Intellectual Property: Currency of the New Economy

As Peter Drucker predicted, so has it come to pass; the new economy companies that proliferate in the United States and across the Group of 8 ('G8') countries are predominantly fueled by human capital, and enterprises participating in advanced economies are service-based and knowledge-driven.

The knowledge resident in our people that manifests itself in codified (patents, trademarks, and copyrights) and non-codified (know-how, trade secrets) intellectual capital is the single most significant source of value in the new economy. When codified, intellectual capital is transformed into intellectual property ('IP'), which conveys an ownership right in inventions that quite often serve as the foundation upon which entire businesses are built.

Given the legal standing of IP assets and their centrality to the ongoing process of building, managing, and leveraging value that private sector leaders are responsible for stewarding, IP is the primary focus here. If what is posited above is indeed true and IP is the critical source of value for new economy companies, it is important that we understand how these intangible assets are perceived, valued, and leveraged relative to the hard assets that were so vital to industrial era growth. Specifically, the way in which the capital markets view IP assets and the means by which IP is emerging as the currency of the new economy will be considered.

Traditional Lending and IP's Early Emergence As an Asset Class

While there is still a large hangover of industrial era perceptions regarding the real sources of value in today's businesses, nowhere are these perceptions more entrenched and antagonistic to corporate growth than in the credit policies of traditional commercial lenders. Traditional lender credit policies have historically viewed IP as 'boot collateral' ' entirely unsuitable as a form of collateral to support a loan but nonetheless susceptible to encumbrance as part of the blanket lien requirements that persist to this day.

The historical resistance to lending against IP has been attributable to:

• Perceived challenges associated with valuation.
• Perceived challenges associated with monetization of IP collateral in the event of a default and foreclosure.
• Limited motivation on the part of the lending community due to the fact that the IP assets would otherwise be encumbered and there was little or no incentive to take risk through lending money against the IP or unencumbering it so that a third-party lender could lend against it.

Throughout the history of banking and asset based lending ('ABL'), credit based on asset classes such as accounts receivable; inventory; and property, plant, and equipment have evolved over time, so in some respects IP's emergence as an asset class is following a well-established pattern. Those in the vanguard of the lending business who were capable of assessing and managing risk associated with tangible assets such as accounts receivable and inventory when others found these risks unknowable drove the expansion of traditional lending beyond real property lending.

Similarly, a group of innovative players came forward beginning in 1997 to enable IP to serve as an acceptable form of collateral in asset-backed transactions. Initially it was the so-called 'Bowie-bond issue' conceived and led by David Pullman that raised awareness among the lending community as to the latent value of intangibles such as copyrights. Charles A. Koppelman's finance firm, CAK Universal Credit Corporation, then proceeded to serve as arranger of several transactions which enabled similarly cash flowing IP assets to serve as a source of cost-effective debt capital.

In addition, the lead specialty lenders involved in 'factoring' pharmaceutical royalty streams such as Paul Capital, Royalty Pharma, and Drug Royalty all entered the market with issues whereby their portfolios of cash flowing IP were securitized. Leading investment bank securitization businesses that had cut their teeth on mortgage backed securitizations and then migrated to credit card and student loan facilities discovered IP during the late 1990s as well, as reflected in the sample listing of early stage IP transactions summarized in Table 1.

[IMGCAP(1)]

In mid-late 2003 and early 2004, IP lending was extended to non-cash flowing IP for the first time. Firms like the Principal Financial Group-sponsored IP finance firm, IPI Financial Services, entered the market during this period and extended debt capital against naked IP irrespective of cash flows from licensing. Prior to this time, the cash flows that derived from IP as an underlying asset were utilized to support securitizations and bond issues. The sustainability of the cash flows and the ability to model them enabled rating agencies like Standard & Poor's and Moody's to rate these transactions and facilitated the extension of partial guarantees or 'wraps' by firms like MBIA, FGIC, and AMBAC. In a very real sense, these deals borrowed from structures used with great success for other asset classes (mortgages, credit cards, auto loans) and were completed and sold down into the market with an almost agnosticism toward the IP that served as the underlying asset. In such transactions, the IP can be viewed as a means to an end; but it is not
necessarily IP risk that is being taken by investors but instead investors looked to historical cash flows to give them comfort with future flows that would be used to pay down their notes. Obviously, this kind of approach does not require an in-depth understanding of IP and the risk associated with it.

Instead of using a sophisticated and costly sale-license back structure and the bankruptcy-remote special purpose entities that were commonplace in securitizations but unnecessary in more straightforward asset based loans, IPI established itself as the first pure play IP lender and the first to simplify the lending process by requiring only a senior secured position in borrower IP. In this way, IPI's approach to IP lending was greatly simplified and, by design, made fully complementary to loans offered against a company's hard assets offered by traditional hard asset lenders.

Included in Table 2 is a graphic representation of the structure of a senior secured IP-based loan as conceptualized and implemented by IPI and, more recently, by Paradox Capital.

[IMGCAP(2)]

IPI did the pioneering work in establishing senior secured IP lending and drew on the $40MM fund that it raised from Principal Financial Group to essentially refine this lending model. During its existence, IPI extended debt capital against the IP of Wise Foods (maker of Wise branded potato chips, Cheez Doodles, and Quinlan pretzels), Cambridge Display Technology (owner of a fundamental patent portfolio in next generation flat panel display technology ' OLED), and BCBG Max Azria (leading fashion designer in women's contemporary), among others.

