Thursday 27 August 2009

Securitization of IP: Urban Legend, or Playing Soon in a Theatre Near You?

Probably no word in the finance world has taken on a less flattering connotation in recent times that the word "securitization" (unless it is the word "leverage", but the two go hand in hand). With the collapse of the sub-prime securitization market, and the financial carnage that followed, the term has come to represent, rightly or wrongly, the nefarious excess of financial alchemy running amok in the name of pure greed.

I am too far-removed from the daily life of Wall Street and the like to have any reliable clue to what extent the securitization of assets will play as the financial world climbs out of its current economic malaise Against that backdrop, I read with interest a piece that appeared on July 31, 2009, in Entitled "A Starring Role for IP", the article addresses the issue, as set forth in the caption preceeding the text of the article, of whether,
"[a]s the securitization market comes back to life, [and] private-equity firms are finding deal flow in intellectual property, [w]ill the structured finance market support IP deals"?
The heart of the article is expressed in the following paragraph from the article:
"The predictable income streams derived from song royalties, paid year after year, along with licensing fees collected from the use of trademarked brands, underpin private equity interest in IP. Beyond the scope of capitalizaing on regular streams of income, IP also offers another incentive for financial buyers. It has the potential to be securitized or packaged into bonds that are backed by royalty payments as collateral. The bonds can then be used to refinance existing debt of portfolio companies--an attractive option for overleveraged private-equity-owned-companies--or conversely as acquisition financing."
The article discusses in some detail what is described as the succcessful securitization of the Dunkin' Brands in 2006 (pre-the Great Recession, I note). By sucesssful I assume means that the financial arrangements secured by the IP (read: trade marks, not donuts) were more favourable to the borrower than the other financial alternatives that were considered. In truth, however, the article reaches back and forth in time to bring merely a few examples of successful securitization of IP rights, with no reference to even the legendary Bowie bonds. The impression one receives is that this is still a marginal activity.

Spot the Securitized Asset

And so to the question: will we see an uptick in IP securitization as a sanitized alternative to the media-discredited investments in sub-prime mortgages and the like? From where this simple-minded IP practitioner sits, I am skeptical. The article suggests at least two interrelated reasons. First, the likelihood of getting a triple-A rating "without a monoline wrap" (I think that means a default swap or some other form of insurance) is not high, which means that the borrower will have to pay a higher interest rate for its bonds, thereby defeating the purpose of the exercise. Second is the "esoteric" and sui generis nature of IP rights. Valuation, both for the present and over the life of the bond, poses difficult problems, and the ability to assign a market value for the IP assets must certainly be a daunting challenge.

IP Securitization Made Simple

That said, I wonder whether there is some further room for interaction between the finance and IP worlds in exploring the potential for securitization of IP assets. When I spoke last month in India on trade mark valuation, one of the co-speakers on the programme represented the accountancy-valuation side of the profession. I came away with the feeling that I had too little an appreciation for the accountancy-valuation side, and my colleague had too little an appreciation for the IP-legal perspective.

There are two possibilities here. Either it does not really matter for valuation that our perspectives are so unconnected, because the IP-legal side has so little to offer, or it does matter, with the result that valuation is not being carried out as well as it might be. If the latter is true, then what is needed is a hightened dialogue to take advantage of the potential cross-fertization between the financial and IP-legal worlds. Something similar might well apply in connection with IP securitization. Investment houses, private equity funds, and banks--are you listening and are you interested?

1 comment:

Unknown said...

I have been working toward bringing more substantive IP analysis into the valuation process ever since I was on both sides of a $150MM deal involving a consumer product acquisition. The value of the deal was premised on the fact that the 5 patents covered the product and would provide my client with a long-term sustainable competitive advantage that would allow premium pricing in a market that was typical the province of commodity pricing. The patents were strong and the go ahead was made for the deal. What wasn't reviewed (or even suggested by the M&A attorneys) was whether the patents covered the innovation (which was the assumption upon which the premium pricing calculations and NPV of the deal were based) or only the invention. Shortly after the close of the deal, it became apparent that there were (literally) dozens of ways to solve the same problem, and that my client had paid $150MM for only one of these solutions. Put simply, the patents covered an invention not the innovation. Price erosion quickly occurred, and my client ended up paying a huge price for permission to play in a commodity space.

This war story educated me to the fact both finance and IP expertise must be present in the valuation process. Think about it: the competitive advantage obtained from a patent depends substantially on the breadth and quality of the underlying legal document(s). This means that valuation of a patent portfolio can be greatly enhanced by including an analysis of the underlying legal components of the patents. In this regard, I have reviewed other deals and have predicted poor results based upon a quick review of the patents involved. Certainly there are reasons other than IP to go forward with a deal, but if the financing of the deal is premised upon the IP, the quality of the IP and that of neighboring IP must be part of the equation.

I have recently begun working with IP valuation experts who understand the interplay between long-term value and IP quality. The key is to communicate that this analysis is different from that of traditional IP due diligence. Finance people generally don't like to work with IP lawyers because they take to long, cost too much and take the analysis far deeper than what is needed in the context of a deal. As a result, IP due diligence is given short-shrift in most deals.

What I propose is that a "back of the envelope" subjective assessment in a very short timeframe be conducted in a fairly short timeframe. This analysis is tee'd up to be placed in their financial models. Imprecise? Yes. But needed? Yes.