IP-backed securitisation: realising the potential
Nigel Jones and Ann Hoe
“A goldmine”, “a real source of potential”, “an adolescent about to enter adulthood”, “our next big new asset class for structured financing deals” – just a few of the optimistic terms used to describe the future of IP-backed securitisation in recent years. Governments in a number of key markets (eg, Luxembourg, Spain and Japan) have changed their laws to make it possible, or easier, for these deals to be done. Yet the potential has not been realised. This chapter considers why that might be and identifies the areas in which the potential is most likely to be realised in the future.
Why is it a hot topic?
IP assets are increasingly being recognised as key business assets. Their management, including to fund business activities, is now said to be “a pillar of corporate strategy”. In addition, there is an increasing desire on the part of most IP owners to turn them from being a cost to a profit centre.
Figures quoted to support this thesis are impressive. Ninety per cent of worldwide corporate net worth can be attributed to intangibles and intellectual property. The total asset value of patents alone is about US$1 trillion, with the value of total global intellectual property estimated to be between US$4 trillion and US$7 trillion. IP licensing revenue worldwide is expected to exceed US$500 million (compared with an estimated US$18 million for 1990) - IBM alone receives between US$1.5 billion and US$2 billion in annual licensing revenue. In addition, recent changes in accounting standards mean that increasingly companies have to carry out regular valuations of their IP assets, which obviously increases their visibility. Therefore, there is clearly no lack of encouragement for companies and their financial advisers to use these key assets in their financing.
Securitisation and its benefits
Securitisation is one way in which the originator (usually a company, but in some cases an individual) can raise finance. Securitisation can be defined as “a device of structuring financing where an entity seeks to pool together its interests in identifiable cashflows over time, transfer the same to investors either with or without the support of further collateral, and thereby achieve the purpose of financing”.
Therefore, a fundamental requirement is that there be an asset or asset pool that generates a cashflow, and ideally a regular and predictable cashflow. It is this cashflow that forms the basis of the securitisation loan or the asset-backed security (ABS). Essentially the originator sells a stream of cashflows that would otherwise accrue to it. Typically, and put simply, the originator sells its rights in the cashflow-generating asset(s) to a bankruptcy-remote special purpose vehicle company (SPV) in return for a lump-sum payment. The SPV funds the purchase of the assets by issuing the ABS debt to investors. The SPV then repays the ABS debt to the investors with the cashflows generated by the asset(s).
Securitisation has the following advantages:
• immediate cash;
• more cash available;
• higher rating/cheaper finance;
• broader class of investor; and
• improved debt/equity ratio - surplus cash is passed back to the originator as profit.
Underlying assets typical in ABS transactions are those which generate stable and predictable income streams (eg, real estate, mortgage portfolios and aircraft leases). However, in recent years the ABS asset class has widened and investors have shown increasing interest in intellectual property as an asset class for this purpose.
Basics of IP assets and how they can be securitised
The term ‘intellectual property’ refers to a set of rights conferred through statute or common law. These rights vest in the creators of original concepts, brands, products and inventions and, broadly speaking, allow the IP creator to prevent others from using the intellectual property outright or taking substantial parts of it. The main sets of IP rights that lend themselves to IP securitisation are patents, copyright and trademarks. It is useful to examine each of these rights to illustrate how they can generate cashflows.
A patent is a monopoly right that enables the proprietor to prevent others from using the technology developed by it without its licence. A patent lasts for a fixed period (20 years). Therefore, by licensing third parties to use the underlying technology of the patent, the proprietor can generate regular cashflows in the form of royalty payments. Patents with several years of proven licensing revenues or patents relating to technologies that form part of industry standards will provide good opportunities for ABS investors.
Copyright arises automatically in original literary, musical and artistic works that are recorded. Such works include computer software, music, books and films. The copyright enables the proprietor to prevent third parties from copying the copyright works for a period of 50 or 70 years after the death of the author. Those which show stable cashflow generation will be particularly attractive to ABS investors.
Trademark protection can be granted in respect of anything that can be represented graphically (eg, brands, colours, shapes). A trademark owner has the exclusive right to use its trademark in relation to the products and services for which the trademark is registered and it can prevent others from using it. Trademarks last indefinitely (subject to the payment of renewal fees and continued use). Brands that prove their popularity over extended periods of time will be particularly attractive to ABS investors.
