"We decided we needed to get into the world and make an impact." – LUKE DÜSTER, PRINCIPAL
Nate Hukill and Luke Düster first met in Shanghai, when the city was a boomtown with a skyline that was a forest of cranes. As college students studying abroad, they shared a small room, a tight budget—and a mischievous streak. So one day they snuck into a nearby luxury hotel to relax in its hot tub. There they met a Japanese businessman who regaled them with stories of the deals that moved those cranes. At the time, Hukill was studying language and Düster international affairs, but that night in 1995 they both made a fateful decision to switch to finance. "We decided we needed to get into the world and make an impact," Düster says.
Since then, Hukill and Düster have etched out a career finding alternative financing solutions in the life sciences arena. It's a field where long development times and risky product bets can make it difficult to structure deals that both the investor and the company find advantageous. In fact, for early-stage biopharma companies, obtaining financing from traditional banks is expensive or impossible. And raising venture capital often comes at a big price—a piece of the company—when it is available at all.
"There is a distinct need for capital resources given the shrinking universe of VC funds, and we've found some success by offering non-dilutive credit-oriented strategies," Hukill says.
A former professional cyclist, Hukill became a pioneer in a financial product known as a royalty bond. In a typical royalty arrangement, an early-stage company that has developed a drug or medical device receives royalty payments from a large pharma firm in exchange for the right to commercialize the product. As recently as a decade ago, the primary way for these early-stage companies to raise capital was to sell the rights to their future payments outright. With royalty bonds, companies can borrow against those future streams instead. Once the bond is repaid, the borrower retains ownership of the residual royalty streams.
Beginning in 2005, Hukill spearheaded Highland Capital Management's entry into biopharma royalties, helping Highland become the largest buyer of biopharma royalty bonds in the U.S. In 2009, he was lured by well-known Houston private equity investor Charles Tate to join Capital Royalty, which specializes in alternative biopharma financing. Tasked with opening CR's new office in Boulder, Colo., he called up his old friend Düster, then an investment banker in Richmond, Va.
With interest rates near rock-bottom, royalty bonds are appealing to private equity investors who are hungry for yield. In fact, non-traditional asset-backed securities are doing very well across the board as investors bounce back from the financial crisis, Reuters recently reported. About 7.5 percent of non-mortgage asset-backed securities issued in 2012 were backed by nontraditional cash flows, up from 5.3 percent in 2010, according to a Reuters research unit.
Royalty bonds first captured public attention in the late 1990s when rock musician David Bowie issued bonds tied to royalties from his music catalog. Recent bonds have been issued backing the Miramax film library, timeshare properties, and more.
In the case of life sciences-based royalty bonds, Capital Royalty helps control investor risk by focusing on products that are already FDA-approved. It also conducts intensive research.
"One thing that distinguishes CR is the level of diligence they do on the companies they are lending to," says Morrison & Foerster attorney Bill Veatch, who has significant experience with monetization of royalty streams and works closely with CR. "They talk to the doctors and the nurse practitioners, the people who actually use the medical device or product, and figure out if the technology is performing well and is worth investing in."
CR recently closed its sixth investment in its most recent fund and is looking to deploy about $1 billion in capital over the next several years. Veatch has assisted with five transactions and is working on new investments as well. A typical example is TriVascular, a medical device company that markets a stent that allows repair of an aortic aneurysm without the need for open-heart surgery.
The new frontier for CR is structured debt, which has become the most popular form of capital for high-growth companies in the healthcare arena, Düster says. According to Veatch, the simplest form of structured debt is a loan in which the life sciences company's patents and related cash flows act as collateral. More complicated is a structured deal in which the funds go to a created subsidiary rather than to the borrower directly. This special-purpose entity receives the patents, the license, and the cash flow, Veatch says. If the borrower were to enter bankruptcy, the subsidiary is protected and the lender has a first claim to the IP as collateral.
"With structured debt we have rights to all the company's assets, but we give the company a two- to four-year period where they pay the interest only," Düster says. "Companies that are launching new products or investing in new product development can use the capital to fund their growth initiatives, as opposed to financing debt repayments."
For Hukill and Düster, honoring the commitment they made in Shanghai means helping CR grow and remain innovative. "We want to build something that matters," Hukill says. "I can't tell you it's the next Blackstone or KKR because we'll be unique. But it's a firm that will likely be a household name in 10 years."
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