Ne tere en eee cL ery Viera ceiy ccs? tntetoctuat Asset Management Sentero Oct a IP-backed securitisation: goldmine or hype? Anyone familiar with the IPyvatue conference circuit will by now have heard about intellectual property-backed securitisation. Coming at a time when many companies are facing liquidity squeezes, attention has been focused on the previously untapped value residing in intangible assets and the ways in which these assets can be used to plug into readily available asset-backed debt funding. By Nigel Page According to its fans, IPbacked securtsetion is poises to take off in avery big way. With ‘90% of worldwide corporate net worth now being attioutes to intangibles and intelectual Property (and the total asset value of patents Worldwide estimated to be US$ trilon), the verve with which industry proponents are ‘Seeking to market this apparent goldmine borders on the evangelical. The ongoing liquidity scueezo, inoreased openness to IP ‘commercialisation, and availablity of highy- Specialises financial, legal and tax advisers in {his feid, have converged, they say, creating a ‘unigue nexus of opportunity Certainly, momentum is building and deals ~ ‘eny of them grouna-breaking ~ are Undeniably getting completed aeross a number Of industry sectors. The dearth of liquidity has been a powerful marketing tool, with many ‘companies (especialy those in the mic- ‘macket) apparently eager to grasp the ‘Scountisation funding lifeline. Rather than ‘swallowing the 22% to 30% rates of return \donanded by mezzanine lenders, exoritanty expensive ecuity capital, or combinations of the two, the mysteres of structured financing an I00k like an eminently viable alternative. Understending securitisation By any measure, the assetbacked securitisation (ABS) markt is huge. In its simplest form, asset securitisation means the conversion of assets or cashflow into. ‘Marketable securities (ypicaly rated) called assethacked securities, These are sold 10 investors, and repaid from the cashiiow derived ‘rom a poo! of income praducing assets. And though the end result of securtisation is finoncing, it isnot financing 2s such ~ the Company secutising ts agsets is not 3008 borrowing money. Securitisation has a puter Df sdvantages for issuers. In particular, at the ‘mid-market level, even unrated entities can ‘ssue highiyrated, investment grade secunties, that carry a lower rate of interest than ‘conventional bank nancing The structured market has evolved ‘dramatically since the eariest securtisations of teal estate assets in the US inthe 19708/1980s. as consumer finance companies began to securitise consumer Credit to push up their debt ratings and ‘minimise financing casts. From those. beginnings, structured products nave evoWed {fom being just one more altemative funding Source, to perform otter roles including being ® tool for risk, a source of liquidity, 2 diversified and tallored investment product ‘and a strategic arbitrage platform. According to figures released ty Asset Securitization Feport, asset-backed commercial paper peaked &t US$7540n in 2002, ending O21 2003 at USS 70400, |P-backed securitisation is a relatively recent Phenomenon, The first desis sprang fram the film stucio sectar in the earty 19908 and were based around the futureflow structure already established in the wider ABS market. But ‘widespread attention only began to focus on the potential for tP-backed deals withthe so ‘called Bowie Bond dealin 1997. To date, the total market size remains small. In 1997 there were just US$30m in known [Pbackes securitisation transactions. By 2000 that hod {70m to an estimated USS4.2abn and by the end of 2002 that figure was closer to 'USS25bn, once figures far whole-campany ‘eal were factored in, David Edwards, vce president of ‘securtsetion metketing at Atradus (formerlyaE aera ne a telat) Se All ABS transactions follow a basic structure ‘The issuer transfers the assets to be ‘scoured to a special purpose entity (SPE), sually-@ wholly-owned subsiciary of the Issuing compery. The SPE transfers these assets toa trust, which then issues securities backed by the assets. These securities are sold to investors ether via a private Placement, or an SEC-registered public ‘offering, The asset owner (the issuing ‘company) continues to service the assets, collecting payments from those obliged to ‘make them and placing thefunds in a ‘Segregated account in the trust's name. The ttustee makes interest and prinoipal payments to the bondholders trom thase funds, Because the transaction means removing the securtised assets from their orginal ‘owner, this Isolates from the owner's business risk (bankruptey, for example). This ‘means that ABS securities oan be rated investment grade by rating agencies, qualifying them for a much lower rate of interest than other debt, even where the original asset owner was unrated and ‘therefore unable to access the public and private debt securities markets, ‘The costs of structuring an ABS desl, ‘especialy the first one undertaken ty a ‘company, se usualy higher than arranging ‘bank financing. Buti the deal is large enough, ‘or folowson deals are envisaged, the cost ifference Is reduced. In any event, because of ‘the lower interest rates on its secures, the [ABS deal will genevaly be less costly overal ABS deals are comparatively ‘straightforward where assets with fixed ‘ceshflows are concerned (eg, pools of ‘mortgage or auto loans). However, where trademark