What’s blocking access to the goldmine?
Although IP assets are capable of generating large cashflows, using them as the basis for ABS structures is not straightforward. The difficulties have sometimes been exaggerated and the fact that many in the securitisation field are relatively unfamiliar with IP rights has not helped. Most people involved in this type of financing will have their own mortgage or tenancy agreement, and will understand at least the basic features of the assets that have historically been used for this type of financing structure. In contrast, very few will have ever seen, let alone be the owner of, an IP right. Therefore, fear of the unknown is clearly a factor here, and one which this chapter seeks to address. However, there are a number of issues which are peculiar to IP assets that need to be understood and addressed before embarking on this type of deal, including the following:
• Valuation – the intangible nature of IP assets makes accurate and reliable valuation difficult. In particular, valuation linked to the cashflow generation potential of the asset is notoriously difficult; especially as events beyond the control of the originator may affect the level of cashflow. However, methods of modelling predicted cashflows are becoming more sophisticated and reliable.
• Jurisdictional differences – IP assets are predominantly national rights, subject to the jurisdiction of the territory to which they relate. There is no uniform worldwide patent, copyright or trademark law. If the IP assets to be owned by an SPV are from a number of jurisdictions, the due diligence process will require legal expertise in all the jurisdictions concerned, which can significantly increase the overall cost of the transaction.
• Extensive due diligence – due diligence costs associated with IP rights can be high. Assessing the validity of patents and proving title to copyright, for example, can require costly expert legal evaluation.
• High administration costs – in order to maintain the value of IP assets it may be necessary to pay: legal fees to enforce the SPV’s right to prevent unlicensed use of the IP assets by third parties; legal fees to defend validity/ownership challenges in respect of the IP assets; administrators to ensure that renewal fees in respect of patents and trademarks are paid prior to registry deadlines to avoid inadvertent lapse; and renewal fees themselves.
• Unpredictable cashflow – the SPV may be due to pay back a debt instalment at a time when the cashflows generated by the IP assets are insufficient or, worse, when the IP assets actually produce a loss. However, default on the ABS in these circumstances can be avoided by using credit enhancement techniques such as over-collateralisation (see the Chrysalis deal below), third-party guarantees and insurance policies.
• Obsolescence – with regard to patents, a previously successful patent may be superseded by a subsequent technology, thereby dramatically reducing its cash-generating capacity.
• Fashion – cashflows generated by trademarks and copyright are subject to swings in fashion. A particular brand/product/artist/author/performer can become unfashionable in a fairly short space of time. The effect of bad publicity can be potentially devastating to the cashflow-generating potential of such IP assets. No one will need reminding of the potential for product liability litigation to reduce the value of IP rights dramatically (eg, Merck/Vioxx).
• Link to originator business – given that the assets are closely linked to their business and the originator is likely to want to carry on exploiting the IP assets underlying the ABS, it may be difficult to achieve the bankruptcy remoteness that ABS rely on. In addition, brands have little value independent of their associated business. The value of brands in a liquidated company (and their ability to generate cashflow) is likely to diminish or vanish.
• IP litigation risk – the sole cashflow-generating aspect of IP assets is in the proprietor’s right to prevent third parties from using them without a licence. If a third party successfully challenges the validity (regarding patents or trademarks), subsistence or ownership (regarding copyright) of an IP asset, the SPV will no longer have this right and the IP asset’s cashflow generation potential is reduced to zero. Due diligence and effective protection techniques should ameliorate this risk.
The key to overcoming many of these issues is to ensure diversity of the portfolio being transferred to the SPV. Failure to address this issue has been the cause of some of the failures in the past, and the fact that the reports of those failures have not always explained their cause may have dampened enthusiasm unjustifiably.
Where are the richest seams?
The film industry has taken to IP securitisation with considerable enthusiasm and is responsible for the greatest proportion (by value) of IP securitisations carried out to date.
