Building and enforcing intellectual property value 2006 1

Global
IP-backed securitisation: realising
the potential
Linklaters
Nigel Jones and Ann Hoe
A goldmine, a real source of potential, an
adolescent about to enter adulthood, our next big
new asset class for structured financing deals just
a few of the optimistic terms used to describe the
future of IP-backed securitisation in recent years.
Governments in a number of key markets (eg,
Luxembourg, Spain and Japan) have changed their
laws to make it possible, or easier, for these deals to
be done. Yet the potential has not been realised. This
chapter considers why that might be and identifies
the areas in which the potential is most likely to be
realised in the future.
Why is it a hot topic?
IP assets are increasingly being recognised as key
business assets. Their management, including to fund
business activities, is now said to be a pillar of corporate
strategy. In addition, there is an increasing desire on the
part of most IP owners to turn them from being a cost to
a profit centre.
Figures quoted to support this thesis are impressive.
Ninety per cent of worldwide corporate net worth can
be attributed to intangibles and intellectual property.
The total asset value of patents alone is about US$1
trillion, with the value of total global intellectual
property estimated to be between US$4 trillion and
US$7 trillion. IP licensing revenue worldwide is
expected to exceed US$500 million (compared with an
estimated US$18 million for 1990) - IBM alone
receives between US$1.5 billion and US$2 billion in
annual licensing revenue. In addition, recent changes
in accounting standards mean that increasingly
companies have to carry out regular valuations of their
IP assets, which obviously increases their visibility.
Therefore, there is clearly no lack of encouragement for
companies and their financial advisers to use these key
assets in their financing.
Securitisation and its benefits
Securitisation is one way in which the originator (usually
a company, but in some cases an individual) can raise
finance. Securitisation can be defined as a device of
structuring financing where an entity seeks to pool
together its interests in identifiable cashflows over time,
transfer the same to investors either with or without the
support of further collateral, and thereby achieve the
purpose of financing.
Therefore, a fundamental requirement is that there be
an asset or asset pool that generates a cashflow, and
ideally a regular and predictable cashflow. It is this
cashflow that forms the basis of the securitisation loan or
the asset-backed security (ABS). Essentially the originator
sells a stream of cashflows that would otherwise accrue to
it. Typically, and put simply, the originator sells its rights
in the cashflow generating asset(s) to a bankruptcy-
remote special purpose vehicle company (SPV) in return
for a lump-sum payment. The SPV funds the purchase of
the assets by issuing the ABS debt to investors. The SPV
then repays the ABS debt to the investors with the
cashflows generated by the asset(s).
Securitisation has the following advantages:
immediate cash;
more cash available;
higher rating/cheaper finance;
broader class of investor; and
improved debt/equity ratio - surplus cash is passed
back to the originator as profit.
Underlying assets typical in ABS transactions are
those which generate stable and predictable income
streams (eg, real estate, mortgage portfolios and aircraft
leases). However, in recent years the ABS asset class has
widened and investors have shown increasing interest in
intellectual property as an asset class for this purpose.
Basics of IP assets and how they can be securitised
The term intellectual property refers to a set of rights
conferred through statute or common law. These rights
vest in the creators of original concepts, brands, products
and inventions and, broadly speaking, allow the IP
creator to prevent others from using the intellectual
property outright or taking substantial parts of it. The
main sets of IP rights that lend themselves to IP
securitisation are patents, copyright and trademarks. It is
useful to examine each of these rights to illustrate how
they can generate cash flows.
Patents
A patent is a monopoly right that enables the proprietor
to prevent others from using the technology developed
by it without its licence. A patent lasts for a fixed period
(20 years). Therefore, by licensing third parties to use the
underlying technology of the patent, the proprietor can
generate regular cashflows in the form of royalty
payments. Patents with several years of proven licensing
revenues or patents relating to technologies that form
part of industry standards will provide good
opportunities for ABS investors.
Copyright
Copyright arises automatically in original literary,
musical and artistic works that are recorded. Such works
include computer software, music, books and films. The
copyright enables the proprietor to prevent third parties
from copying the copyright works for a period of 50 or 70
years after the death of the author. Those which show
stable cashflow generation will be particularly attractive
to ABS investors.
Trademarks
Trademark protection can be granted in respect of anything
that can be represented graphically (eg, brands, colours,
shapes). Atrademark owner has the exclusive right to use
its trademark in relation to the products and services for
which the trademark is registered and it can prevent others
from using it. Trademarks last indefinitely (subject to the
payment of renewal fees and continued use). Brands that
prove their popularity over extended periods of time will
be particularly attractive to ABS investors.
Whats blocking access to the goldmine?
