Drug royalties in a real asset portfolio

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.

This increase in drug approval and royalty transaction activity comes against a far more explosive backdrop of overall growth in health-care expenditures. According to information from the World Health Organization, total global expenditures on health-care goods and services hit roughly $6.5 trillion as of 2012, up from approximately $3.3 trillion in 2000. More important than the nominal increase, this represents a significant expansion relative to global gross domestic product. When combining private and public expenses, total health-care outlays as a percentage of production globally have risen to 9.1% from 8.2%, an increase that is observed across developed and emerging economies alike.

Going back to 1995, health-care spending as a percentage of GDP in the U.S. has increased 31% cumulatively, or about 1.6% per annum. Although spending in the U.S. represents a far larger portion of the economy than any other nation, growth in spending on health care is a nearly ubiquitous phenomenon. For example, during this period, China's spending on health care has risen 52.7% while Germany's is up a more modest 11.6%. Interestingly, the average growth rate of health-care expenditures as a percentage of GDP since 1995 for the six largest economies in the world (ex-U.S.) has been 31% cumulative or 1.6% per annum, identical to that of the U.S.

Even within health care, sales of prescription drugs have risen more rapidly. Global sales of pharmaceuticals alone hit nearly $1 trillion in 2013, almost tripling from $350 billion in 2000. According to information from the Centers for Disease Control and Prevention, prescription drug use across all age groups in the U.S. has risen substantially during the past 20 years. Of note, the increase and overall usage rates have been much higher for those age 65 or older.

Global demographic trends suggest spending on medical care broadly, as well as prescription drugs specifically, will only continue to increase. The percentage of the population age 65 or older has risen notably in many developed nations in the past 20 years. According to projections from the World Bank and United Nations, the trend is likely to accelerate even further. By the year 2030, many developed nations will see 20% to 30% of their populations fall into this age bracket.

Participating in the revenue growth of prescription drugs stemming from an aging population can provide a natural hedge against mortality extension risk. The fact that improving access to medical care and prescription drugs provides the population with a longer and healthier life is an unmitigated social good. However, the resulting improvement in mortality assumptions increases the projected benefit obligation of a pension plan as well as explicitly expands current health insurance costs. For an institutional investor that provides pension and insurance benefit plans, an investment that can generate higher returns in precisely those environments makes sense from an asset-liability matching perspective. (This might become even more important with the new mortality tables released in February by the Society of Actuaries. These changes will have the effect of increasing the expected liability for plan participants anywhere from 2.5% to 17.4%).

Moreover, during this time of increasing medical expenditures, health-care price inflation also has been fairly dramatic. As displayed in Figure 3, the rate of price increase of medical products and services has been nearly twice that of overall inflation for nearly 35 years. It is worth noting again, that even within health-care inflation, prescription drug costs have risen modestly faster. Since 1980, medical care costs have risen 5.1% per year while prescription drug costs have increased at a rate of 5.3%.

For an inflation-linked or real-return portfolio, exposure to the actual underlying real assets that make up the consumer price index is one way in which to ensure that investment returns have a positive correlation with inflation. Medical care as a whole is the fourth largest major component of CPI. Although prescription drug costs might have a modest weight as a subcomponent within medical care, an asset class that can participate in significant price appreciation that is also mathematically linked to CPI can provide an attractive investment profile for a real-return mandate.

While the fundamental outlook for drug royalty investments is positive, and the asset class has both theoretical pension liability hedging and mechanical inflation hedging characteristics that make it attractive, it is not without risks. Fortunately, these risks tend to be idiosyncratic in nature, and hence largely mitigable through asset selection and diversification. The biggest risk in royalty monetization is a subsequent collapse in the revenue. Specific to drug royalty payments, there are a number of different causes of potential revenue weakness, some of which might be predicted and some cannot.

Most of the causes of revenue collapse stem from the introduction of some type of competition, such as generics (price competition) or a new therapeutic technology (efficacy/quality competition), both of which tend to occur with a significant and predicable lead time. However, more unexpected problems can affect drug revenue, for example the development of adverse side effects that take the drug off the market, as was the case for Vioxx. Fortunately, proper asset level due diligence — researching the clinical trial data, analyzing the medical condition, etc. — allows a drug royalty investor to understand and assess the probabilities of these various outcomes.

Additionally, different types of drugs and therapeutic areas have different types of risks. For example, biological compounds typically have much greater intellectual property, or IP, protection simply because they are much harder to reverse engineer than are small-molecule entities. Also, orphan drugs (those developed to treat specific rare medical conditions) often receive preferential tax treatment, enhanced patent protection and facilitated clinical trials processes through government intervention intended to support the production of these small-market drugs. For instance, the typical Phase III clinical trials requirement of testing 1,000 patients may be reduced by the FDA for a drug intended to treat a condition that has less than 1,000 actually diagnosed individuals in the U.S.

In addition to detailed intellectual property due diligence, the threat of revenue collapse can also be mitigated through investment structuring, including features such as minimum revenue thresholds, put-backs or make-whole provisions, or adding other explicit debt characteristics to the structure.

Drug royalty managers capable of performing technical and legal due diligence on the IP, selecting good assets and structuring investments around them, have historically generated net returns to investors in the range of 10% to 12% per year. Notably, given the lack of correlation between royalties and broader debt and equity indexes, the level of return remained consistent through the recent financial crisis.

If an institutional investor has sufficient liquidity to allocate to 10-year closed-end limited partnerships, drug royalty funds can provide a fairly high probability of double-digit nominal returns with a healthy current income component and potential liability hedging upside characteristics. Maybe not a cure-all for public pensions, but it still sounds like good medicine.

Christopher M. Schelling is deputy chief investment officer, director of absolute return, for the Kentucky Retirement Systems, Frankfort, which has committed approximately $50 million to the drug royalty sector. Mr. Schelling also is an adjunct professor of finance, University of Kentucky.