For over thirty years, securitization has been a popular structured finance vehicle. The basic idea of a securitization is to pool a group of income producing assets, issue debt securities and then pay off the debt over time using the income generated by the assets. Assets whose income streams are routinely securitized include home mortgages, credit card receivables, student loans and auto loans. The risk-reward characteristics of securitization are attractive because aggregating quantities of similar assets helps spread the default risk of a single asset across the entire portfolio, improve credit quality and lower borrowing costs.
Just how popular are securitizations? If dollars are votes, then asset securitization is indeed very popular. Although not well known to the public, the Bond Market Association estimated that at the end of 2005, aggregate outstanding securitizations possessed a principal amount exceeding $8 trillion. Compare this figure with $12 trillion, which was the August 2006 estimate of total market capitalization (or equity value) of the S&P 500 Index.
With the size and longevity of securitization markets, it’s no surprise to see some novel applications. Royalty securitizations, involving royalties derived from licenses of intellectual property (IP), are on the rise. Royalties derived from the major flavors of IP - patents, trademarks and copyrights - are all suitable for securitization, but so far, copyrights and trademarks have been the most popular targets. Perhaps most notable was one of the first copyright securitizations by rock singer David Bowie who issued the now famous “Bowie Bonds” in 1997.
How did he persuade Prudential to give him $55 million? In exchange for the cash, Mr. Bowie agreed to forfeit 10 years worth of future royalties from a substantial portion of his music catalog, including such hits as “Let’s Dance” and “China Girl.” Because artists are typically paid a small royalty every time one of their songs is commercially used, they generate streams of annual royalty income. As it turns out, certain royalty streams are well suited for securitization. Here’s a summary of the transaction structure:
|A special purpose vehicle (SPV) was created to contain a portion of the Bowie catalog. Mr. Bowie contributed his catalog ownership rights (including the rights to future royalties) to the SPV. Borrowing against future royalty income, the SPV raised $55 million in debt from Prudential and bought the catalog rights from Mr. Bowie. The SPV then collected future royalties and used them to pay Prudential a contractually stipulated return (principal plus 7.9% interest per year).
But Prudential couldn’t predict exactly how much future royalty income Mr. Bowie’s catalog would command and whether it would be enough to service the $55 million it had invested. As extra security, Mr. Bowie agreed that if the SPV defaulted on its loan obligation, Prudential would end up owning the catalog that was sold to the SPV. So the catalog had become, in effect, the underlying collateral on which Prudential made its investment.
The SPV was also a “bankruptcy-remote” entity. That is, Mr. Bowie and Prudential were each protected from unrelated risks that might otherwise affect their investments. For example, if Mr. Bowie declared personal bankruptcy, Prudential’s interest in the Bowie catalog held at the SPV would likely be shielded from contentious (and costly) bankruptcy proceedings. Or, if the SPV defaulted on its debt obligation, Prudential’s interests in Mr. Bowie’s estate were limited to the catalog at the SPV. This allowed Mr. Bowie to protect his other assets and continue receiving royalties from the rest of his catalog as well as any new recordings.
Following Mr. Bowie’s success, other artists have taken advantage of royalty securitization, including such notables as James Brown, the Isley Brothers, Iron Maiden and Rod Stewart. However, like music sales, copyright securitizations have declined recently and investors have moved into other areas. To provide lower cost financing, income streams from trademark royalties have been securitized by companies such as Triarc (Arby’s), Guess? (apparel) and Bill Blass (apparel). Drug patent royalties have also been securitized by BioPharma Royalty Trust ($80 million) and the Royalty Pharma Finance Trust ($225 million). Not to be outdone, movie makers have also entered the fray: DreamWorks SKG issued a $1 billion securitization on its movie catalog in 2002, and Vivendi Universal followed suit in 2003 with its own $750 million securitization.
So what does the future hold? The number of successful deals completed this far signals longevity for royalty securitizations. Moreover, the growth of IP-only transactions, the evolution of IP holding companies and the sustained increase in related IP litigation all indicate that IP is maturing as a distinct asset class - a significant growth signal for royalty securitizations. Portfolio, rather than single-asset, transactions will characterize successful royalty securitizations. If average deal sizes increase, royalty securitization could become quite mainstream by reducing relative transactions costs and keeping the attention of major investment banks. Finally, because of the unique nature of patent claims and the legal rights/enforcement process surrounding them, securitizations of copyright and trademark royalties will likely continue to dominate the securitization landscape. Overall the picture looks bright for royalty securitizations as an important and growing niche of IP management and value extraction.