Although IP assets are capable of generating large
cashflows, using them as the basis for ABS structures is
not straightforward. The difficulties have sometimes
been exaggerated and the fact that many in the
securitisation field are relatively unfamiliar with IP
rights has not helped. Most people involved in this type
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Global Linklaters
of financing will have their own mortgage or tenancy
agreement, and will understand at least the basic features
of the assets that have historically been used for this type
of financing structure. In contrast, very few will have
ever seen, let alone be the owner of, an IP right.
Therefore, fear of the unknown is clearly a factor here,
and one which this chapter seeks to address. However,
there are a number of issues which are peculiar to IP
assets that need to be understood and addressed before
embarking on this type of deal, including the following:
Valuation the intangible nature of IP assets makes
accurate and reliable valuation difficult. In particular,
valuation linked to the cashflow generation potential of
the asset is notoriously difficult; especially as events
beyond the control of the originator may affect the level
of cashflow. However, methods of modelling predicted
cashflows are becoming more sophisticated and reliable.
Jurisdictional differences IP assets are
predominantly national rights, subject to the
jurisdiction of the territory to which they relate. There
is no uniform worldwide patent, copyright or
trademark law. If the IP assets to be owned by an SPV
are from a number of jurisdictions, the due diligence
process will require legal expertise in all the
jurisdictions concerned, which can significantly
increase the overall cost of the transaction.
Extensive due diligence due diligence costs
associated with IP rights can be high. Assessing the
validity of patents and proving title to copyright, for
example, can require costly expert legal evaluation.
High administration costs in order to maintain the
value of IP assets it may be necessary to pay: legal fees
to enforce the SPVs right to prevent unlicensed use of
the IP assets by third parties; legal fees to defend
validity/ownership challenges in respect of the IP
assets; administrators to ensure that renewal fees in
respect of patents and trademarks are paid prior to
registry deadlines to avoid inadvertent lapse; and
renewal fees themselves.
Unpredictable cashflow the SPV may be due to pay
back a debt instalment at a time when the cashflows
generated by the IP assets are insufficient or, worse,
when the IP assets actually produce a loss. However,
default on the ABS in these circumstances can be
avoided by using credit enhancement techniques
such as over-collateralisation (see the Chrysalis deal
below), third-party guarantees and insurance policies.
Obsolescence with regard to patents, a previously
successful patent may be superseded by a subsequent
technology, thereby dramatically reducing its cash-
generating capacity.
Fashion cashflows generated by trademarks and
copyright are subject to swings in fashion. A
particular brand/product/artist/author/performer
can become unfashionable in a fairly short space of
time. The effect of bad publicity can be potentially
devastating to the cashflow-generating potential of
such IP assets. No-one will need reminding of the
potential for product liability litigation to reduce the
value of IP rights dramatically (eg, Merck/Vioxx).
Link to originator business given that the assets are
closely linked to their business and the originator is
likely to want to carry on exploiting the IP assets
underlying the ABS, it may be difficult to achieve the
bankruptcy remoteness that ABSs rely on. In addition,
brands have little value independent of their
associated business. The value of brands in a
liquidated company (and their ability to generate
cashflow) is likely to diminish or vanish.
IP litigation risk the sole cashflow-generating aspect
of IP assets is in the proprietors right to prevent
third parties from using them without a licence. If a
third party successfully challenges the validity
(regarding patents or trademarks), subsistence or
ownership (regarding copyright) of an IP asset, the
SPV will no longer have this right and the IP assets
cashflow generation potential is reduced to zero. Due
diligence and effective protection techniques should
ameliorate this risk.
The key to overcoming many of these issues is to
ensure diversity of the portfolio being transferred to the
SPV. Failure to address this issue has been the cause of
some of the failures in the past, and the fact that the
reports of those failures have not always explained their
cause may have dampened enthusiasm unjustifiably.
Where are the richest seams?
Film
The film industry has taken to IP securitisation with
considerable enthusiasm and is responsible for the
greatest proportion (by value) of IP securitisations
carried out to date.
In 2002 DreamWorks used US$1 billion raised from the
securitisation of copyright in a film portfolio to refinance
outstanding credit facilities. Moodys assigned the
securitisation SPV an AAA rating. In 2004 Paramount
raised US$210 million on the back of film royalties for films
that were not yet in existence. The films were to be
produced or acquired by Paramount over a three-year
period. Moodys assigned a Baa2 rating to this transaction.
In September 2005 Marvel Enterprises completed a US$525
million non-recourse debt facility to finance its production
of up to 10 films based on its comic book characters
(including Captain America, Nick Fury and The Avengers).
Paramount was again involved as the future distributor of
the films. The SPV was a Marvel subsidiary. It pledged the
theatrical film rights to the characters as collateral for the
loan. The deal was backed by Ambac and was AAArated.
