hold onto their patent and license the drug production out to a major pharmaceutical company. Although companies enjoy holding a patent and a royalty stream for their products, there is now an alternative that allows the companies to be paid up front for the estimated value of their royalty streams. A new line of companies have emerged that purchase royalty streams generated from pharmaceutical products. This allows drug discovery firms or inventors to reduce the risk associated with the future cash flows of their royalty stream. The inventors of a drug are able to be paid upfront for a portion of their royalty stream; and in turn some percent of their royalty is redirected to one of these royalty purchasing companies. We will call these royalty purchasing companies investors. How Transactions Work Inventing a drug is often achieved by many parties, including: universities, research doctors, and discovery phase pharmaceutical companies. These parties will be collectively referred to as the inventors. All of these parties may be entitled to a certain percentage of the future income that the 2 P a g e

4 drug generates; this is known as a royalty. These parties have the option of periodically collecting their royalties after licensing the drug to a pharmaceutical manufacturing/marketing firm, or they can have the royalty stream valued by private investors and then sell it immediately for cash. They can sell any percentage of it they desire. There are numerous advantages to the second strategy, such as: It reduces the risk and uncertainty of future earnings. It provides cash immediately to the inventor, which can be used for other projects. Can be used for financing a commercial launch of the drug 3. Useful for companies participating in divestitures. If a drug appears to be promising after completing early clinical trials [Phase I,II], the drug may start to be evaluated by investors for its revenue potential. After performing due diligence if it is decided that the drug has a strong patent and can be valued accurately, a royalty purchasing company (investor) may make an offer to the royalty holders. If the transaction is approved, then the investors will provide cash up front for the inventor and the investors will start collecting the agreed royalty percentage for the duration of the contractual term. Below in Figure 1 is a diagram of a typical transaction. Figure 1 Typical Transaction Structure Patent Royalties from Sales Marketing Company Inventor Royalties from Sales Cash to Purchase Royalty Investor 3 P a g e

5 Advantages and Disadvantages for Inventors & Investors There are advantages and disadvantages for the parties involved in these transactions and it is important to analyze these in order to predict the success of the royalty purchasing companies. We will review them first from the inventors perspective, and then from the investors perspective. From the inventors perspective this transaction can help provide needed capital, reduce the risk associated with future cash flows, help to fund the commercial launch of the drug, or provide a pay out during a divestiture. By providing cash at the closing of the transaction the inventors can be rewarded immediately for their work and this is often preferred over the alternative of waiting several years to realize full payment. If the inventors are pursuing other projects, which they usually are, this capital may serve as an excellent alternative to issuing debt or trying to raise money through equity rounds. This is especially true during economic downturns where debt tends to become expensive, and companies search for ways to raise non-dilutive capital. We highlight this trend by pointing out that during the current recession this business has grown substantially by providing much needed capital to companies. The dollar value of royalty deals in 2008 was $1.7 billion, compared to only $400 million in Another reason inventors may prefer to sell part of their royalties is to reduce the risk associated with holding one product for several years. If during the life of the royalty the drug revenue is adversely impacted by large litigation suits, or by a competing drug, the inventor is financially shielded from this because they already collected their payout. Another benefit for the inventor is that they may use the money they were paid for a portion of the royalty stream to build production facilities to produce the drug. Finally, the deal could be very helpful if there is a divestiture of a product or unit and the company wishes to be paid for the future earnings from one of the drugs. The main disadvantages for the inventor are incorrect valuation of the product, and the small market size. If the product is undervalued by the investor, then the inventor may lose a lot of potential 4 P a g e

