HFB Hochschule für Bankwirtschaft
Business School of Finance and Management

Securitization of Intellectual Property as a Funding Alternative

Master Thesis

Master of Arts (Banking & Finance)
Specialization ‘Investment Banking’

by

Alexander C. K. Kirsch

2005

„Just as the electronics industry was formed when the vacuum tubes were replaced by transistors, and transistors wee then replaced by integrated circuits, the financial services industry is being transformed now that securitised credit is beginning to replace traditional lending. Like other technological transformations, this one will take place over the years, not overnight. We estimate it will take 10 to 15 years for structured securitised credit to replace to displace completely the classical lending system – not a long time, considering that the fundamentals of banking have remained essentially unchanged since the Middle Ages.”

(Lowell L. Bryan)

OUTLINE

I. LIST OF ABBREVIATIONS ... V
II. LIST OF FIGURES ... VII
III. LIST OF TABLES ... IX

1. Introduction ... 10

2. Challenges of corporate funding ... 16

3. Introduction to intellectual property ... 23
3.1 Definition and classification ... 23
3.2 Different types of intellectual property ... 27
3.2.1 Patents ... 27
3.2.2 Trademarks ... 32
3.2.3 Copyrights ... 35
3.2.4 Other types of intellectual property ... 38
3.3 Economic weight of intellectual property ... 40

4. Intellectual property: a new asset class in securitization? ... 44
4.1 Securitization – the tool in brief ... 44
4.2 Definition of IP in the securitization arena ... 48
4.3 Market overview ... 50
4.4 Benefits and hindrances of IP securitization ... 58
4.4.1 Corporates ... 58
4.4.2 Investors ... 64
4.4.3 Banks ... 66
4.4.4 Hindrances of market growth ... 67
4.5 Funding conditions ... 71
4.6 Case Study: BioPharma Royalty Trust ... 74

5. Identification of securitizable intellectual property ... 76

6. Major issues in the structuring process ... 87
6.1 Transaction structure ... 87
6.1.1 Introductory remarks ... 87
6.1.2 Direct IP securitization ... 89
6.1.2.1 IP true sale structure ... 89
6.1.2.2 IP sale and lease-back structures ... 90
6.1.3 Indirect IP securitization ... 92
6.1.3.1 Basic IP royalties structure ... 92
6.1.3.2 Conditional assignment structure ... 94
6.1.3.3 Secured IP loan structure ... 96
6.2 Servicing ... 97
6.3 Credit enhancement ... 99
6.3.1 Introductory remarks ... 99
6.3.2 Internal credit enhancement tools ... 100
6.3.3 External credit enhancement tools ... 105

7. Execution of an IP backed securitization ... 109
7.1 Introductory remarks ... 109
7.2 Transaction preparation ... 110
7.3 Documentation ... 113
7.4 Rating Process ... 114
7.5 Marketing and distribution ... 122
7.6 Other borrower obligations ... 125

8. Conclusion ... 127

IV. APPENDIX ... CXXXIV

V. BIBLIOGRAPHY ... CXXXIX

I. LIST OF ABBREVIATIONS

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II. LIST OF FIGURES

Figure 1: Classification of intangible assets
Figure 2: Intellectual property types
Figure 3: Number of patents granted in the Europe from 1997 to 2003
Figure 4: Share of intangible assets in S&P 500 corporations in 1979 and 1997
Figure 5: The transition from the ‘Labour Economy’ to the ‚Knowledge Economy’
Figure 6: Securitizable asset types
Figure 7: Growth in worldwide ABS and CDO issuance by region
Figure 8: Asset backed securities outstanding in 2003 by asset type
Figure 9: Worldwide number and volume of IP securitization issuance
Figure 10: Worldwide volume of IP securitization: broad vs. the narrow definition
Figure 11: Number and volume of IP deals by deals size clusters
Figure 12: Historical IP asset type distribution by number of deals
Figure 13: Historical IP asset type distribution by volume of deals
Figure 14: IP deal distribution by sector and number of deals
Figure 15: IP asset class distribution by volume of deals
Figure 16: Historical IP securitization by number of deals and country of originator
Figure 17: Historical distribution of funding terms in clusters
Figure 18: Historical average deal size per industry
Figure 19: Structure diagram of the BioPharma Royalty Trust deal
Figure 20: Requirements of IP assets to be securitizable
Figure 21: Example for an amortization cycle of an average movie
Figure 22: Zerit® cash-flow history
Figure 23: Distribution of success multiples of major US film studios in 1989
Figure 24: Securitizability analysis for the HIV drug Zerit®
Figure 25: Transaction type distribution by deal volumes
Figure 26: IP true sale structure
Figure 27: IP sale and lease-back structure
Figure 28: Sale and lease-back IP investment trust structure
Figure 29: Basic IP royalties structure
Figure 30: Conditional assignment structure
Figure 31: Secured IP loan structure
Figure 32: Increase of credit enhancement via sequential amortization
Figure 33: Average transaction size by number of tranches
Figure 34: Example for the functionality of the excess spread mechanism
Figure 35: Illustrative example of typical sales curves of music works
Figure 36: Investor base: IP deals vs. European CMBS

