The biopharma industry is facing significant challenges to their existing business models because of expiring drug patents, declining risk tolerance of venture capitalists and other investors, and increasing complexity in translational medicine. In response to these challenges, new alternative investment companies have emerged to bridge the biopharma funding gap by purchasing economic interests in drug royalty streams. Such purchases allow universities and biopharma companies to monetize their intellectual property, creating greater financial flexibility for them while giving investors an opportunity to participate in the life sciences industry at lower risk.

Royalty Pharma is a privately owned alternative investment company that focuses on the acquisition of these pharmaceutical royalty interests. The company invests in products after regulatory approval and, more recently, also in the late stages of clinical trials. By the end of 2013, its portfolio consisted of royalty interests in 39 approved and marketed biopharmaceutical products, and 2 products in clinical trials and/or under review by the FDA and/or EMA. With such a large portfolio diversified across multiple therapeutic indications, it is the global leader in dedicated royalty investment entities. In this case study, we analyze Royalty Pharmas unique financing structure and business model.

When purchasing the rights to a royalty, depending on the sellers desired cash flows, Royalty Pharma can provide different types of payment schedules, such as an accelerated royalty or a synthetic royalty. In an accelerated royalty investment, Royalty Pharma provides the seller with the cash flow from a royalty over a shorter duration than the actual royalty.

For example, suppose the seller agrees to receive a fixed annual payment from Royalty Pharma for three years instead of 3% royalty on net sales over the course of 9 years. Assuming net sales of $1 billion per year, and a discount rate of 10%, what is the minimum acceptable fixed annual payment for this three-year agreement? Assume all cash flows including royalties occur at the end of the year so the first payment is made in exactly 1 year. (Note: Your answer should be expressed in units of millions of dollars.)

$ _____

Royalty Pharma finances its acquisitions by an approximately even mixture of debt and equity: $4.2 billion and $4.0 billion, respectively. In doing so, the fund is able to gain access to low-cost debt capital. The reduced cost of capital allows Royalty Pharma to pay higher prices for royalties while still providing attractive returns to investors.

Suppose the debt, which is held primarily by banks and other institutions, is split across various maturities: $1.7 billion with an interest rate of 3.00% per year maturing in 3 years, $1.9 billion with an interest rate of 3.25% per year maturing in 4.5 years, and $600 million with an interest rate of 3.5% per year maturing in 5 years. Assume Royalty Pharma operates with a total debt to EBIDTA ratio of 4-to-1, and the median earnings to interest expense ratios (EBITDA/interest expense coverage ratio) of US rated industrial companies are as follows:

Rating Coverage Ratio

AAA 100

AA 36

A 12

BBB 8

BB 6

B 4

What will be Royalty Pharma's interest expense in Year 1 (this upcoming year)? (Note: Your answer should be expressed in units of millions of dollars.)

$ _____

Assume the beta on Royalty Pharma's portfolio of assets is 1, the risk-free rate is 0.5% per year, and the market portfolios risk premium is 6% per year. According to the CAPM, what is Royalty Pharma's expected return? (Note: Your answer should be a number in percentage form. Do not enter '%'.)

An example of pre-FDA-approval financing is Royalty Pharma's "adaptive financing" for Sunesis Pharmaceuticals lead product candidate, Vosaroxin. At the time, Vosaroxin was being evaluated in a Phase-III, randomized, double-blind, placebo-controlled trial among patients with first relapsed or refractory acute myeloid leukemia (AML).

Suppose, given a 2.5% significance level threshold for a one-tailed Z-test, the trial was designed to have a 90% probability of detecting a 2-month increase in overall survival among patients in the study. If the treatment response standard deviation was 6.5 months and there are an equal number of patients in each arm of the study, then how many patients would the study require in total? Assume that treatment responses are independent and identically distributed given the treatment arm. Therefore, by the central limit theorem, the average treatment response in each arm can be estimated by a normal distribution.

(Note: Your answer should be the total number of patients in the trial, NOT the number of patients in each arm.)

While Sunesis had sufficient capital to fund the original Phase-III design of the trial, the company was seeking an additional $25 million to fund a potential expansion of the study based on the results of an interim analysis. At that time, an independent data safety monitoring board (DSMB) would decide whether to stop the study early for efficacy or futility, continue the study as planned, or implement a one-time increase in sample size with an additional 225 patients. By designing the study this way, Sunesis could avoid conducting an unnecessarily large trial in certain cases, potentially reducing the overall cost and risk of their study.

