[Updated Nov. 26, 2013] When Charles Tate moved home to Texas after a 35-year career as a New York finance executive, he started weighing opportunities for a new investment firm. Plenty of Texas investment firms were already focused on real estate and oil and gas. But Tate had seen first-hand the potential of biomedical innovation while serving on the boards of top healthcare institutions in the Houston area. Medical schools, research centers, and hospitals are clustered at the city’s sprawling Texas Medical Center.
“Because of the presence of the Texas Medical Center, I identified healthcare as a strategy in which we would be a pioneer and have an advantage,” Tate says.
In particular, Tate concluded that innovation in healthcare was going to depend on innovation in the financial sector to fund the growth of both its research institutions and its young biotechnology or device companies whose inventions could change the face of medicine. Financing can be hard to come by for these organizations. In 2003, Tate founded the Houston-based investment firm Capital Royalty to address this need.
Startups and research institutions frequently receive a stream of royalty payments from licensing their intellectual property to the large biopharmaceutical companies that develop drugs, medical devices, and other technology based on that intellectual property. Theoretically, the prospect of regular royalty income could help innovative institutions raise the upfront capital they need to expand labs, buy equipment, and fund their next R&D programs—just like a regular paycheck helps workers get car loans.
But many financiers don’t see small growth companies or institutions as great credit risks. Future royalty streams are hard to predict: checks can shrink when a high-flying drug is suddenly replaced by one even better, or cheaper, and new products can take longer than expected to be developed or approved in the ever-changing and often uncertain landscape of health care.
Over the past decade, however, Capital Royalty has developed 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 Exagen Diagnostics of Albuquerque, NM, reflects the latest evolution of Capital Royalty’s strategy. The firm will lend as much as $25 million to Exagen, which plans to expand the sales force for its test for systemic lupus erythematosus.
On Nov. 18, Capital Royalty announced it had also invested $40 million in Solta Medical, a Hayward, CA-based aesthetic medicine device company that sells devices for skin resurfacing, acne reduction, body contouring, and skin tightening, as well as tools and accessories for liposuction.
Capital Royalty has made most of the investments from its current fund in the form of structured debt, as it did with the Exagen and Solta deals. A structured debt transaction reduces the firm’s investment risk while offering advantages to companies seeking capital.
In this form of transaction, growing companies gain a long-term commitment of capital, but may draw on the money only as needed. This can reduce the amount they end up paying in interest. In some structured debt deals, the loans can be partially repaid with royalty interests or equity stakes in the borrower company, according to a Capital Royalty white paper.
Tate and Duster say Capital Royalty invested in Exagen because of its well-regarded management team and the value of its lead test, Avise SLE+ Connective Tissue. The test is designed to confirm a lupus diagnosis and rule out the possibility that a patient’s symptoms are due to other common diseases of the connective tissue. The test could spare wrongly diagnosed patients a round of treatment costing as much as $30,000, he says.
Exagen’s announcement on the debt deal doesn’t specify an interest rate, and Capital Royalty declined to give details about its returns on investment. The firm’s white paper on structured debt says interest rates typically range from the high single digits to the mid-teens.
Capital Royalty says its structured debt financing is meant to allow borrowers to retain more of the potential value of their companies by avoiding the need to sell shares to raise money while also reducing risk for investors.
“Capital Royalty is the bridge between investors seeking attractive risk-adjusted returns and innovative, life science companies seeking a source of growth capital that is less dilutive than traditional equity or equity-linked alternatives,” Tate says.