Specialist alternative income fund BioPharma is one of my core holdings within my portfolio. I like the fact that it boasts a steady income and is also (hopefully) a relatively uncorrelated asset class. The central underlying idea seems opportune – an alternative source of funding for drug companies based on the income generated by their more mature products. I’ve appended my long analysis of the fund from earlier this year below.
The fund IPO’d in March 2017, raising gross cash proceeds of $423.3m – in addition, $338.6m of shares were issued to acquire a seed portfolio, representing gross proceeds at launch of $761.9m. The company is targeting a yield of 7% pa on the IPO price of $1.00 per share, with a target of 4 cents in the first year. The fund is targeting a net total return of 8-9% pa over the medium term.
For the first few months of the fund’s existence, the news was relatively sparse, but given recent developments, it now seems that the managers were just very busy with a whole bunch of deals. Yesterday brought two announcements. According to Numis the first announcement is that the fund is increasing its already ample firepower by considering an issue for “ up to 20% of the share capital (c.152m shares) prior to the end of January 2018. On pricing, it states that it will be at “a price not less than the most recently published NAV per share plus a premium to cover the costs of the issue”. It notes that “any placing is likely to include participation by some cornerstone investors”.
This fundraising coincides with another new deal – the third in a few weeks. The fund recently advanced a seven-year term loan to Tesaro (Libor +8% on the first tranche), secured by US rights to Zejula and Varubi. The other deal was with Lexicon, which consists of a loan with interest rate of 9.0% secured by substantially all of Lexicon’s assets, including its rights to Xermelo and sotagliflozin. The latest deal consists of a funding line of between $140m-$160m to acquire a 50% interest in a stream of payments linked to tiered worldwide sales of Onglyza and Farziga, diabetes agents marketed by AstraZeneca. Payments will be received from 2020 through to 2025, based on product sales during 2018-2020. BioPharma Credit is acquiring the 50% interest in the stream of payments from a wholly-owned subsidiary of Royalty Pharma Investments, an affiliate of the investment manager, which acquired the stream of payments from Bristol Myers Squibb on 14 November 2017. According to Numis 2 the manager expects to generate high single-digit annual returns from the investment.”
The need for cash is increasingly obvious – these three deals forces the manager to raise some cash fairly quickly. Numis reckons that the fund now has cash of “£162.1m (21.4% of net assets), with commitments of up to $359.5m (46.2% of net assets). “
The closing price on Friday was $1.074, which looks a bit pricey given that it represents a 8.2% premium to the NAV of $0.9924 at 31 October. But I wouldn’t under estimate the constant demand for uncorrelated, alternative sources of income, especially those secured on relatively stable income streams.
Here’s my longer original note on BioPharma.
Many investor’s have got used to the idea of alternative forms of funding, but most won’t have encountered royalties financing. This funding mechanism has been around for an age and it’s simple in design. Imagine that I have an asset which produces a regular income. I could borrow money via a term loan where the bank has recourse on my overall business to fund business development. But if I miss the payments, the bank grabs my business.
An alternative, widely used in the mining space, is to borrow money against the security of an underlying product – or mine in the case of the resources sector. The lender secures their money against a stream of future revenues from the project. The risk is that the underlying product or asset won’t produce the necessary cashflows. If they do, an agreed percentage of the cash is assigned to the lender in lieu of interest.
Royalties work for different types of businesses, in different sectors, and at different stages in the development of a product. In mining they can work early on in development, when the project is struggling to sell any actual stuff stuff out of the ground – the cash is used to fund development and is then repaid later. Massive mining giant Glencore for instance has been happy to buy and sell royalties to its assets.
In other sectors by contrast royalties work with more mature products, late in the product development cycle. In the pharmaceutical sector for instance many drug business have products that generate lots of cash but are probably slowly approaching the peak in their earnings potential – and the business needs to free up cash for new products.
Overall we believe that royalties are a good idea, and a fantastic source of income diversification for investors. They can give you high yields, and if chosen correctly they are also backed by real, cash producing assets. They are not risk free but the high yields mostly compensate for the extra risk – all royalty lenders make sure they understand the cashflow profile of the businesses they lend money to.