In 2002 DreamWorks used US$1 billion raised from the securitisation of copyright in a film portfolio to refinance outstanding credit facilities. Moody’s assigned the securitisation SPV an AAA rating. In 2004 Paramount raised US$210 million on the back of film royalties for films that were not yet in existence. The films were to be produced or acquired by Paramount over a three-year period. Moody’s assigned a Baa2 rating to this transaction. In September 2006 Marvel Enterprises completed a US$525 million non-recourse debt facility to finance its production of up to 10 films based on its comic book characters (including Captain America, Nick Fury and The Avengers). Paramount was again involved as the future distributor of the films. The SPV was a Marvel subsidiary. It pledged the theatrical film rights to the characters as collateral for the loan. The deal was backed by Ambac and was AAA rated.
The willingness of investors and rating agencies to back deals based on IP assets that do not yet exist shows how much interest there is in such financing arrangements in the film industry and the considerable potential for future deals in this industry sector.
The music industry has also discovered IP securitisation and is responsible for the greatest number of IP securitisations. It is also responsible for the most famous IP securitisation, the Bowie bond. Based on part of David Bowie’s back catalogue, the bond was launched in 1997 and raised US$55 million. Moody’s gave it an AAA rating. Since then a number of artists have released copycat bonds.
The disappointing performance of the Bowie bond did not deter Chrysalis from raising £60 million from the groundbreaking securitisation of its international music catalogue in 2001. This deal was over-collateralised to a significant extent, since this figure represented a mere 40 per cent of the estimated current value of the catalogue. It was the largest ever music royalties deal, including over 35,000 copyrights from hundreds of songwriters in different jurisdictions, and was the first securitisation by a music publisher rather than an individual artist.
The global slump in music publishing sales and the prevalence of peer-to-peer music-sharing sites on the Internet have put music copyright-backed securitisations in danger. However, the recent crackdown on these sites and the increasing popularity of legal music download sites such as iTunes seem likely to re-establish the attractiveness of this form of ABS.
Broadcasting rights deals are particularly important for individual sports teams and, perhaps more importantly, the governing bodies of individual sports, and there have been a number of examples of IP securitisations in this area. Examples include the securitisation of future licensing revenues from a portfolio of Formula 1 Grand Prix contracts, which formed the basis of a US$1.4 billon securitisation in 1999; and the €94 million securitisation of football sponsorship, advertising, trademark licence agreements and television rights licence agreements by Parma AC in 2002.
The proven track record of steady, predictable income from this type of transaction suggests that this could also be a source of future cashflow using the IP securitisation model.
The pharmaceutical sector offers perhaps the greatest potential for growth in this type of financing, but only where the circumstances are right. The development of new drugs involves massive research and development costs for pharmaceutical companies. One way in which these costs may be recouped is by licensing, which has been proven to work and, in appropriate situations, should prove attractive in the future. However, so far examples of such financing are limited. They include Royalty Pharma AG’s 2003 AAA-rated securitisation of the licence revenue it received from a portfolio of 13 different drugs, each with historically strong sales, which raised US$225 million, and Drug Royalty Corporation’s issue of single A-rated notes backed by pharmaceutical patent royalties in March 2006, which raised US$42 million.
The potential here is obviously huge. However, the demand will be limited among the largest pharmaceutical companies and is more likely to be attractive to smaller companies in the sector, whose IP rights would probably need to be aggregated in order to generate sufficient volume and diversity. A range of models are actively being considered by players in the field, based on both early-stage and mature products, and further deals seem likely in the not too distant future.
Income from many mature brands meets the key securitisation criteria of being proven, steady and predictable. Examples of deals based on such trademark rights include:
• Calvin Klein’s US$58 million securitisation in 1993, which was linked to future sales of its perfume products;
• Guess?’s US$75 million deal based on securitising its domestic and international trademark licences; and
• Athlete’s Foot’s raising of between US$30 million and US$40 million from securitising its franchise resources.
There are of course risks linked to fashions and reputations, but with appropriate modelling and a suitably diverse portfolio it seems unlikely that these issues will prevent such deals being executed in future.
IP-backed securitisations present unique challenges as compared to securitisations based on more established asset classes. However, past successes have shown that no challenge is insurmountable and, with increased experience in dealing with IP rights, the consequently greater familiarity with them and how best to structure deals on which they are based, the challenges should become easier to meet in future. Combined with the substantial value of IP assets on company balance sheets and the increased awareness of their true value, these developments suggest that the deal flow for IP-based securitisations is likely to become stronger in the coming years.