Royalty Flush

A new private equity fund, led by a retired Hicks Muse partner, will seek opportunities in the chronically inefficient healthcare royalties market. David Snow examines this alternative, alternative strategy, and checks in with the only other private equity firm to have executed it – New York's Paul Capital Partners

After retiring from the firm he founded, Tom Hicks plans on spending more time managing his baseball and hockey teams. By contrast, recently retired Hicks Muse Tate & Furst co-founder, Charles Tate, has chosen a different path – he's turned to drugs.

More specifically, Tate, who built his reputation buying and selling companies, is now interested in pursuing an entirely different type of asset – drug royalties.

Put plainly, a royalty is an interest in a revenue stream generated from the sale of a product. Royalties based on the sale of drugs and other medical products have now captured Tate's attention, not to mention the attentions of the many investors who have backed two previous, similar vehicles managed by New York-based Paul Capital Partners.

Medical royalties are vastly underappreciated assets in the corporate world, and, in addition to big pharmaceutical companies, are held by an unusual cast of characters – universities, research labs, and the professors and inventors who work at these institutions.

Proponents of medical royalty investing see an opportunity for arbitrage, but they also see a desire among many limited partners for current income, a prominent component of this strategy.

Tate and his new, Houston-based firm are currently in the market seeking $300 million (&€252 million) for a vehicle called Capital Royalty Fund. A source close to the effort says the fund will see a first close this summer.

Joining Tate are two Canadians who have been pursuing this strategy for 10 years. Jim Webster, the managing partner, and Harry Loveys, a principal, left Toronto-based Drug Royalty, a business dedicated to the buying and selling of drug royalties. For much of its history, Drug Royalty was a publicly traded company but it was acquired in 2002 by Inwest Investments, a Canadian private investment firm. At the time of the acquisition, Webster was president of Drug Royalty.

From 1994 to 2002, Webster and Loveys invested roughly C$100 million (US$72 million; &€61 million) in royalty purchases. A source close to the two says these activities yielded a fully realised gross IRR of 30 percent.

Of particular interest to dividend-hungry institutional investors, much of that return had a current-income component to it. Drug Royalty's activities yielded a roughly 20 percent annual return from royalty cash payouts, according to the source.

Drug royalties are owned by an eclectic mix of institutions and people. Many are understandably unaware that there are any groups on the planet eager to relieve them of these assets. A source close to Tate's group reckons the total value of the drug royalty market to be between $40 billion and $80 billion, with only about $1 billion worth of capital chasing deals.

Much of that capital earmarked for medical royalties is controlled by New York-based Paul Capital, the only major private equity firm to have seriously and successfully pursued this niche strategy. The Paul Royalty Fund is managed by, appropriately, two medical doctors, Walter Flamenbaum and Gregory Brown, and a finance specialist, Lionel Leventhal.

Brown, who left a career as a thoracic and vascular surgeon for the world of medical-related finance, says Paul Capital first became aware of the royalty opportunity while pursuing a type of deal for which the firm is better known – the secondary transaction.

Paul Capital was exploring the interest of a pharmaceutical company in divesting its portfolio of interests in private equity partnerships. The company demurred, but asked if Paul Capital were interested in its inventory of medical royalties. “They said the Street didn't give them any credit for their royalties,” says Brown.

In 2000, Paul Capital closed its first healthcare royalty fund with $300 million in committed capital. A year ago, the firm closed its second such vehicle on $650 million. Paul Royalty Fund currently has 11 investment professionals based in New York, London, San Francisco and Basel, Switzerland. Brown says the royalties team has done roughly half of its deals in Europe.

The medical royalty – any royalty, for that matter – investment strategy is rather different from that of private equity. For one, the royalty strategy is not correlated to the stock market and is much less dependant on the capital markets, claims Brown. In fact, royalty investments aren't even equity. “We're a private nonequity fund,” says Brown.

But a successful medical royalties investment team will follow certain practices that mainstream private equity professionals will find familiar – intense due diligence, intense networking for deal flow and creative thinking.

Most drugs and other medical products are developed after years of research. Most US drug patents, when issued, are good for 20 years, after which competitors may begin to sell generic versions of the drug. Therefore, by the time Paul Capital and other specialists get their hands on an asset, it may have 10 years of payouts left. Some drugs may continue to sell well after the expiration of a patent, others won't. In addition, competing pharmaceutical products can suddenly emerge and bury the prospects of an established one.

Part of the targeted return in the medical royalties strategy comes from the payouts, and part comes from conducting arbitrage based on superior predictions of how the products will sell.

As with any asset class, sellers of drug royalties have a variety of reasons for selling. But in the medical royalties game, the seller dynamics are peculiar to the drug development industry.

Pharmaceutical companies large and small may want to sell off cash flow-producing inventories of royalty interests to help finance an acquisition. This source of deal flow is, of course, huge – for many big pharma companies, in-license royalty streams account for half of revenues.

While royalty investors primarily focus on corporate sellers, universities and research labs are also major holders of royalties, as many drugs are developed within these institutions. Oftentimes academic institutions will sell off royalties in order to raise money to launch a new capital-raising campaign. In some cases, political issues persuade university financial directors to unload certain drug royalties.

But the most interesting sources of medical royalties are the professors, clinicians and inventors who created the products. Many of these individuals are happy to sell their royalty interests for diversification or estate planning purposes, but not all are as financially savvy as they are scientifically astute. Their ranks also include some real characters, says Brown. “Not surprisingly, people who are brilliant scientists often have interesting personalities, and often can be iconoclastic,” he says.

Brown relates the story of a researcher who, through rather unusual circumstances, realised the need to do some estate planning and sell some royalty interests. Each time he received an (increasingly enormous) royalty check, he would drive to the local bank and make a deposit in a drive-up teller machine. Eventually, the researcher found he was stymied in this routine because the deposit forms available did not include enough spaces to write all the digits on his royalty checks.

“When you have a drug hit, many people own royalties,” says Peter Martenson, a director at La Jolla, California-based private equity consultant Pacific Corporate Group. “In a way, they've hit the lottery, but then they realise it's paid out over 20 years. An investor can go in, take a projection, and buy the royalty interests at a discount.”

The drug royalty play does not hold forth the prospect of a Google-type homerun event, but in today's market many investors see any risk-mitigated strategy offering a high-teen, low-twenties return as just what the doctor ordered.