The willingness of investors and rating agencies to
back deals based on IP assets that do not yet exist shows
how much interest there is in such financing
arrangements in the film industry and the considerable
potential for future deals in this industry sector.
Music
The music industry has also discovered IP securitisation
and is responsible for the greatest number of IP
securitisations. It is also responsible for the most famous
IP securitisation, the Bowie bond. Based on part of David
Bowies back catalogue, the bond was launched in 1997
and raised US$55 million. Moodys gave it an AAA
rating. Since then a number of artists have released
copycat bonds.
The disappointing performance of the Bowie bond
did not deter Chrysalis from raising 60 million from the
groundbreaking securitisation of its international music
catalogue in 2001. This deal was over-collateralised to a
significant extent, since this figure represented a mere
40% of the estimated current value of the catalogue. It
was the largest ever music royalties deal, including over
35,000 copyrights from hundreds of songwriters in
different jurisdictions, and was the first securitisation by
a music publisher rather than an individual artist.
The global slump in music publishing sales and the
prevalence of peer-to-peer music-sharing sites on the
Internet has put music copyright-backed securitisations
in danger. However, the recent crackdown on these sites
and the increasing popularity of legal music download
sites such as iTunes seem likely to re-establish the
attractiveness of this form of ABS.
Sports
Broadcasting rights deals are particularly important for
individual sports teams and, perhaps more importantly,
the governing bodies of individual sports, and there have
been a number of examples of IP securitisations in this
area. Examples include the securitisation of future
licensing revenues from a portfolio of Formula 1 Grand
Prix contracts, which formed the basis of a US$1.4 billon
securitisation in 1999; and the 94 million securitisation
of football sponsorship, advertising, trademark licence
agreements and television rights licence agreements by
Parma AC in 2002.
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Linklaters Global
The proven track record of steady, predictable
income from this type of transaction suggests that this
could also be a source of future cashflow using the IP
securitisation model.
Pharmaceuticals
The pharmaceutical sector offers perhaps the greatest
potential for growth in this type of financing, but
only where the circumstances are right. The development
of new drugs involves massive research and
development costs for pharmaceutical companies. One
way in which these costs may be recouped is by
licensing, which has been proven to work and, in
appropriate situations, should prove attractive in the
future. However, so far examples of such financing
are limited. They include Royalty Pharma AGs 2003
AAA-rated securitisation of the licence revenue it
received from a portfolio of 13 different drugs, each
with historically strong sales, which raised US$225
million, and Drug Royalty Corporations issue of
single A-rated notes backed by pharmaceutical
patent royalties in March 2005, which raised
US$42 million.
The potential here is obviously huge. However, the
demand will be limited among the largest pharmaceutical
companies and is more likely to be attractive to smaller
companies in the sector, whose IP rights would probably
need to be aggregated in order to generate sufficient
volume and diversity. A range of models are actively
being considered by players in the field, based on both
early-stage and mature products, and further deals seem
likely in the not too distant future.
Consumer brands
Income from many mature brands meets the key
securitisation criteria of being proven, steady and
predictable. Examples of deals based on such trademark
rights include:
Calvin Kleins US$58 million securitisation in 1993,
which was linked to future sales of its perfume products;
Guess?s US$75 million deal based on securitising its
domestic and international trademark licences; and
Athletes Foots raising of between US$30 million and
US$40 million from securitising its franchise resources.
There are of course risks linked to fashions and
reputations, but with appropriate modelling and a
suitably diverse portfolio it seems unlikely that these
issues will prevent such deals being executed in future.
Conclusion
IP-backed securitisations present unique challenges as
compared to securitisations based on more established
asset classes. However, past successes have shown
that no challenge is insurmountable and, with
increased experience in dealing with IP rights, the
consequently greater familiarity with them and how best
to structure deals on which they are based, the challenges
should become easier to meet in future. Combined
with the substantial value of IP assets on company
balance sheets and the increased awareness of their true
value, these developments suggest that the deal flow for
IP-based securitisations is likely to become stronger in
the coming years.
Building and enforcing intellectual property value 2006 4
Global Linklaters
Ann is a partner in the structured finance group at Linklaters. Her practice
includes securitisations and other structured financings with particular
expertise in whole business securitisations.
Ann Hoe
Partner, London
Tel +44 20 7456 4974
Email ann.hoe@linklaters.com
Linklaters
United Kingdom
Nigel is head of the IP group and co-head of the healthcare group at
international law firm Linklaters, based in the London office. His practice
includes work with colleagues in Linklaters' finance practice, in London and in
the firm's other offices around the world, on IP-based finance transactions, a
significant proportion of which has been in the securitisation field.
Nigel Jones
Partner, London
Tel +44 20 7456 5832
Email nigel.jones@linklaters.com
Linklaters
London