Healthcare royalties: a funding gap with opportunities
The term “royalty” is centuries old. It stems from the gold and silver mines in Great Britain which at one time were the property of the crown. In return for an upfront payment, interested parties were granted the right to mine “royal” metals. Subsequently, many other industries – from oil and gas to music and theatrics – have borrowed the concept.
We can think of today’s royalties as an advance on a future paycheck. They are the mechanisms by which entities can collect future cash flows (in whole or part) in exchange for an upfront payment. The future cash flow payments directly link to a particular product’s sales over a set timeframe. Royalties are an alternative financing option to traditional forms of borrowing and equity, although they come with a similarly structured financial contract.
Royalties are here to stay
Healthcare royalties have become a permanent and integral part of the pharmaceutical industry since their infancy in the early 1990s. Before healthcare royalties became widely used as an alternative financing solution, large pharmaceutical companies funded the drug development process in-house through their own research and development (R&D) arms.
However, over time the need to find new ways of funding drug development became more urgent. A variety of recurring trends were responsible. One of the most pressing was the high risk and expense associated with funding compounds in the early stages of development. Other needs include a decline in the productivity of R&D departments and the increasing complexity of applying research findings. Pressures for change also mounted as key drugs lost exclusivity to generic equivalents, reducing revenues.
It’s estimated that by 2002, external developers produced 16% of all new drugs at the ten largest US pharmaceutical companies. By 2012, this figure had more than doubled to 33%. Royalties have become a permanent fixture in the industry.
This transformation of financing solutions has led large pharmaceutical companies to outsource drug discovery efforts to innovators in a resource-efficient manner.
As a consequence of the continuation of the trends mentioned above and the remaining need for biomedical innovation, by 2016, 70% of the sales generated by large US pharmaceutical businesses were of drugs made by small to mid-size developers. This transformation of financing solutions has led large pharmaceutical companies to outsource drug discovery efforts to innovators in a resource-efficient manner.
The need for funding
There are three broad categories of innovators. These are small- to mid-sized biopharmaceutical companies, inventors, and universities. Each innovating group serves a different purpose in the broader drug discovery process. There is a common thread, however: each has a funding need.
Innovators have a variety of motivations to sell or structure royalty financing. Most aim to create greater flexibility. For example, a university may seek to sell a royalty to fund a new building or research facility. As such, a sizeable opportunity for alternative investment managers to step in and bridge the funding gap now exists. It also offers investors the ability to participate in the life sciences industry at lower risk because royalty streams are typically tied to the life of the product’s underlying patent.
In addition, royalty investors can access cash flows linked to sales generated in a regulated monopoly. Meanwhile, royalties’ financial structure resembles the likes of senior secured debt. This tends to give investors high priority in the event of a default.
Specialist lenders may also step in to meet the funding need with debt backed by royalties. Traditional lenders such as banks may be unwilling or unable to provide debt financing, while an equity-financed approach would dilute control of the business. Specialist lenders can provide debt, secured against royalties, in greater size but at a higher cost than traditional lenders. Importantly, however, this allows the royalty owner to retain ownership of the stream and control of the business, while providing greater financial flexibility.
These incentives are fuelling healthy levels of investment opportunity in the healthcare royalty market. The sky-rocketing average cost to approve a new drug (estimated by the Tufts Center for the Study of Drug Development to be around $2.6 billion) is another growth catalyst for this sub-segment of the pharmaceutical industry. Meanwhile, the US Food and Drug Administration approved a record number of new drugs in 2018, most of which will require additional financing for commercialisation.
The looming ‘patent cliff’, when the patents of several key drugs will expire, is also driving new development. Companies are attempting to backfill the expected sales void from generic competition. An average of industry experts’ estimates suggests that the healthcare royalty market offers around $14 billion per year of deal flow.
Other asset classes also make the healthcare royalty market appear attractive on a relative basis today. Bond yields are at, or near, record lows, while equity valuations are lofty. There is a general lack of yield available in the market.
Healthcare royalty strategies offer investors access to a high level of current income. Royalty streams yield between 5% and 20%, depending on the current stage of the product’s clinical development. In addition, royalties are usually hold-to-maturity assets. This means investors are not reliant on capital markets for the purposes of an exit.
Historically, the healthcare royalty market has been observed as having a low correlation to credit or equity markets, or even the broader economy. Instead, the success of the strategy is more closely linked to broader trends in demographics like the ageing of the population, which stimulates healthcare spending. The world’s 60-plus population is set to expand by 56% between 2015 and 2030. And worldwide pharmaceutical sales are growing at a compounded annual rate of 6%. As such, institutional investors can play an important role in helping to address unmet clinical needs by providing financing to fund pharmaceutical research for the future.
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