After conducting its due diligence, Royalty Pharma conditionally agreed to pay Sunesis the $25 million to acquire a royalty interest on the future net sales of Vosaroxin. However, under the terms of the agreement, Royalty Pharma would only invest the $25 million if, following the interim analysis, the study was stopped early for efficacy or if the sample-size increase was implemented. In return, assume Royalty Pharma would get a 3.6% royalty interest on future net sales of the drug if the study was stopped early for efficacy, or a 6.75% royalty on future net sales if the sample size was increased. Assume these scenarios were estimated to occur with probability 10% and 40%, respectively. Furthermore, the probability that the study would be terminated early for futility and abandoned was estimated to be 5%. If the sample size was increased, Royalty Pharma estimated there was a 10% chance the therapy would show a strong effect, a 65% chance that it would show a weak effect, and a 25% chance that it would show no effect and be abandoned.

Finally, if the DSMB decided that the trial should continue as planned, Royalty Pharma would have the option of making the $25 million investment upon the un-blinding of the study (i.e., the results were made known) in exchange for a 3.6% royalty interest on future net sales. Given this scenario, Royalty Pharma estimated there was a 15% chance the therapy would show a strong effect, a 60% chance that it would show a weak effect, and a 25% chance that it would show no effect and be abandoned. As such, Royalty Pharma would be able to significantly limit its exposure to the risk of an undesirable outcome of the clinical trial and, at the same time, position itself to receive a sizable royalty in the event that Vosaroxin was approved.

Vosaroxin was projected to be highly profitable, especially if it the trial was stopped early for efficacy. Under this scenario, future net sales were projected to have a present value of $4 billion. If, however, the trial required a sample-size increase, then future net sales were projected to have a present value of only $2.5 billion under the strong effect scenario, and 0.5 billion under the weak effect scenario. Finally, if the DSMB decided that the trial should continue as planned, the future net sales would have a present value of $3 billion under the strong effect scenario, and $0.5 billion under the weak effect scenario.

Build a decision tree for Royalty Pharma that shows the cash flows and probabilities of each possible scenario. Your tree should have 8 outcomes with 3 failures and 5 successes.

What is the probability that the clinical trial fails and the project is abandoned? (Note: Your answer should be a number in percentage form. Do not enter '%'.)

Hint: Remember that the probabilities leaving a branch must sum to 100%.

At the end of 2006, Royalty Pharma purchased Cambridge Antibody Technology's (CaT) passive royalty interest in Abbott's Humira. This occurred as part of AstraZeneca's $1.3 billion purchase of the remaining 81% of CaT it did not already own. Since the non-core passive asset was not as useful as upfront capital for AstraZeneca, it sold the royalty interest to Royalty Pharma for $700 million.

Consider the following term sheet from 2006 for the Humira royalty acquisition opportunity:

Product: Humira (subcutaneous injection)

Compound: Adalimumab (biologic, monoclonal antibody)

Product Type: TNF Inhibitor

Indications:

Rheumatoid Arthritis (RA), Psoriatic Arthritis (PsA), Early RA

Marketers:

WW (excl. Japan): Abbott A1/AA, $64bn market cap, NYSE-listed

Japan: Eisai

Launch Dates:

US: January 2003 (RA)

EU: September 2003 (RA)

Royalty Holder:

Cambridge Antibody Technology (CAT)

AstraZeneca (AZ) expected to close the acquisition of CAT in June 2006

Royalty Terms:

CAT receives 2.688% on worldwide sales

Duration: December 2017 (US and Non-US)

The figure below reports the worldwide sales for Humira from 2007 to 2017:

Given the $700 million purchase, and the subsequent royalties, what is the internal rate of return of this deal from Royalty Pharma's perspective? Assume all royalties occur at the end of the year so the first payment is received exactly 1 year after the $700 million purchase. (Note: Your answer should be a number in percentage form. Do not enter '%'.)

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Hint: A spreadsheet can be used to solve this question. Alternatively, an online solver such as WolframAlpha can be used to solve the equation for the IRR.

Suppose Royalty Pharma's portfolio consists of equally-weighted royalty interests in 40 approved and marketed biopharmaceutical products. Assume each royalty stream has an annualized expected return of 6.5%, and return standard deviation of 20%.

If the correlation amongst projects is 10%, then what is the annualized expected return of the portfolio. (Note: Your answers should be numbers in percentage form. Do not enter '%'.)

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