Guest comment by Edward Truant, Slingshot Capital
Despite a major shift in corporate balance sheet asset composition from tangible to intangible in recent decades, stemming largely from the shift to a knowledge-based economy, there has been surprisingly little growth in the number of alternative asset managers with intellectual property-focused strategies.
The result has been an under-allocation of risk-adjusted capital to companies and academic institutions in IP-intensive sectors that either do not plan to litigate or that will be litigating but only as part of a holistic and diversified business and/or IP licensing strategy. While these IP owners may seek capital to finance objectives such as non-dilutive growth, technology licensing or royalty audits and monetisation, often the IP owner must choose between a litigation funder that does not specialise in broader financial solutions or a financing source that is not specialised in IP.
Recently, IP-focused managers with credit-oriented strategies have come into focus, which are targeting this market gap. In the US, in addition to Soryn IP Capital, hedge fund manager Fortress has an existing IP credit fund and Aon is currently raising capital for a debut IP credit fund.
IP value proposition
According to recent reports, intangible assets represent around 90 percent of S&P 500 market value compared with around 30 percent in 1985 and now represent more than a third of the market value of US publicly traded companies.
IP refers to creations of the mind, such as inventions, literary/artistic works, designs and symbols/names/images used in commerce. The primary forms of intellectual property are:
Patents: protecting inventions and discoveries;
Trade secrets: protecting valuable information that is intentionally kept secret;
Copyright: protecting artistic works in a fixed medium of expression;
Trademarks: protecting “signs” associating products and services to an owner.
While each form of IP offers different protections, the value of each lies in its legally proscribed, exclusionary right that prohibits third parties from practicing or “infringing” the IP without permission. It is this exclusionary right that promotes healthy competition and innovation ecosystem by, for instance, incentivising R&D, encouraging investment, protecting market share, and allowing the licensing of these rights to either promote synergistic business relationships or stop unauthorised copying.
IP value creation
IP gains sufficient value to form the foundation for a financial transaction when third-party commercial actors have either begun to use the IP or desire to use it in the future. When this situation occurs, IP rights can create value in several ways, including:
licensed to third parties that wish to practice or produce the technology associated with the underlying IP;
exploited to negotiate cross-licenses that allow IP owners access to sought-after technologies;
sold to third parties that wish to practice or produce the technology associated with the underlying IP;
enforced against third parties that are practicing the underlying IP without a licence;
serve as the basis for significant insurance policies;
the principal basis for an M&A transaction and a key driver of M&A activity;
central to value creation following a business separation or spin-off transaction;
facilitate the formations of JVs for co-development of new technologies, which increase enterprise value; monetised through the sale of all or part of contracted royalty payments associated with particular IP.
In turn, IP owners and managers (eg, companies, academic and research institutions, and law firms), can leverage these sources of IP value to raise debt and equity capital in several
Although IP offers a unique and significant source of value, many owners and managers of IP experience difficulty when attempting to leverage their IP to achieve an appropriate risk-adjusted cost of capital due to the lack of IP expertise and or transactional flexibility among the investing community.
IP credit generally involves highly structured, privately negotiated financial contracts of varying types. Counterparties are often companies possessing valuable IP portfolios, which are underserved by the capital markets.
Just as private debt funds take different shapes and sizes, so too does an IP credit fund. Where the underlying IP and/or associated rights or income streams can be assigned predictable licensing, monetisation and/or sale value, various transactions can be structured to leverage or maximise the value of the associated IP.
Investment and structuring
Investment types within the private credit strategy include senior loans, loans secured by IP, loans secured by legal judgments, loans secured by insurance policies, convertible debt instruments, highly structured preferred equity, common equity, and warrants.
The duration of private credit investments is generally one to five years and expected returns on these investments will vary based on the existence of negotiated downside protections.
The following terms and structures can be applied/designed to allow for an appropriate risk-adjusted cost of capital:
Delayed draw funding schedules and performance-based milestone provisions;
Events of default/material adverse event scenarios;
Minimum cash/treasury requirements;
Prepayment protection (make-wholes, yield maintenance, non-call provisions);
Structural and/or contractual seniority over IP or other assets;
Affirmative and negative covenants/financial covenants;
Warrants or other instruments with equity-like kickers;
Credit enhancements via IP-related insurance policies.
Managers of IP-focused funds often possess a multidisciplinary IP expertise, with additional expertise in credit or distressed strategies. Such expertise allows management teams focused on IP-specific strategies to not only appropriately measure risk and value potential, but to appropriately structure such transactions to capture value and mitigate downside.
Management’s IP experience is also as an advantage when sourcing deals from among counterparties seeking a value-add financial partner with a deep understanding of IP. Because multidisciplinary IP expertise is a prerequisite for managers, barriers to entry remain high and competition for deals is less than other sectors. Typical counterparties involve operating companies (both private and public) and universities that own foundational IP, or revenue streams associated with such IP, as well as law firms representing such entities.
Use of proceeds
IP-focused private credit transaction proceeds may be used for general business purposes and IP-related expenses or investments. This is an important distinction between IP litigation finance and IP-focused private credit, with the latter allowing for significantly more flexibility for the use of proceeds.
Demonstrating the quantifiable value of IP, the insurance industry has recently introduced products aimed at insuring various aspects of IP which provide downside protection for investors. Such products include:
Collateral protection insurance for credit deals;
Judgment preservation insurance;
IP litigation insurance.
Secular shifts in the economy should be forcing investors to think about value differently. It’s indisputable that IP is clearly the basis for knowledge-based company valuations and so value must be attributable to IP when considering financing alternatives. I believe IP credit has a bright future as existing players have had great success producing consistent returns in a sector that otherwise believed to be volatile.
Edward Truant is the founder of Slingshot Capital and an investor in the consumer and commercial litigation finance industry