6 earnings. However, there are methods to reduce the potential damage from this. Some inventors that are hesitant to sell their royalty stream add a contractual clause that requires the investors to pay the inventor extra monies if royalties exceed a certain value. This tactic has been used in one major transaction between the company Royalty Pharma and Memorial Sloan-Kettering Cancer Center with the drugs Neupogen and Neulasta 5. Due to the highly specialized nature of these transactions it is possible for companies to hedge their risk of being undervalued by adding protective contractual terms. Another disadvantage for the inventor is the market size of only $1.7 billion as of This does not permit many of the Big Pharma companies to sell a meaningful amount of their royalties. This has lead to Big Pharma companies selling royalty streams to one another; such as Pfizer selling royalty interests in their cancer drug Vidaza to Celgene Corporation for $425 million 6. For investors there are numerous advantages. Investors such as Royalty Pharma, Cowen Healthcare, and Paul Capital are able to participate in a mutually beneficial transaction and purchase a royalty stream. These companies are funded by private investors and can be thought of as specialized private equity companies. These companies are able to use their cash and purchase a percentage of multiple streams from inventors, and diversify their earnings risk. It is apparent that this strategy for risk diversification is sound; Both Moodys and S&P have rated Royalty Pharma s portfolio as AAA 7. Another attractive quality of the industry is that investors are also able to take their royalty stream and securitize and syndicate it to a number of smaller investors. Investors also have the advantage of being protected from the costs incurred by the marketing company that actually sells the drug, which is typically a major pharmaceutical firm. In other words, investor s revenues are top line driven; whatever costs are incurred by the marketing company through R&D, marketing, and litigation are not reflected in their royalty payout. However, when the marketing companies increase their advertising budget for the drug, it helps increase the top line and thus the royalty holders get paid more. 5 P a g e

7 Disadvantages for investors are if they overvalue the future cash flow generated by the drug. This could occur if a competing drug comes out, if there is litigation surrounding the drug they invested in, or if the patent is weak and generics start selling it. These can be substantial problems if they occur. Luckily the risk can be hedged by thorough due diligence on the drug. There is a very thorough process of due diligence by working with expert research doctorates, intellectual property attorneys, and clinical trial companies. Additionally the risk may be hedged by investing in drugs with only very strong patents, such as biologics which utilize recombinant DNA technology and have special patent protection. Major Investors in the Industry The industry is relatively small and there are only a couple of companies that currently participate. Those companies are Royalty Pharma, Cowen Healthcare, Paul Capital, and DRI Capital. The combined deal volume in dollars was $1.7 billion in 2008, compared to only $400 million in 2006, that is an impressive growth rate of about 325% in two years. This industry is definitely still in its infancy, and it is only a matter of time before more venture capital and private equity firms start participating in these deals. Below in Table 1 is a list of some of the transactions over the past few years. Many of the transaction details are not disclosed publicly. Table 1 Select Transactions in the Pharmaceutical Royalty Purchasing Industry Product Drug Use Royalty Investor Marketing Company Lunesta Sleeping aid for insomnia Paul Capital Aventis (now Sanofi-Aventis) Vidaza Cancer Treatment Celgene Corporation Pfizer Rituxan Non-Hodgkin s B-Cell Royalty Pharma Genentech, Inc. lymphoma Neupogen / Neulasta Neutropenia associated Royalty Pharma Amgen with chemotherapy Zerit HIV/AIDS Royalty Pharma Bristol-Myers Squibb 6 P a g e

8 Future Outlook for the Industry This industry is still in its infancy and has not yet gained full acceptance by inventors. Its presence is unknown to many inventors, which prevents it from having widespread adoption. However, given the ability of this industry to provide liquidity in the form non-dilutive capital and to diversify risk, it will probably grow extraordinarily quickly as valuation techniques improve on the royalty streams. Pharmaceutical development companies and other inventors will definitely enjoy being able to hedge against some of the risk in a product launch and get an early cash payment. The growth of 325% in two years is evidence to support this conclusion. Despite the fact that the current royalty purchasing market is booming it is not large enough to support Big Pharma s royalty streams. However, as more private equity investors enter the arena and the investment pool grows in size, Big Pharma companies may begin diversifying their risk and selling some of their royalty streams. After Big Pharma begins selling their royalty streams this market could potentially become tens of billions of dollars in size. 7 P a g e

9 References Annual Report for GlaxoSmithKline. Rep. GSK, Web. 22 Oct < 2 Tufts Center for the Study of Drug Development. Publication. Vol. 30. Boston: Tufts University, Print. 3 "Understanding Royalties." Royalty Pharma Web. 20 Oct "Royalty Pharma Deals Aren't Just for Start-Ups Anymore." Wall Street Journal [New York City] 30 Sept Print. 5 "Case Studies of Memorial Sloan-Kettering Cancer Center." Web. 22 Oct "Understanding Royalties." Web. 21 Oct Royalty Pharma Corporate Brochure. Report P a g e