High-yielding and uncorrelated: are healthcare royalties the answer for schemes seeking diversified returns? Gill Wadsworth investigates.
Global pharmaceutical revenues are predicted to reach $1.8trn (£1.25trn) by 2018, having surpassed the magic $1trn mark back in 2014.
According to Forbes, the top three pharmaceutical companies Pfizer, Novartis and Merck, held assets of $169.3bn, $125.8bn and $98.3bn respectively in 2015, while the UK’s own GlaxoSmithKline boasted assets of $63.4bn and had a market worth of $114.1bn.
The pharmaceutical industry has long attracted pension fund investment either through stocks, shares and bonds. Now drugs companies are offering an alternative investment for pension funds: royalties.
Increasingly, pharmaceutical companies pay outside organisations such as universities and biotech firms for the right to use their patented drugs rather than use their own in-house research and development.
A healthcare royalty investment involves a fund manager – usually a private equity specialist – taking over the patent deal from the drug company and receiving the income stream instead.
For pension funds this structure has several attractions: the steady supply of income; it lacks a correlation to traditional stocks and bonds; it is relatively long-term in nature; and most importantly, has the potential to offer positive returns. Clarke Futch, managing partner of Health- Care Royalty Partners which specialises in the asset class, says: “Royalties provide pension funds with exposure to a relatively high-yielding asset class that has demonstrated to be non-correlated to broader market or economic cycles.”
He adds: “Royalties are generally derived from pharmaceutical sales, which have grown consistently even during periods of low or negative GDP growth, as well as periods of volatility in the equity and debt markets.”
Royalty cashflow streams for the healthcare sector are influenced by patient populations – and their treatment needs – rather than general market and economic conditions. Consequently they do not move in line with financial markets.
And it’s not just against traditional asset classes that royalty payments behave contrarily; other alternative asset classes are also uncorrelated. Futch says: “Compared to other alternative investments, royalties are also attractive as they are not dependent on an exit event such as a sale or initial public offering.
Rather, royalty payments are often tied to the life of a patent, and are typically paid quarterly up until patent expiration.”
Pension funds are acutely aware of the negative impact of the ageing population, but this improved longevity is also the driving force behind the success of health care royalty payments.
Sam Porat, head of alternative yield strategies at investment manager Neuberger Berman, says: “As western populations have been ageing and older people consume more healthcare, royalties often grow over time. These growing income streams can replace income lost by pension plans due to reduced yields over the past several years.”
ROYALTIES IN ACTION
Two years ago the £15.34bn Strathclyde Pension Fund set up a direct investment portfolio in an effort to reduce volatility against a backdrop of a maturing membership.
Among the more esoteric investments made within the £400m fund was a £15m allocation to Healthcare Royalty Partners, which targets a 12% internal rate of return.
Futch says: “Royalty investing will gain traction among pension funds, particularly as they continue to seek out assets that can deliver non-correlated yield in the current low interest rate environment. The profile of royalty investments, which often represent long-dated assets that provide fairly predictable cash flows, provides a good match for pension funds seeking stable returns to pay out to pensioners.”
The £2bn Cumbria County Council pension fund also chose Healthcare Royalty Partners for its first foray into the market with a £25m investment in 2014. The royalty allocation was part of a major increase in alternative investment by the Cumbrian fund, which almost tripled its investment from 3% of the total fund in 2014 to 11% in 2015.
The handful of pension funds investing in royalties remains limited to the larger end of the spectrum. As is often the case with any pioneering asset class, it is the well-resourced schemes able to test the water, and then as demand increases so the opportunity grows for their medium sized counterparts to join the fray.
Lynda Whitney, partner at consultant Aon Hewitt, says as pension funds become aware of the compatibility of royalties funds with their own investment objectives they should grow in popularity. Whitney adds: “We have seen people looking more widely for those sorts of sources of regular income streams.
“It is certainly something you can see has the right characteristics and be of interest potentially. The lack of investment so far may be an issue of scale or packaging, but it has a number of interesting attributes.”
Providers, too, anticipate an increase in royalty investment. Neuberger Berman’s head of UK institutional Ed Jones, says as pension funds become more sophisticated – either by bringing more investment expertise in-house or working with specialist advisers – he is seeing and anticipating further interest in royalty-based strategies.
So far those offering investment in healthcare royalties have been almost entirely specialist investors. Futch says the complexity involved in assessing the drug risks and structuring the securities, means only firms with the necessary healthcare expertise and with established private equity vehicles focused on these types of opportunities can hope to take part.
However, there is a growing interest from more traditional fund managers in including royalties in their alternative investment funds.
Mike Brooks, co-manager of the Aberdeen Diversified Growth Fund at Aberdeen Asset Management, says he does not have any exposure to healthcare royalties in the current portfolio, but is assessing the asset class for potential investment. Brooks says: “One of the attractive features of the asset class is the potential diversification benefits. Given the potential for returns that are consistent with our approach of investing multiple unrelated areas offering attractive risk-return dynamics, healthcare royalties could be an interesting asset class to add to sit alongside existing alternative investments in aircraft leasing, litigation finance and peer-to-peer lending.”