III. LIST OF TABLES

Table 1: IP deal structurers and their track records
Table 2: Practical example for a timetable of a CMBS transaction
Table 3: Advantages and drawbacks of IP securitization
Table 4: Requirements of IP assets to be securitizable

1. Introduction
In a world where technology, brands and information have become the dominant competitive factors, intellectual property (IP) rights are often a company’s most valuable asset. Intuitively these assets should – like any other valuable asset – play an important role for the funding of a company. However, a reality check shows that this is not the case. While tangibles like real estate can be leveraged e.g. through mortgage loans, a portfolio of IP often requires large portions of equity investments. The reason for this inefficiency is that most industries may not recognize their IP assets on the balance sheet although they require active exploitation and management just like (and sometimes even more than) tangible assets (Agiato, 2002). As an alternative to the book value normally the market value or any other reliably appraised value would be used. As there is no general market value for IP assets, lenders have to consider other valuation techniques. It will be shown later that the few markets where IP assets are traded highly depend on the existence of reliable valuation methods. To meet this demand for valuation tools, some techniques have been developed. However, compared to the evaluation of tangible assets these techniques are in their infancy and do not comply with debt capital market’s required level of accuracy. Consequently, lenders do not have a benchmark they can use to accept and evaluate IP as collateral for their funds.

Due to the fact that the ‘real’ value of IP assets can not be measured accurately enough, IP assets are usually considered with the only element that can be quantitatively analyzed: the future cash-flow the asset generates. To come to the anticipated future cash-flow lenders analyze historical cash-flow data, extrapolate it to the future and stress it to come to a sustainable value. However, the ‘real’ value of an IP asset comprises more than the current cash-flow element. Especially the potential future applications in goods and services as well as potential future licensing activities need to be considered when talking about an IP asset’s value. So far, this part of the asset value is typically ignored in the context of corporate funding.

Rating agencies face the same problem when analyzing a company’s credit quality. Although rating agencies are market leaders in the area of risk assessment they face a tough challenge in understanding all associated aspects of assets that are as complex and whose value drivers are as hard to quantify as is the case for IP assets. Consequently, the assessment of credit risk requires thorough due diligence in combination with asset specific expertise that lenders and rating agencies have to acquire before they can handle the ‘IP challenge’. As a consequence, IP backed debt easily leads to unfavourable funding conditions regarding inadequate interest rates, shorter loan terms and limited flexibility. Cunningham (2000) comments: “[…] by making loans secured by hard assets like machinery, equipment and inventory, bankers are overlooking the most valuable collateral: a company’s designer names and brands”. From a macroeconomic perspective this lack of acceptance leads to capital misallocation and inefficient use of resources. Nevertheless, in the last couple of years a trend towards new ways to utilize this misunderstood asset class could be observed. John M. Brosnan confirms: “I am getting more and more inquiries from companies interested in finding ways to leverage intellectual property rights as collateral” (Kossovsky, 2004, p.3).

One promising new way to leverage IP is to securitize it. Securitization, which has been established as a funding tool since the late 1970s, provides completely new opportunities for the corporate funding process and the leverage of IP portfolios. Rudder (2004, p.6) finds: “With the advent of the Bowie Bonds in 1997, the capital markets became a new avenue for the monetization on intellectual property assets”. However, not only originators can profit from the benefits of IP securitization. Also investment banks and investors can earn their stake in this new finance tool. Some market players such as Harris Nesbitt (2003, p.3) have realized that “bulge bracket and league table players need to identify growth in areas outside of traditional ABS sectors to continue their past success”. IP securitization could be such a new area of growth. Otherwise, investors have the opportunity to invest in unique securities and new asset classes without being exposed to the associated company risk. These completely new products can provide both increased diversification for their portfolios and interest rates that have an extra spread on top of the rates of comparable bonds of the same rating class.

