Securitisation may offer new potential for managing intellectual property.
Ross Webber explains.
In February 1997, David Pullman, founder of the Pullman Group, a division of Fahnestock & Co. Inc. launched the BowieBond. This asset backed security netted David Bowie over $55 million collateralised by the future cash flows generated from the royalties of his first 25 albums, along with sheet music sales. The loan was packaged as a security and sold in a private placement to the Prudential Insurance Co. of America. Moody's rated the bonds as investment grade A-3, the same as General Motors.
Mr Bowie pulled off a financial first. His back catalogue of hits sells more than one million albums a year. David Pullman said Mr Bowie was interested in more than cash. “Money is not what drives him...It was really being the first, to do something innovative...The idea of the first-ever securitisation of intellectual property excites him.”
Besides Mr Pullman, the other main player in the Bowie deal was William L. Zysblat, Mr Bowie's business manager and president of Rascof Zysblat Organisation (RZO Inc.) in New York. The two men were meeting on an unrelated matter in 1996 when Mr Zysblat mentioned that the artist's recording and distribution deal was due to expire in a few months.
They discussed the idea of a securitisation, and what began with scepticism developed into enthusiasm. There was no reason why it could not fit into the standard asset backed security mould: the sales had a predictable cash flow and a measurable history, there was no bad debt and little risk. The problem was that this was unchartered territory. No one knew if the market would be receptive to bonds backed by music copyrights; it had never been done before.They did it. Subsequent deals have included artists as diverse as Dusty Springfield, Iron Maiden, Motown's Holland, Dozier & Holland, James Brown, Joan Jett and Crosby, Stills & Nash. Owners of intellectual property from outside the music world have also been paying close attention and getting more interested and involved.
What are Bowie Bonds and how do they work?
Although some of the financial structuring is highly complex and confidential, the concept is relatively simple. The key is predictable cashflow. All that is needed are a steady sales history and promising future prospects.
Conventional asset-backed securities are fixed income securities, or IOUs, that are backed by cash-generating assets as collateral. Traditionally, the collateral has come in the form of credit card receivables, car loan payments, home equity loan cash flows, leasing payments or some other less mainstream sources of cash. The sources of assets have historically been leasing companies, commercial banks, savings & loans, and other financing institutions. These companies sell them to underwriters who re-structure the pool of loans and sell them to investors.
In this instance, the issuer (Mr Bowie) hired an investment bank (Fahnestock / The Pullman Group). The investment bank, by representing the issuer, plays the role of bringing together potential lenders and borrowers. Mr Pullman set up a trust or special purpose vehicle (SPV). This SPV receives royalty payments from more than 250 songs from Mr Bowie's first 25 albums. Recording-artist royalties usually range from 10% to 25% of the suggested retail list price for top albums, less an assortment of negotiable deductions. A $17 compact disc, for example, might yield a $2.30 royalty3.
The SPV issued bonds in a private placement to the Prudential Insurance Co. These bonds have an average term of 10 years, paying 7.9% interest payments with the principal repaid at maturity. Once the negotiated figure (in this instance $55 million) is paid back to the Prudential, the surplus is paid to Mr Bowie. The deal ties up the rights to the collateralised property, and it is the right to the future earnings that, in effect, constitutes security for repayment of the loan.A bond selling at par would have a yield equal to its coupon interest rate. Therefore, if this bond were issued at par, its yield would also have been 7.9% on the day of issue. The yield on 10-year Treasury notes was 6.3%. The difference between these two yields (7.9% - 6.3% = 1.6%) is the default risk premium (credit risk).
Lenders will require the asset backing the loan to be readily realisable. Preferably, there should be a liquid market with some reasonable certainty in valuation. That rarely applies to intellectual property (there are many competing IP valuation methodologies and, not unconnected, an almost complete absence of a liquid market).
A newly set up firm in Palo-Alto, California, plans to help high-tech software firms place value on their intellectual property in development. IP Valuation Inc. offers software and consulting services to evaluate royalty streams associated with intellectual property development, with an eye to securitising that revenue down the road.
IP Valuation has so far focused on helping its high-tech clients identify the timing and size of the royalties associated with their developments. To do this, it designed a framework where defining certain rights – triggered by the passing of each revenue “event” in the development cycle – allows estimations of cash flows. These include the right to acquire IP, the right to market IP and the right to payments upon shipping of products using the IP.
