As in other sectors, private equity funds are playing an increasing role in the financing of biotech and pharmaceutical drug companies. Not only are these financings growing in size and number, but they are also involving greater innovation. One significant innovation that is gaining momentum is royalty financing.

Royalty Financing

Royalty financing is a method of financing research and development projects by selling partial interests in promising, but not yet fully commercialised, products or out-licenses.

Although currently a small number of private equity and hedge funds are providing the capital in these financings, there is a large pool of institutional capital interested in investing in these funds because, unlike typical private equity investments, royalty investing produces non-correlated absolute returns. We have observed a growing number of these institutional investors looking to make direct investments in royalty streams.

These transactions appear in a wide variety of forms in Europe and the United States, but they generally follow one or two basic structures. In nearly all cases, a small public or pre-public pharmaceutical company with limited capital and a very small portfolio of products is looking for capital to fund its research and development. We will call this company “Small Pharma”.

Typically, either one of Small Pharma’s products is the subject of an outlicense with Big Pharma, which will invest or has invested in the expensive operational infrastructure required to distribute and sell the product (the passive case), or the product has not yet been subjected to a meaningful out-license (the synthetic case). In both cases, Small Pharma is close to completing the relevant regulatory processes in order to be able to sell the product in the United States and/or Europe.

The delineating factor between the passive case and the synthetic case is the presence or absence of an existing out-license. This factor will inform both the economic analysis and the IP due diligence effort. The passive case requires a closer analysis of the terms of the out-license. The synthetic case necessitates a balance between maximising the potential achievement of the investor’s target return with incentives sufficient for Small Pharma to feel that it is worth its while.

Intellectual Property Rights

It is axiomatic to say the interest of an investor in Small Pharma depends on Small Pharma’s technological innovation and the efforts it has taken to protect those innovations.

For this reason, Small Pharma’s intellectual property (IP) rights—and more specifically, patent rights—are its core assets and form the center of any royalty investment, whether passive or synthetic.

The key issues in assessing Small Pharma’s IP are the strength and scope of its portfolio, the ownership of its patent rights and its freedom to use the technology without risk of infringing third-party IP rights. Investors should also undertake a careful analysis of the patent claims, as well as the patent’s file history, to assess whether all core technology is covered by a patent or patent application.

Frequently, due diligence reveals gaps in the coverage of the portfolio. The result is that additional applications must be filed. Investors must also investigate whether patent rights have been secured in key territories outside the United States, such as in Europe and Japan, particularly if such rights are necessary for international commercial exploitation (in the synthetic case) or are subject to the out-license (in the passive case). Other issues to be addressed are inventorship and ownership of the patents. Challenges to inventorship or ownership can jeopardise the investment.

An investor should also examine third-party patents in Small Pharma’s technical field to determine that it can operate freely. An assessment must be made as to whether there is any possibility of a patent infringement suit from someone in the field with a blocking patent. If so, licenses must be obtained to salvage the deal.

Portfolio Analysis

A recent change in the patent statutes (35 U.S.C. Section 122), which provides for the publication of pending patent applications after 18 months, will assist an investor in analysing a portfolio.

Previously, an application could remain on file at the US Patent and Trademark Office (USPTO), free from scrutiny, for years. A competitor’s patent rights can now more readily be analysed and a determination made as to whether they will block a company’s entry into the market with a new technology or product.

Of course, an infringement suit can be crippling to Small Pharma, as it is not only time-consuming and expensive, but, worse, there is the possibility of an injunction that will end any future sales of the drug product.

Future Opportunities in Pharmaceutical Investments Royalty investing involves unique due diligence issues. The risk of setbacks in regulatory approval, as well as the patenting process, must be assessed and integrated into the evaluation. One well-known example of the uncertainties of approval is ImClone’s highly touted monoclonal antibody, Erbitux. When the US Federal Drug Administration (FDA) rejected ImClone’s clinical trial plan, the company’s stock plummeted and its partnering deals went into a tailspin.

More recently, the rejection by the USPTO of Genentech’s “Cabilly” patent, covering methods of producing monoclonal antibodies, put hundreds of millions of US dollars in royalty revenues in jeopardy for Genentech and its licensing partners.

A potential obstacle to any lucrative partnership may be the impending threat of biogenerics. Recently, some of the first biologics—blockbusters such as interferon, human growth hormone and insulin—have begun coming off-patent. With a world market for biogenerics estimated at potentially US$5 billion by 2008, these patent expirations create massive opportunities for investors in generics.

But one current hurdle for generics is the absence of any regulatory framework for approval of follow-on biologics because The Hatch-Waxman Act, which provides the mechanism for generic small molecule pharmaceuticals to seek approval for marketing in the United States, currently does not provide for biologics. Lobbyists are pressuring the FDA to allow the generics industry to use an abbreviated regulatory approval process for biogenerics.

Should this change in the near future, generics will likely seek approval to market a number of generic biologics that are presently being manufactured and sold abroad—drugs such as erythropoietin (EPO) and interferon. Should a regulatory structure like Hatch-Waxman be implemented for biologics, challenges to the patents of the innovator companies will likely follow.