This thesis is, however, focused on the opportunities that IP securitization presents for corporates. Being aware of the important role IP assets have for most companies of all size categories, this is an area with substantial upside potential for corporate funding. Using IP in corporate funding can be more attractive than other collateral “because there is generally a lower credit risk, which results in a lower cost of financing, and pledging intellectual property collateral will often allow a borrower to secure financing without the need to alter its capital structure” (Schavey Ruff, 2003, p.1).

My motivation for the topic
The future upside potential in corporate funding leads to the motivation for choosing this subject area as topic for a thesis. Having worked for two years in the securitization business for a German mortgage bank and having participated in the structuring of several synthetic Mortgage Backed Securities (MBS) deals, there is interest to learn more about other more exotic asset classes. Although every deal has its challenges securitization of mortgage loans has become very much standardized. Today MBS is the largest asset class in the securitization arena. Structuring these deals is still challenging, however, creativity in the structuring process is limited and new issues tend to become rare.

Intellectual property on the other hand is fascinating to analyze. Market participants have seen transactions which may seem strange prima facie but that appear to be very efficient having a closer look at them. Apart from the well known Bowie Bonds, a transaction which is backed by sales revenues of David Bowie’s music catalogue, only few deals have reached public interest. Readers will be surprised that many of the recent major blockbusters like The Matrix, Gladiator or A Beautiful Mind have been securitized. The same was done with the music of James Brown, fashion labels such as Guess?, BCBG or Candies, the Formula One Racing and the Madame Tussaud’s Wax Cabinet IP catalogue. As the IP asset universe is almost unlimited the market will see more new asset classes to come. Already today the asset classes range from entertainment deals over securitization of drug patents to deals that are backed by stocks of champagne or revenues generated by crematory chains. Investors are waiting for further innovations coming into the market. However, to date securitization of IP has failed to live up to the hype that the high profile of the Bowie name has created. Year for year market participants had expected the market to grow at a much higher pace but have been disappointed ever again. This thesis is designed to analyze the obstacles and discuss key drivers that hinder the market to develop more rapidly and with more enthusiasm than is currently the case.

The fascination for these exotic assets meets the current problems in corporate funding in Germany and some other western countries. Funding has become extremely difficult for some type of corporates, especially for those who do not have direct capital market access and for those whose assets are primarily of intellectual nature. Often these companies depend on their banks’ and equity providers’ willingness to provide funds. In combination with the above mentioned problem of incorporating the IP’s value in the credit quality assessment, this leads to severe funding problems for this type of companies. Considering the impact that the Basle II capital adequacy rules will have and already do have on the funding of SMEs, the need for alternative funding becomes obvious. On the one hand risk-appropriate Tier I weighting (and as a consequence risk-appropriate loan pricing) has been an urgently needed development. On the other hand, companies whose assets are inadequately considered in a bank’s internal borrower rating process (as is often the case with IP assets) are clearly put in a worse position. As in Germany SMEs make 99% of all enterprises, 70% of total employment and 50% of the GDP (Reich, 2004), this issue is quite substantial for Germany’s and other comparable knowledge economies’ future success. The importance of alternative funding sources is further emphasized when considering the restrictive funding policy banks have established with the beginning of the economic downturn after the burst of the technology bubble. Consequently, this thesis’ intention is to level the ground for alternative capital market funding sources such as IP securitization by explaining it to market participants and highlighting the opportunities it can offer.

Target of this thesis
This thesis is designed to introduce securitization of IP rights as an alternative instrument in the corporate funding process. It is set up in a way that the corporate treasury, which has the responsibility for a diversified and economically optimized liability side and hence has a natural interest in new funding alternatives, can get an understanding for the instrument as such. Moreover, a treasurer shall be enabled to assess whether the balance sheet of his company comprises IP assets that have the potential to serve as collateral for a securitization. In case this asset identification process leads to positive results, the thesis additionally points out the crucial issues that have to be faced and analyzed before structuring this type of transaction. Although primarily focused on the corporate treasury’s needs, this thesis also gives other interested readers a holistic view of risks, benefits and economic impacts of an IP backed securitization. To fully understand the whole concept, perspectives need to be switched from time to time, e.g. to understand rating agencies’ or investors’ concerns which in turns lead to certain structuring issues for the originator.

Summarized, the thesis aims to answer the following five key questions:

1. What is IP, what is securitization and how does it work in detail to use IP as collateral for a securitization transaction?
2. What are the advantages and drawbacks of IP securitization?
3. What are the requirements for IP assets to be securitizable?
4. What are the major issues of structuring an IP backed deal?
5. What types of companies can profit from securitization of IP?

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