A useful income from drugs

An interesting alternative investment idea for those seeking income is to invest in royalty-based funds. Royalties are used by many businesses at different stages, but a particularly attractive area – and one opening up to investors – is in the pharmaceutical sector. Many drug companies have products that generate a lot of cash, but are close to peak earnings potential. Meanwhile, the business needs to free up money to develop new products. So they raise funds for investing in future products, secured against the cashflows from existing products.

This is a mature, well-run sector – the global market is worth $1.1trn and growing at around 6% a year, and demand for key drugs is relatively predictable. Intellectual property (IP) revenue is supported by long product life cycles – many of the bigger players boast bulging portfolios of patent-protected products with 12 to 15 years or more of commercial exclusivity. Meanwhile, the pharmaceutical industry has fragmented, which has also increased the number of creditworthy counterparties an investor might be happy to deal with. As one major player observes, the “dramatic growth in the number of smaller biotech companies has created counterparties with a much higher cost of capital”: they need to offer more in return for funding.

The sector also offers low correlation with the business cycle – 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 – if not zero – correlation with mainstream equities.

The problem has been accessing these royalty payments. Until recently, drug royalty funds were the exclusive preserve of institutional investors. But not now. Earlier this year, a fund called BioPharma Credit (LSE: BPCR) listed on the London stockmarket, raising gross cash proceeds of $423m at its initial public offering. In addition, $338.6m of shares were issued to acquire a seed portfolio, taking total gross proceeds to $761.9m (you can find out more about this at BPCrUK.com). It currently trades on around $1.10 a share, versus net asset value (NAV) of $0.98. Note that it is listed in dollars, which introduces the risk of currency volatility.

The fund is run by New York-based Pharmakon Advisors, which has invested over $1.3bn in life-sciences debt since its inception in 2009. It will invest in a portfolio of debt and royalty assets issued by life-sciences companies or secured on life-sciences assets. The initial seed portfolio is made up of a note issued by RPS BioPharma Investments, which is secured by royalties on 21 pharmaceutical products (paying a 12% coupon), with a value of $185.1m, as well as loans to pharmaceutical and medical device companies.

The management fee is 1% a year, plus a performance fee of 10% of returns in excess of 6% a year, subject to a high watermark. Ongoing expenses are expected to be an extra 0.59% a year, notes Numis. The company is targeting a 4% yield (based on the issue price) and, it says, “once substantially invested, will target an annual dividend yield of 7%… together with a net total return on NAV of 8%-9% per annum”. I’ve invested myself (back at the IPO in April), largely because of its income yield and in the hope that it does provide the aforementioned non-correlated returns over the long run.

Activist watch

Activist investor Elliott Management revealed this week that it owns a 5% stake in a subsidiary of Hitachi. Hitachi Kokusai Electric, which makes semiconductor-manufacturing equipment, has been involved in a disputed takeover attempt by US private-equity group Kohlberg Kravis Roberts. The deal would have seen KKR buy a 48% stake at ¥2,503 a share, valuing the company at more than $2bn. However, a committee representing minority shareholders declined to back the offer, noting that the unit’s share price had hit ¥2,845 in July following “better than expected results”. Elliott highlighted the issue in its disclosure on Monday, saying it is encouraged by the board’s efforts to protect shareholders’ interests.

In the news…

• The Bitcoin Investment Trust might be “the most overvalued investment ever”, says Richard Dyson in The Daily Telegraph. Although the New York-listed trust’s shares trade at around $790 (£599) each, the NAV (the value of the underlying investments, which consist solely of the digital currency itself) per share is $423 – an 87% premium. With most investment trusts, the premium rarely moves above 12%, notes Dyson. More to the point, this trust is designed to track the price of bitcoin, not trade at a huge premium, which rather defeats the purpose of the vehicle.

• The world’s two largest high-yield corporate-bond exchange-traded funds (ETFs) face questions over whether they have delivered the performance they promised, says Chris Flood in the Financial Times. BlackRock’s flagship $18.3bn high-yield ETF has delivered 5.7% a year since its launch in April 2007. However, its performance target – the Markit iBoxx Liquid High Yield Index – returned 6.2% a year. Similarly, State Street’s $12.5bn JNK bond fund has delivered 5.9% a year since November 2007, against 8.1% for its stated benchmark. The underperformance may partly be explained by the fact that fees for bond ETFs tend to be higher than for equity ETFs. Moreover, the US high-yield bond market is simply “too big” for any one ETF to track efficiently, notes Stephen Baines of Kames Capital.

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