ang other IP assets are involved, licence royalties are often tie to the amount ‘of products sold. Therefore IP income often fluctuates and it can be hard to predict with precision what the cashflow will be In two, five, oF 10 years time. However, the rating agencies usually accept adequate historical ‘experience (typically thee to five years) with 8 particular company’s portfolio as being ‘sufficiently reliable data to project future performance. This means that ABS deals cen be used to unlock value In IP assets that Would otherwise remain untapped. “Most securitised assets pay off and tisappear over time but most IP assets (especially trademarks and copyrights) have long lifespan and can even become more Valuable over time. When an IP-backed ABS ‘eal reaches matutty and the secures have been paid off, the assets can therefore be used in enother ABS deal One point to stress where IPhacked deals are concerned Is the matter of detiniton. Quite often, Packed securitisation deals get Confated with whole-business deals which, ‘nile prevalent in the European market, ere problematic structures In the United States Under the horrowerfiendly US bankruptcy legislation. in Europe, and particulary the UK, \ihole-business deals (whore the issuer rants security over his core assets, usually Inthe form of 8 fixed and flesting charge) have flourished until quite recently, ethough the market has now started to coo! of. In the US, however, where the concept of a flaating ‘charge over all assets doos not exst, deal structures tend to be much more asset- Specific and for the purposes of this article, attention Is focused on doals where IP assets are the primary focus. ‘ith thanks to Andrew Kate, partner m the Los Angeles office of Mitchell Sibererg & ‘Koupo, ‘Financial alchemy turns intelectual ronerty into cash: seeuntzation of trademarks, ‘onyights and other intellectual property” Gerting NOM, the credit insurance and trade receivables menagement compary in which Deutsche Bank and Swiss Re are the primary shareholders) expiains thatthe vast majority of Issuance by collar volume has occurred in the flim industry, folowed by musie although by transaction number there have been far more In the music industry. "Fim catalogues represent large, precletable assets with clearly defined historical cashflows and relatively tle variance," says Edwards. Similar, he explains, futurefiow transactions backed by film Catalogues tend to show less voiatity as the ‘im industry has followed the same pattern for any yoars where @ few blockbusters (perhaps 5% of the total releases) finance the rest of the releases. “This allornothing type of ‘economics exhibits the same log normal distbution thet call options and technology do clustering around zero, vast mat of ite value, and a small percentage wit high payoff. ‘The few hits pay forthe many flops and the catalogues behave lke a portfolio of assets whose diversification smooths the voiatity of revenues,” Edwards says. Nick Gournas of Ambac Assurance (a provider of financial guarantees to these deals) agrees. with Edwards thet fim financing deals ore essentially extensions of futureow ‘transactions, demanding the same cashiiow modeling. However, the greater focus on IP means focusing on more techrical elements, ‘and that means a higher standard of dligence is Tequired. Fortis reason, he exalain, these deals are expensive and hard to justi to issuers looking to raise much less than US$100m from the transaction. For Goumas, a8 {or many others interviewed while researching this article, drug royalty deals represent areal ‘Source of potential. “There's defintely ‘something happening there and these deals could begin to make sense, even to companies that already have accoss to capital but Nevertheless want to realise value for their IP portfolios,” Goumas says. However, he warns that technical issues romain - other patents may be needed before value can be realised, for ‘exemple, “On top of that there are what we call Clif risks - notably whether given drug causes side effects and has to be withdrawn from the marketplace, and whether a competing drug ‘comes onto the market. And then there are unforeseeable legisatve risks,” Goumas explains. “While challenging, we have seen transactions in the space and there are those that have successful conclusions. On others, there may be some way to go yeti the probability of success is high factspecific,” he adds Wall Street hangs back, unt! now With @ few exceptions, the predominantly mid market focus of these deals to date has, unt uite recently, place them oftiimits for many cof the big Wall Sueet houses, Bear Steams ‘and Morgan Stanley have both bucked the trend the former advising on one of the headline DreamWorks deals, as well as two sports facilty financings, and the latter ‘dvising on the Arby's franchise Teebackee eal completed with Swiss Re New Markets ‘and Ambac in November 2000), and CSFB and JP Morgan have also featured strongly in ‘Some of the more interesting headline deals ee Intellectual Asset Management Sopimiber/October 2008 24(for instance, CSFB, led by Rob Horowitz, structured and underwrote this summer's Royalty Pharma Finance Trust deal) ‘There are also indications that other Bulge Bracket institutions are keen to get in on the act as antennae pick up the billondolar status of Fecont fm receivables transactions, Certainty JP ‘Morgan, FeetBoston and Bank of America have all been involved in these