We especially like royalty producing income within the pharmaceutical industry. This is a mature, well run global sector, where demand for key drugs is relatively predictable over the long term. Overall, globally, it’s a large and growing market worth US$1.1 trillion and growing at c.6& annually, for all the reasons (aging society) that our readers will well understand. In terms of intellectual property the pharma industry’s revenue is supported by long product life cycles – many of the bigger players boast bulging portfolios full of patent protected products with as long as 12 to 15 years or more of commercial exclusivity. But strong intellectual property (IP) needs investment in research and development – forcing the majors to fund this spending from alternative sources. Crucially we’re also seeing a rapidly evolving business model. There’s been an obvious fragmentation of the industry which has increased the number of creditworthy counterparties – as one major player in this space observes the “dramatic growth in the number of smaller biotech companies has created counterparties with a much higher cost of capital”.
Last but by no means least the pharma sector also offers the hope of low correlation with the business cycle. Demand for pain killers for instance does vary over time but by and large the need for pain killers doesn’t move violently up or down based on the prevailing direction of the business cycle. In the jargon of investing, these drug royalties offer low correlations compared with mainstream equities.
Enter a new fund listed on the London stock market called BioPharma Credit which has just raised gross cash proceeds of $423m at its IPO a few weeks back. In addition, $338.6m of shares will be issued to acquire a seed portfolio, taking total gross proceeds are $761.9m. The cash proceeds include $373.3m via the placing and $50m from additional subscriptions.
The fund aims to pay out a dividend of around 7% per annum from next year and you can find out more about it via its new website which is still a little sparse but at www.bpcruk.com. The fund’s ticker is BPCR and its shares are currently trading at around $1.02 a share – the listing currency is dollars which introduces an obvious risk with future FX volatility.
The fund will be managed by Pharmakon Advisors, based in New York, which according to analysts at Numis, has invested over US$1.3bn in life sciences debt since its inception in 2009. The lead manager will be a certain Pedro Gonzalez de Cosio, a Principal and co-founder of Pharmakon. The Investment Manager will also draw on the expertise of Royalty Pharma, a New York based investor in Pharma royalties since 1996. According to Numis the “ fund will invest in a portfolio of debt and royalty assets issued by life sciences companies or secured on life sciences assets (typically in the US, Europe and Japan). What do these assets look like ? Biopharma says there will be an initial seed portfolio with a value of $338.6m comprising:
- a note issued by RPS BioPharma Investments LP that is secured by royalties on 21 pharmaceutical products (12% coupon), with a value of $185.1m; and
- a portfolio of five loans to pharmaceutical and medical device companies originated by BioPharma Secured Investments III Partners, LP (with a blended gross rate of return of c.11.4%), valued at $153.5m.
The table below, again from the fund’s managers details the different kinds of underlying assets. The range of structures introduces an important point – this fund is complex with lots of different moving parts (notes, tranches, unsecured debt). A brief look through the prospectus reveals that the key assets have to be placed into tax efficient structures, some offshore, which means that this is NOT an investment for those who are allergic to financial engineering.
|’’Debt Assets’’ within the fund will typically comprise:
* Royalty Debt Instruments : Debt issued by a Royalty Owner where the Royalty Owner’s obligations in relation to the Debt are secured as to repayment of principal and/or payment of interest by Royalty Collateral, including the RPS Note.
* Priority Royalty Tranches: Contract with a Borrower that provides the Company with the right to receive payment of all, or a fixed percentage, of the future royalty payments receivable by the Borrower in respect of a Product (or Products) that would otherwise belong to the Borrower up to a fixed monetary amount or a pre-set rate of return, with such royalty payment being secured by Royalty
Collateral in respect of that Product (or Products).
* Senior Secured Debt: Debt issued by a LifeSci Company, which is secured as to repayment of principal and/or payment of interest by a first priority charge over some or all of such LifeSci Company’s assets, which may include: (i) Royalty Collateral; or (ii) other intellectual property and marketing rights to the Products of that LifeSci Company.
* Unsecured Debt: Debt issued by a LifeSci Company which is not secured or is secured by a second lien on assets of the Borrower.
* Credit Linked Notes: Derivative instruments referencing Debt Assets, being a synthetic obligation between the Company and another party where the repayment of principal and/or the payment of interest is based on the performance of the obligations under the underlying Debt Assets
The next table below is also from the fund’s prospectus and talks about one key business Depomed and a pain relief drug called Nucynta (along with with another drug called Gralise plus three others). The narrative – from the fund itself – takes the investor through the journey of this asset into the portfolio, BioPharma III. We’re not medical experts and we can’t comment on the underlying drugs but the financial story is clear – double digit annual returns with the growing likelihood of early repayment by Depomed (according to BioPharma).
