Houston’s Capital Royalty Evolving in Healthcare Growth Financing

11/19/13Follow @Tansey_Xconomy

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a series of financing vehicles based on royalty interests that limit such risks while still providing access to non-dilutive capital. “The financing model for innovation has evolved considerably,” says Tate.

In 2005, Capital Royalty began investing the proceeds of its first fund of $325 million. At the time, it was one of the few firms practicing a form of financing called “royalty monetization.” In other words, it helped innovators  raise cash based on the forecasted value of their future royalty payments. One of the simplest ways an investor can do this is to buy part or all of the rights to the royalty stream.

This form of investing dates back about two decades. The New York City-based investment firm Royalty Pharma, founded in 1996, gained an interest in Genentech/Roche’s groundbreaking lymphoma drug rituximab (Rituxan) in 1998 by purchasing royalty rights in the drug from the Berkeley, CA-based antibody discovery company XOMA. Royalty Pharma now claims more than $10 billion in assets, and interests in 41 products on the market or in late-stage development.

Capital Royalty, in its first three years with an active fund, bought interests in the royalty revenue from a children’s vaccine, an antifungal treatment, and a cancer drug. Due to confidentiality agreements, Capital Royalty doesn’t identify the parties to these transactions publicly.

Organizations that cash out on their royalty rights can shed the risk that the royalty payments won’t develop as forecast due to a host of factors, such as competition, health insurance reimbursement policies, regulatory changes, patent challenges, or emerging safety concerns about a drug. The buyer of the royalty rights takes on those risks, but also gains the potential to make greater returns if the product does much better than expected in the market.

One potential problem with this scenario, Capital Royalty learned, is that investors shopping for royalty rights might find eager sellers when a product’s prospects are less promising, says Luke Duster, a principal at the firm. But the opposite is true for reluctant sellers, whose products typically have much stronger prospects.

As an alternative to persuading innovators to sell their most valuable royalty rights, Capital Royalty has used newer investment vehicles that allow royalty recipients to raise funds without signing over their royalty streams. Among those financing forms are royalty bonds.

Investors buy the bonds, raising capital for the inventor. The inventor—a small company or research center—repays the principal and a fixed rate of interest from the royalty revenues over the life of the bond.  If the royalties are richer than expected, though, the inventor retains the upside.

Royalty bonds also offer advantages to the financier. Capital Royalty reduced its risk by using this mechanism. If the stream of royalties is thinner than expected, the term of the bond can be extended until the obligation is paid off. The life of the underlying intellectual property is usually much longer than the life of a bond, Tate says.

Royalty-based financing has evolved into increasingly complex forms over the past two decades, according to a white paper by Capital Royalty. Agreements can be individually negotiated to balance the interests of investors and royalty rights holders. For example, some royalty bonds allow investors to retain some rights to the royalty payments after the bond is paid off. In such cases, the investor may supply a higher amount of up-front capital to the inventor.

Capital Royalty, which besides its Houston headquarters has offices in New York City and Boulder, CO, has invested in companies from major biomedical research regions including Massachusetts, New Jersey, and California. It has no deals in Texas at this point, but it supports BioHouston, a non-profit that promotes the Houston area as a center of life sciences innovation. Tate, the chairman of Capital Royalty, serves as a business advisor to several units within the University of Texas System.

The firm is now making investments from its second fund, drawing on $805 million in committed capital. It considers investing amounts between $20 million and $200 million in companies that have revenue streams from marketed products. One of its most recently announced deals, with … Next Page »

Bernadette Tansey is Xconomy's San Francisco Editor. You can reach her at btansey@xconomy.com. Follow @Tansey_Xconomy

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