deals, and Merl {Lyne hit the trade headines this summer wth the news that ithed hired Peter Hoffman (formery with FeetBoston Financial Corp) to bolster its IPbacked seourtsaton capably Ira Wegner at Bear Stearns is a recognised ‘authority on this sector and, for him, there Is definitely opportunity in the market ~ although he remains concerned by the damaging effects of hype on Issuer expectations, “We've looked at a number of deals, some in the ‘entertainment area, and some in the pharma royalty area. Inthe latter area, we think that deals Involving pools of royalties ~ rather than single companies ~ could be the way this develops. Cortainly iis unikely forthe: ‘moment thatthe big drug companies would do cone of these deals on a standslone basis, as it could bo more expensive for them than raising thet own debt ~ and for the smaller ‘companies, it could stil be hard to get a rating,” he says, Asked to highlight what he watches out for Ina potential deal, Wagner points to long ‘te1m, contractually obligated and relatively stable revenue streams. Dave Moran from Partner Re, the reinsurance group which is @ Fisk taker in a number of transsetlons in this ‘Space including the Guess? deal handled by JP Morgan Securities earlier this year, shares this outlook. "We try to identity risks that we ‘ean understand and that usually means efining a finite set of risk crivers. We look for cashfiows that are clearly attbutabe to the assets because this makes it easier for us to measure what can go wrong. We also look to have a general agreement of the economies ‘and deal sizing from early on ~ which is critical {8 these deals take @ longtime to Work out (oetmeen three to nine months on average), he says. Concerns, Moran explains, stem from IP assets for which the cashflows lack a sufficient history, assets that are yet to Produce a cashflow steam, end cashfiows ith high levels of volatility without a correspondingly appropriate level of subordination. Wagner bemoans the unrealistic expectations that market hype has heaped on this sector. “We've pitched businesses where We say diverse assets could perhaps raise US$25m, only to have someone else pitch in ‘saying the assets could raise US$35m. That IP-backed securitisation One of the more interesting deals of 2002 was ‘the DreamWorks deal fim ibrary/uture fl ‘secutisation, rated by Moody's. The ttensacton was sponsored by DreamWorks LLC (OreamWonks) and backed by a portfolio of Ive fection and animated films produced or 2 produced by DreamWorks. The USS:ibn facility (structured by JP Morgan Securities and Feet Secures inc) was, shadowrated investment grace, had a fnencial uerentee policy issued by Ambac, and was ‘syndicated toa group of asset backed ‘commercial paper condults. It functions as a ‘evolving faciity through which the issuer, DW Funding LLC can borrow, pay down, and re borrow amounts on a revolving basis. The 37 {llms included inthe facity consisted of 2002 releases including Minority Report and Road to Perdition, 2s well as older releases inclusing ‘American Beauty, Gladiator and A Becutital Mind. Unie earlier DreamWorks securltisations, DW Funding was structured to emave fim production risk, and to reduce the {eciliy’s exposure to flm performance rik. This was accomplished by seling eligible fms Into the fecity eight weeks ater thee domestic ‘theatrical release. ‘Moody's also rated Vivend! Universal Entertainment's (VUE) securitisation facty, Universal Fm Funding LLC in Apt this year kind of tak stil derals too many deals,” he says, Pete Walsh is co-head of origination and structuring in Haris Nesbitt Corp's US securitisation group; he agrees with Wagner about the hype. "We're seeing some actvty but piracy has been a big issue, as well as the litigation risk surrounding patent enforcement ‘and exploitation and excess hype in the music sector,” he says. For Walsh, deals in the USS75m to $US100m range are principal targets. “ight now, we see real promise in Intesnationalflm assets and drug royalties, 98 well as, o a degree, some of the US Universities, which sit on a lot of assets anc ‘could face some funding problems themselves,” he says. Walsh, who has done deals in sports, musle and movies to date, ey that for his team there is no general rule for what makes these deals work. “They are all very asset and seller-specifi. Ifthe ‘transaction is simply about collecting cheques from revenue streams, then there will be limited financial isk involved, But If there's an ‘executory element, we take & much closer look,” he explains. If brands are involved, in (essignng ta Aaa rating), once again with a ‘nancial guarantee pole issued by Amb. Uke the Dreemorks deal, this fect is backed by @ portoio of fms (his time recuced or co produced by Universal City Stucios Productions, itself ayned by Vvend). ‘The inital 124 fms that are included inthe facility consist of flms released ater 1995, The feclty is intended to refinance a fin rary and finance, on an ongoing bass, anticipated gross receipts in distbution ‘windows associated with newlycompleted fms Produced, coproduced or acquired by Universal Like the DW Funding deal, eligible fs are sold ito the facility eight weeks after their domestic theatrical release. By reviewing historical data and VUE's projection medel, Moody's determined that at this point in a fm’ release ils possible to work out wth @ relatively high level of certainty, the utmate level of revenues it wil generate thvough