Royalty financing has emerged over the past decade as an attractive investment
vehicle in the life sciences space. It offers private equity and venture capital
investors several advantages over traditional debt financing, and it provides life
sciences firms with new ways to raise capital and fund investment for biologics and
other complex therapies that require extensive R&D and increased time to market.
Below, we discuss some of the various factors driving the growth of royalty
financing transactions as well as certain unique commercial factors.
In the healthcare context, the term “royalty financing” is typically applied to two quite
different types of transactions: 1) “royalty monetization,” where investors purchase
the rights to some or all of a royalty stream for a lump sum; and 2) “development
financing,” which refers to investor funding for development of a product in exchange
for a percent of future product sales. Universities, hospitals and other nonprofits are the
most common recipients of royalty monetization, while biotechnology companies are
the most common recipients of development financing. The royalty financing market
has been estimated to provide $14 billion per year in deal flow.
Advantages for Investors
Faster Return on Investment
Royalty financing is appealing to investors looking for a faster return on investment
than equity typically provides. Equity investors must typically wait for the occurrence
of an IPO, exit event or leveraged recapitalization to recoup some or all of their
investment. By contrast, royalty monetization provides immediate access to an existing
cash flow through the acquired royalty stream. Likewise, in development financing
deals, investors typically receive returns as a percentage of future net product sales,
which can often be expected to occur before the opportunity for an equity exit.
Increased Certainty
Increased certainty is another benefit of royalty financing. With traditional equity,
the investment value is a function of many disparate factors, including the target’s
entire product portfolio (and the accompanying uncertainty as to which products
will be blockbusters and which will be busts). Royalty financing transactions permit
investors to cherry-pick products with proven track records or that, in the eyes of the
investor, have a high likelihood of success.
Mitigation of Market Volatility
Royalty financing is also attractive to investors looking to minimize the risk of
market volatility. By investing in a particular product’s royalty or revenue stream,
the investment is directly tied to the underlying economics of the product. While an
investor certainly takes on the risk of such
product’s commercial failure, the investor
is less susceptible to general market
volatility (including, for example, the
market over or undervaluing a particular
piece of news or fluctuations from current
political conditions) that can directly
affect the value of an equity investment.
Unique Commercial Aspects
Flexibility
Royalty financing offers investors the
flexibility to structure agreements
in ways that are tailored to their
investment goals. Development
financing deals, in particular, have fairly
bespoke contracts and provide the
opportunity for creative structuring.
For example, royalty payments in
these types of transactions may be
treated as consideration for entering
into debt financing. Recently, Mannkind
Corporation executed a development
financing agreement and related
debt facility with Deerfield Private
Design Fund II, L.P. (“Deerfield”) and
Horizon Sante FLML SARL. The debt
financing was broken down into four
tranches and provided Deerfield with
the option as to whether it would fund
later tranches if certain conditions
were not met (including, for example,
conditions relating to drug trial results
and FDA approval). In exchange for this
flexibility, Mannkind’s royalty payments
to Deerfield would decrease if Deerfield
elected not to fund a debt tranche. This
type of mechanism allows the parties
to adjust the economic terms and risk
profile of a deal over time as development
progresses and more information
regarding the product and its likelihood
of success becomes available.
Development financing agreements
may also include other arrangements
designed to protect investors. For
example, PDL BioPharma’s financing
of Ariad Pharmaceuticals’s Iclusig drug
provided PDL BioPharma with a put
option obligating Ariad Pharmacuetical
to repurchase the royalty payments upon
exercise of the option if certain conditions
were met (including the company’s
bankruptcy, a change of control or
the company’s failure to make royalty
payments within a specified time frame).
Ariad Pharmaceutical also granted PDL
BioPharma a security interest in the
royalty payments and certain patent
rights, among other collateral. These
types of backstops allow investors to
hedge the risk of relying solely on a
product’s uncertain future revenues
(particularly when the royalty supplier
has weak growth or is pre-revenue).
Although royalty monetization
agreements are far more uniform in terms
than development financing agreements,
there is flexibility here as well. In most
royalty monetization agreements, the
purchaser obtains the entire royalty
stream, but the agreement can be
structured for the royalty supplier to
retain a certain percentage of the royalty
payments and/or the milestone payments.
In a recent deal between Agenus Royalty
Fund LLC, Agenus Inc. and Xoma (US)
LLC, for example, Agenus purchased only
33% of the royalty payments and 10%
of future milestone payments.
A Middle Ground for Risk and Reward
Royalty financing transactions typically
do not include guaranteed minimum
payments. In this sense, royalty financing
is riskier than debt financing, which
(assuming no default by the borrower)
guarantees repayment plus interest.
Because of this risk, royalty financing
can ultimately be more expensive for
the royalty seller than traditional debt
financing. On the other hand, royalty
financing agreements do not typically
include a payment cap on the total
amount of royalties payable to the
investor. This type of transaction thus
provides the potential for significantly
higher returns than those provided by
traditional debt instruments. That said,
because the return is still based off a fixed
percentage of sale, one would not expect a
royalty financing transaction to generate
the outsized returns sometimes seen from
early-stage investment, particularly if the
target ultimately undergoes an IPO. As
such, royalty financing can frequently be
thought of as a middle ground between
the two traditional financing poles of
guaranteed return on investment of debt
and the potential for very high returns
from early-stage equity.
Tax Considerations
Royalty financing transactions also
raise a number of tax considerations,
depending on the terms of the
transaction. Because royalty financing
transactions may contain elements of
both a sale and of a financing transaction
or a license, careful analysis is necessary
to determine the tax treatment of
payments. These issues are particularly
acute in cross-border royalty financing
transactions, where withholding taxes
can apply and diminish the returns to
investors. If the business terms allow
for it, tax practitioners sometimes try
to classify royalty financings as loans,
where the rules governing issues such
as cost recovery and withholding taxes
are more predictable.
The Private Equity Report Fall, 2019, Vol 19, No 2