In March 2015, BioPharma III Holdings, LP co-led a US$575 million secured debt facility for Depomed Inc., a publicly traded specialty pharmaceutical company based in California (NASDAQ: DEPO). BioPharma III Holdings, LP committed to a US$200 million investment; US$150 million was funded by BioPharma III Holdings, LP and US$50 million was assigned to co-investors. At the same time Depomed acquired Nucynta, a commercial stage product used to treat severe pain, from Johnson & Johnson for US$1 billion. Under the terms of the transaction, BioPharma III Holdings, LP invested US$150 million in a senior secured loan with a term of seven years, maturing in April 2022. The transaction was expected to generate an IRR (from the date of investment) of approximately 11.8 per cent. with upside in the event of an early repayment. In April 2016, Depomed exercised its right to prepay US$100 million of the US$575 million loan. BioPharma III Holdings, LP received a US$27.4 million payment, which included US$26.1 million in principal and US$1.3 million in additional gains because of the partial early repayment. On 21 February 2017, Depomed publicly disclosed its intention to exercise its right to prepay another $100 million of the remaining debt in April 2017 and an intention to refinance its remaining debt at some point in the future.
In terms of the fund structure itself we like the composition of the board. There will be four independent directors: Jeremy Sillem, Chairman, (managing partner of Spencer House Partners), Duncan Budge (ex. RIT Capital and an experienced investment company director), Colin Bond (CFO of Swiss specialty pharmaceutical company Vifor Pharma), and Harry Hyman (MD of Primary Health Properties). We know of Harry Hyman and Duncan Budge and respect their background greatly – Budge is an experienced fund manager and Hyman has built a great medical assets business in PHP.
Looking to the manager, it’s obviously a specialist in this field with deep expertise of the life sciences and pharmaceutical sector. According to the funds own literature, the investment manager has invested or committed to invest US$1.3 billion in Debt Assets. The fund also says that “None of the Debt Assets previously or currently managed by the Investment Manager are or have previously been judged to be impaired. Of the 21 investments made to date, eight have been fully repaid and all of the remaining loans are current”.
What’s the track record of these previous funds? One fund called BioPharma I made its last distribution to investors in 2014 and realised a Gross IRR of approximately 15 per cent. (Net IRR of 11.2 per cent.). “BioPharma II and III have reached the end of their investment periods and are now returning capital to investors. BioPharma IV is currently in its investment period, and to date has invested approximately US$301 million out of a pproximatelyUS$513 million in commitments”. The fund also quotes a weighted average projected gross return of 13% from the first three funds , 10% net after all fees and expenses. One other big selling point : the fund’s managers are linked to an outfit called Royalty Pharma – “the industry leader in acquiring royalty interests in leading biopharmaceutical products (established in 1996 with total assets of more than US$17 billion)”. Last but by no means least we also like the fact that the investment managers will be putting their own money into the fund. According to the fund, principals of Pharmakon and Royalty Pharma have invested $106.2m, representing 13.9% of share capital.
In terms of fees, the management fee will be 1.0% pa of net assets plus a performance fee of 10% of returns in excess of 6% pa, subject to a high watermark. Additional ongoing expenses of the fund are expected to be an additional 0.59% pa. according to analysts at Numis.
So, why do we think this very specialist fund is worth investing in? The main reason is that suggested income yield. The company has said that it its “target dividend for the first financial year … is 4 per cent. (calculated by reference to the Issue Price) and, once substantially invested, the Company will target an annual dividend yield of 7 per cent….together with a net total return on NAV of 8 to 9 per cent. per annum in the medium term”.
In addition we hope that this stream of income payments won’t be massively impacted by the global business and financial cycle. That might mean that in a possible future downturn, this fund might not crash in value i.e its underlying assets are fairly lowly correlated with the main market. We also think that a putative 7% yield will prove very popular and that because this vehicle is unique – there is no equivalent fund anywhere else available to mainstream investors – it may start to trade at a premium to its underlying assets. We would suggest that a premium of as much as 10% would not be unique for an alternative asset fund with a strong yield.
Obviously there are lots and lots of caveats we’d have to mention. We’ve already observed that the underlying assets are built into a complex structure with lots of financial engineering. The actual drugs in the portfolio will also be subject to their own particular risks, not least increased competition if the product falls out of its patent protection. The industry itself might run into trouble if regulators start to demand lower prices, which could cause problems for royalty lenders. And last but by no means least, this is a listed stock market fund which means that although its underlying assets may not be correlated with the stockmarket, the funds’ shares most certainly are !
Overall though we think this unique, complex fund is worth investing in, banking that 7% yield in 2018 and beyond. The management are experienced and have a good track record and the board looks experienced enough to keep a beady eye on the complex financing that goes on in the back ground.