The pharmaceutical industry has a strong need to access growth capital for the development and production of blockbuster drugs.
There are a number of factors that combine to make this capital need an attractive investment opportunity for institutional investors.
Large pharmaceutical companies have been inefficient with respect to their internal research and discovery engines. And small, specialized biotechnology companies require access to global development and distribution capabilities that they do not have internally, leading to an increased number of licensing partnerships.
These licensing deals typically include a modest upfront payment, milestones tied to key development successes, and an ongoing percentage of the revenue stream for the approved drug (i.e., royalty payments). Upfront and milestone payments typically do not provide biotechnology companies with enough capital to continue to innovate and build a broad portfolio of new drug candidates. In addition, the royalty payments are still somewhat uncertain and spread out over many years, leading to the need to seek additional capital to pay for ongoing overhead and R&D costs.
As an alternative to dilutive equity capital, biotechnology companies can sell all or a portion of their ongoing royalty stream(s) for upfront cash to fuel innovation, a transaction referred to as a royalty monetization.
The capital provider, or royalty purchaser, is thus investing in the future cash flows of the specific drug or therapeutic technology itself, rather than the corporate entity. In this way, drug royalties are merely a specialized form of financing based upon the expected future income stream from a specific asset, not functionally dissimilar to mortgage origination, aircraft leasing or even, to a lesser extent, master limited partnerships. Drug royalties have the additional benefit of being non-correlated with broader debt and equity indexes, because performance is tied to the number of patients suffering from a particular condition rather than the performance of the overall market.
As investors have realized this, the marketplace for pharmaceutical royalties has grown substantially. Market participants estimate roughly $2.5 billion worth of royalty monetization transactions took place each of the past three years compared with just $200 million in 2003. During this period, public pension plans in particular have become large investors in the space, with the $220 billion Canada Pension Plan Investment Board, Toronto, a very notable and high-profile example. This has certainly helped contribute to the credibility and institutionalization of the sector.
Some of this growth in transaction volume is being driven by a recent increase in the number of drugs being approved, after a period of relatively modest FDA approvals.