Credit worthiness is rated by credit-rating agencies such as, Moody's, Standard & Poor's, Duff & Phelps and Fitch Investors Service. They rank financial instruments based on their issuers' chances of defaulting, which does not merely mean failing to pay the full interest and principal on the debt, but also the potential for delays in payment. Not only is the amount and risk of cash flows important, but their timing also plays a major role in determining their value.The highest quality rating from S&P is AAA, followed by AA and so on. Rating below BBB is referred to as non-investment quality or junk bonds. Non-investment means that certain institutional investors (insurance companies) are not allowed, by law, to invest in these bonds. US government bonds are not rated as they are considered default free. The A-3 rating for the Bowie Bond ranks it as investment grade, but more susceptible to adverse changes than those with higher rankings.
The difference between these sorts of asset backed securities in a securitisation deal and a collateralised loan is important. In a securitisation, even one in which intellectual property assets are the sole reason for receivables to flow in, it is rare for security to be taken over those underlying intellectual property rights. Take the example of a studio securitising its future income from a stable of film releases: Typically, an SPV will be formed which will borrow cash from investors and pay the sum borrowed to the studio in exchange for the right to future income from audience receipts. Audience receipts will flow from the various film distributors to the studio, which will pass the cash onto the SPV. The SPV uses this cash to repay capital and interest on its loan. Surplus cash will be passed back to the studio as profit.
For conventional asset backed securities, selling the original loans to underwriters means that the lending institution does not have to absorb the risk of potential delinquencies, and at the same time immediately receives the present value of the associated future cash flows. With more cash on hand, the lending institutions have more immediate money to lend to potential borrowers. Thus, getting them of their books reduces risk and provides a source of immediate cash for further lending.
All the typical benefits of securitisation apply. It may insulate the seller of receivables from any adverse currency movements affecting the future cash flows. It diversifies sources of finance and lessens dependence on bank loans. It takes the receivables and the funding loan off the balance sheet.It is not just the music men who are exploring these avenues. In 1993 Calvin Klein raised $58 million securitising the royalties arising from perfume brands with the CK trademark. Increasingly, technology-based companies are licensing their intellectual property and allowing their products to be manufactured and distributed by companies with an established presence. Securitisation can work well with this license-based business model.
Raising substantial capital sums by securitising future license revenues may well have significant fiscal advantages over more orthodox debt or equity financing routes. For example, a securitisation could raise capital to reduce liabilities, thereby both improving the debt/equity ratio and the return on capital.
The Bowie deal opened the door for the use of music, books, films and computer software to raise capital. Lawyers say the deal is a variation on using intangible intellectual property assets such as trademarks as collateral, an increasingly popular financing technique. Lenders recognise there is “inherent value in the underlying intellectual property,” says Lanning G. Bryer, a partner at Ladas & Parry. “You will see more and more and more of it. The word has gotten out: it is a new source of income.”
The bondholders of course, have their concerns. In the Bowie deal, unlike fixed mortgage or car loans, the royalties are earned from publishing and record sales, performances and radio or video air play, which can fluctuate. In addition, Mr Bowie is not a US but a Bermuda resident. This raised tax questions.Potential bondholders had questioned how the assets would be protected from bankruptcy, estate problems or third-party creditors. Hence, the corporate structure (SPV) was established to remove Mr Bowie personally from the asset.
What does this mean for insurers?
Historically, investment banks and financiers have been the sole possessors of the technology, know-how, credit and capital experience to put these deals together. Currently, the largest dealers in derivative products are still commercial banks such as Chase Manhattan and JP Morgan. The convergence in the financial world now has investment banks, securities firms and insurance companies getting in on the act.
As financial intermediaries, banks have traditionally offered foreign exchange and interest rate hedging products to their customers. In recent times, mortgage and asset backed securities have evolved. By acquiring knowledge of financial engineering, insurance companies, with their inherent expertise in risk management can compete in this market. It is with the construction of special purpose vehicles or “bankruptcy remote subsidiaries”, such as Centre Solutions' Trinity Re 1999 Ltd., that strong insurers with powerful credit ratings like ACE, XL Capital, AIG, Centre Solutions etc. are increasingly able to carve niches in this lucrative field.
The use of SPVs to reduce credit risk is analogous to traditional asset securitisation. Investors in the Trinity Re 1999 deal indirectly assumed a portion of the exposure of Centre Solutions (Bermuda) Ltd., to hurricane losses under a reinsurance contract written to cover a book of Florida residential property insurance. Investors in an IP securitisation deal are simply assuming the credit and timing risk of the cash flows generated by the underlying IP asset. Loan securitisation for any asset backed security, including intellectual property, requires credit enhancement. This is the role of the guarantor. There is no reason why this guarantor cannot be Munich Re as opposed to Fannie Mae.