its compete frst ojo. The amount VUE can withdraw from the facility for each fm is based on a percentage ofthis ultimate revenue Projection. The facility was syndicated to 3 _0Up of asset backed commercial paper ‘conduits by JP Morgan Securtles and Bank of ‘America Seourtis. Seuce Nt’ nectars Sais 122 Intellectual Asset Management Septeribor/October 2003Fetal for example, he adds, his tgam takes a very close look to see if damage could be done to the value by anything causing brand deterioration ‘Although Walsh looks forward to larger deals coming through from the drug royalty Sector in particular, he does not expect any ‘al specialisation in Wail Street just yet “The {economics ofthe financial matket over the, fast couple of years have made people quite leery of specialisation,” he says, Specialist business, Wil Set aside, in the main, the malorty of the deals so fer have been underwritten by three boutique finance fms: UCC Capital Corp (formerly CAK Universal Capital Cor), the Pulinan Group (architects of the landmarc ‘owe Bond deal) and Royalty Pharma AG which ‘completed the first patent royalty socurtsation With Yale University’s USS145m BioPharma Royalty rust del, founded on the patent and licensing agreement between the univeraty and Bastot Myers Squibb for te Zerit drug Robert D'Loren, president and CEO of UCC Capital, explains wiy he believes so much Dotental exists in IPrelated deals, “Commercial banks are stil lending based on {an oldfashioned supply-chain madel, Our view 's that, in the next economy, those supply. Chain models wil not survive. The new model for the next economy isa ValueNlet made! where preduction will be outsourced to the lowiestcost common denominator.” he say, ‘What that means, D'Loren explains, is thet a company’s value revolves around ite brand ‘and its ability market, merchandise and establish new production and distribution Cchannols “and that's what we are designed to finance,” he says, UCC Capital has been a pioneer in this field, Early on it advised on whole-company securtsations for TVF Records and Performing rights orgenisation SESAC, as well {88 putting together the Bill Blass bond issue, where US$25m was monetized by the royalty stream generated by the late designer's label ‘The acquisition of that business was financed Principally by the sale of US$25m in asset backed securities with UCC Capital lending ‘money to the new business owners, Blase” largest licensee, Haresh Tharani and Blass CFO, Michael Grovernan. Rated BBB+ by Fitch, the bonds are settiquidsting and due te be paid off in 2009, Since then, UCC Capital has gone on to ‘advise on a numberof ther IPbacked Securitisation, including the USS30m Gloria Vanderit bond dealin 2004. tacked by the company’s earnings from trademarks and licensing agreements); the US$20m bond deal for Candies inc completed in 2002 (ated Baad by Moody’s investors Service): and the July 2003 deal forthe Athlete's Foot, with tongerm ‘redrate bonds (rated 8/aa3 by Moody's) backed by franchise revenues and privately lated. UCC Capital also announced last year ‘that, using copital from a General Electic unit, ‘Rhoped to make as much as US$500m in loans to companies wiling to put their regular income from patents (o from the licensing of fashion logos) up as colateral - UCC Captal, wil hen bundle those loan into bonds for sale on Wall Street. For Loren, the consolidation in lnvestment banks and finance companies has ested a gap in the market for an improved lending model which he hopes to exploit, ‘The tine between securitisation and financing) Specialist niche IP finance firms currently {crowd the IP monetisatian space, some ot them focused on securitisation, others on IP Collateralsed loans, and iti ittle surprise that many companies find thernselves unable 'o differentiate between each type of actviy, AAS a matter of definition, secuttsation Is one Foute for iP monetisation, and using IP as Collateral for loans is another. Keith Berget is Senior VP of intellectual Broperty for the newh-aunched niche frm IP |nnovations Financial Services, which provides financial institutions with 100% fnanelal ‘uarantoes for P-backed loans (and has Secured USS25M in financial capital support from Principal Fiencia! Group to facitate these transactions). He is convinced that the {ime is right for this actity, and that it helps fill a space for tP-monetisation alongside ‘ecurtsation. "There is incceasing, socialisation around this area in ‘organisations, with a palpable shit over the last eight years as CFOs, CTOs and heads of IP have actually come together to invest in ‘and monetise IP. This is creating a ink ‘between R&D, IP end monetisation,”" he says, Berget,formery general manager of Strategic intellectual asset management and rector of corporate strategy for Motorola, ‘and more recently senior VP of strategy, business development and licensing for Cambridge Display Technology, argues that because each IP-backed loan comes with IP's 100% financial guarantee, al risk of defauit essentially eliminated, so‘allowing lenders to leverage ther existing infrastructure and Increase earnings without taking on any. economic risk, He estimates that a lender with 2 Portfolio of 10,000 iPcentre clients (Le.. Companies that maintain significant IP holdings) has the opportunity to book an ‘dationa! US$40 lion in loans during the fist year of IP's programme, generating ovor Intellectual Asset Management Sestember/Octaber 2003 23