As pension funds seek stable, long-term returns, healthcare royalties are emerging as an attractive asset class for UK investors. With their predictable income streams and low correlation to market volatility, could royalties offer a reliable alternative to traditional investments? Aysha Gilmore reports.
When thinking about royalties one might recall the Hugh Grant film About a Boy, where Will Freeman (played by Grant) lives without any responsibility or commitments, thanks to royalties let to him by his father’s naff but successful Christmas song.
So, when thinking about income generation and creating steady returns, could royalties offer a similar opportunity for pension funds?
According to David MacNaughtan, partner and head of Sagard Healthcare, one of the key attractions to investing in royalties, particularly healthcare royalties, is the consistent returns and income they generate.
Healthcare royalties are payments made to individuals or entities from the commercial use or sale of healthcare-related products, such as drugs or medical devices.
“This is a great diversifier and a great completion strategy for a fixed income portfolio. So, this has fixed income-like characteristics with equity like upside potential,” he says.
The “promise” of healthcare royalty investing is that it is based on “medically necessary approved drugs”. Consequently, the returns investors receive every quarter are not correlated with the broader markets. This is due to the pharmaceutical products being prescribed in “good times and bad, regardless of the credit market”, MacNaughtan explains.
“For schemes that are interested in income, matching assets and liabilities, this is a great way to incorporate this predictable cash flow stream into your forecasts,” he says.
Alongside this, the lack of correlation to broader markets gives healthcare royalties a “defensive nature” as even in recession, patients still need these prescribed drugs. Furthermore, royalties often have inflation protection as prices for these products can increase, even with regulatory constraints, MacNaughtan adds.
Compared to other sorts of royalties, MacNaughtan explains that healthcare royalties are “well established”, offer “market exclusivity” and have persisted to generate “attractive returns”.
By contrast, industries such as music and technology don’t offer all of these incentives as they are rapidly changing sectors.
Who is investing?
Railpen, one of the biggest pension funds in the UK, has tapped into the asset, investing $1bn in healthcare royalties, which makes up 3% of the growth fund. The pension fund also had exposure to music royalties, which it sold in 2021.
For £34bn Railpen, the fund accessed the asset class through an external manager, who acquired a portfolio of royalty rights on the fund’s behalf.
Speaking to the Private Markets Profile, Craig Heron, director of public markets at Railpen, says: “The exposure to healthcare royalties sits alongside other alternative, diversifying exposures such as natural catastrophe reinsurance and a trend-following strategy.
“When evaluating our alternatives portfolio, we are looking for assets that will diversify our exposure to the equity risk premium, and provide us with a high single digit, or low double digit return over the long-term.”
Asked whether Railpen might increase its allocation to royalties, Heron explains that while the fund does have some “additional headroom” for increased exposure it is “not markedly so”.
Alongside Railpen, other pension schemes in the UK, including funds within the Local Government Pension Scheme (LGPS), have also allocated capital towards royalties. Cumbria Pension Fund, for example, has committed $75m to various Healthcare Royalty Partners funds.
A spokesperson for Cumbria Pension Fund says that the fund invested in the asset due to the “high net return and diversification” it offered. However, the spokesperson stated that the fund is “not particularly” interested in increasing its allocation further.
For mature pension schemes like those in the LGPS, royalties can be an attractive investment due to their predictable income stream and alignment with long-term investment horizons.
Other LGPS funds that have committed to royalties include, Strathclyde, Scottish Borders, East Riding, and Westmoreland and Furness pension funds.
Underwriting challenges
As with all investments, royalty investing comes with its challenges.
According to Heron, while Railpen’s experience in the area has been positive, “there can be challenges around underwriting the appropriate business case for products, and so if revenue growth disappoints then returns are also likely to disappoint”.
Heron also highlights that these transactions come with production and counterparty risk.
For MacNaughtan, the challenge lies in the complexity of healthcare royalties: “This is not an area for generalists,” he says.
