Royalty Financing: An Appealing Alternative to Traditional Life Sciences Financing

November 2019

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

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