Another factor for the insurers to consider is the potential for this form of alternative risk transfer (ART) to impinge on their current business of IP protection in a traditional insurance indemnity policy. To combat this, they will need to develop their own solutions.
In January 1999, AIG Risk Finance, introduced B FIRST (blended finite insurance and risk securitisation transactions), a combination of securitisation and the capacity of the capital markets with risk transfer elements in policies that include finite and excess-of-loss coverage.
The product was designed to combine the strategic risk financing and profit sharing of finite insurance with the catastrophic loss protection and liquidity available through securitisation.
Under the B FIRST programme, a company could obtain an insurance or reinsurance policy underwritten by an AIG member company. That policy would provide multi-year coverage, profit sharing and catastrophic loss protection. The programme can be constructed to provide the insured with liquidity by linking insurance coverage with a pre-established parametric event to a measurable statistic, such as wind speed or Richter scale magnitude.
The challenge is to develop a model for IP cash flows using historical data or simulation methodology. The distinct lack of a pre-established parametric event is another poser for the industry gurus. This B FIRST programme was designed, however, to be able to accommodate other short tail or hard-to-place risks, such as, weather, mortgage insurance, residual value insurance, and credit risk.
“There is a significant need for affordable capacity to address major natural catastrophes and other hard-to-place risks, while the capital markets see insurance-linked bonds as an attractive means to diversify their portfolios,” says Tobey Russ, president, AIG Risk Finance.
“By accessing the capital markets, companies can benefit from increased availability of affordable capacity and a potential reduction in the volatility of insurance premiums.”
Other insurers and reinsurers are also demonstrating their appetite to gain this expertise. American Re Securities Corporation recently hired Charles W. Kerner, formerly of Deutsche Bank, as managing director of securitisation/origination in response to a growing interest in securitisation among American Re's clients. “Through American Re Securities Corporation, we are providing a wider range of solutions to our clients' changing risk management needs,” says American Re president and CEO Edward Noonan. “These solutions reach beyond the limits of the traditional insurance market, and include securitising risk and drawing from a larger capital pool to offer greater capacity.”
The other side of the equation is, of course, the attraction of a potential new pool of investment grade assets. For example, the Prudential snapped up the whole of the Bowie Bond issue.
As insurance personnel learn more about IP securitisation, their advanced level of knowledge will allow them to pick and choose the deals to be involved with more successfully and on which side of the table they wish to sit.
While there have been a few deals since the Bowie Bond in 1997, there are not as many as there are touted. Investment firms like Nomura Asset Capital Corp. who had worked on a deal with Rod Stewart after forming Nomura Capital Entertainment Finance, have recently left the market and other big Wall Street firms are cooling off.
The pioneers however, are still exploring and looking for new avenues. Alliances are being formed, such as the liaison between Zyblatt and Pullman. “We are aggressively going after the same business, and together we can easily structure, finance, audit, evaluate, service and administrate the artists' catalogues,” Mr Pullman says.
According to Melvin Simensky, a partner at Hall Dickler Kent Friedman & Wood, securitisation is more likely to become a significant technique for raising capital for music industry companies. “It is much more useful as a corporate vehicle,” he says. “Record companies and publishing companies are always looking to get more cash to sign more artists or buy more publishing.”
Similar deals could be done in book publishing with such steady selling authors as Stephen King. Computer software may also prove to be a fertile ground. While computer programs have a relatively short shelf life, a software company could bundle a number of programs to secure a bond offering, and then replace the obsolete asset with new ones for the life of the bond. Credit card debt is similarly structured.
TV, stage and screen actors, like Jerry Seinfeld, who own a percentage of their own show receive revenues over time, whereas the studios get their money up front from syndication. A television syndication securitisation deal would provide them with money now to invest and diversify.
The ingenuity of the Wall Street financiers is boundless. The knowledge and appetite of the average investor are also growing in leaps and bounds. Mr Pullman has paved the way, taking the financing of intellectual property one step further from simple security or collateralised loans. I am sure that we have not seen the end of it.
Ross Webber is marketing manager for Starr Excess International, Bermuda. His article is adapted from his thesis for his MBA degree at the College of Insurance, New York. Tel: +441 295 7827; fax: +441 292-8099; e-mail: email@example.com.