Subsequently, the core operational team from IPI formed Paradox Capital and raised a dedicated $280MM IP fund through its relationships with the global investment bank, Babcock & Brown, and the structured products team at West LB. Since closing on the fund in Q406, Paradox has extended IP loans against the IP of Rachel Ashwell (home products/interiors designer and author of the Shabby Chic style), Cranium (leading board game), California Tan (premium indoor/outdoor tanning products), Robbins Brothers (retail jewelry chain), and Betsey Johnson (leading fashion designer in the vanguard of women's contemporary apparel), among others.

IP Finance Landscape

While the market entry of pure play IP asset based lenders like IPI and Paradox Capital clearly signaled maturation in the IP finance market, it is important to understand the larger context of IP finance into which IP ABL fits. Toward that end, Table 3 provides an overlay of the IP finance landscape and provides a jumping off point for discussion of some of the other businesses active in the space.

[IMGCAP(3)]

To round out the discussion of the evolving IP Finance landscape, it bears mentioning that significant pools of capital are being raised and/or allocated to support new factoring businesses, litigation finance, and IP aggregation and licensing.

For example, it has been reported that Altitude Capital has raised in excess of $200MM in capital to finance IP-based litigation and other high-yield IP finance activities (i.e., mezzanine and equity investment in IP-centric companies). IP aggregators such as Rembrandt, Intellectual Ventures, and Acacia have apparently raised capital to support the acquisition of largely orphan technologies. Venture debt providers like NewLight Capital and the more traditional banks active in this arena (e.g., Silicon Valley Bank) continue to deploy debt capital secured in large measure by the IP assets of venture-backed businesses; though a good number of these transactions are based as much on the credibility and pedigree of the lead venture capital investors in the deal as on the quality and value of the IP, it nonetheless evidences another means by which IP is enabling debt capital investment.

IP collateralization/asset based lending of the type that Paradox Capital is involved in supporting is perhaps the most impactful of all those IP finance businesses in that it permits IP-centric companies to gain access to risk appropriate debt capital. The growing population of middle market new economy companies that are brand/trademark and channel managers often have limited borrowing bases of accounts receivable, inventory and property, plant and equipment. Alternatively, they may be copyright owners with no complementary assets or patent rich companies with significant R&D budgets that support their technology advantage as a licensor to third-party manufacturers. As such, these companies are reliant on highly dilutive equity and/or expensive mezzanine capital to support growth.

Through the emergence of IP (cash flowing or non-cash flowing) as an asset class and a fourth vertical alongside recognized hard assets, middle market IP-centric companies that might hover in the 'B' rated credit range can access cost effective growth capital due to the introduction of IP collateralization/ABL (Table 4).

[IMGCAP(4)]

In essence, the lion's share of what second lien lenders loaned against in the late 1990s and into the early part of this decade was IP. Not directly, of course, but indirectly and incidentally. Leading hedge funds minted during that period such as Back Bay Capital and, to a lesser extent, Fortress and Cerberus started out by recognizing that traditional hard asset lenders could not sufficiently lend up to the debt servicing capacity of borrowers in the middle market. The euphemism for what these hedge funds took second lien positions against in these transactions was surplus 'enterprise value.' In a very real sense, enterprise value is what the hedge funds were lending against, but if one is more granular and analytic it was really the unrecognized and unarticulated value of the IP that makes up much of enterprise value in new economy companies that supported these high-yield second lien loans. IP based collateralization/ABL loans, therefore, represent a natural and logical evolution of second lien lending to an asset based transaction. The same systemic issue regarding traditional lender credit policies and attitude toward IP are addressed by IP collateralization/ABL as second lien loans, but the risk is made cognizable and the pricing of the capital deployed is brought more in line with that risk.

Conclusion

The new economy companies that proliferate in the advanced economies of the world are increasingly IP-intensive. As such, creative sources of capital like IP-backed lending will become increasingly prevalent, and the cost of growth capital will better align with the quality of the tangible and intangible assets that serve as collateral for loans and the underlying credit quality of borrowers.

Current credit policies at the traditional asset based lenders have yielded a seam in the market that is being filled by financial services firms that are in the vanguard offering financing solutions that include IP-backed senior secured loans, IP-based venture debt, securitization structures, IP acquisition/aggregation, and litigation finance. Despite recent corrections in the sub-prime mortgage market, an ample supply of capital remains in search of attractive returns. In such an environment, IP's positioning as a leading form of collateral in the overall category of esoteric assets will garner it an increasing level of attention from investors.

Since the inception of the active era of IP finance in the late 1990s, IP finance has evolved to far more than securitization and bond issues based on cash flowing IP. The quality and value of IP are becoming knowable for a select group of specialty lenders who understand the centrality of IP to enterprise value. IP finance is no longer merely a vision. It is a reality. As a result, IP is increasingly becoming the currency of the new economy and an asset around which capital is mobilizing.

Keith Bergelt is the President & CEO of Paradox Capital LLC, a subsidiary of the global investment bank Babcock & Brown, which focuses exclusively on financing IP assets.

As Peter Drucker predicted, so has it come to pass; the new economy companies that proliferate in the United States and across the Group of 8 ('G8') countries are predominantly fueled by human capital, and enterprises participating in advanced economies are service-based and knowledge-driven.

The knowledge resident in our people that manifests itself in codified (patents, trademarks, and copyrights) and non-codified (know-how, trade secrets) intellectual capital is the single most significant source of value in the new economy. When codified, intellectual capital is transformed into intellectual property ('IP'), which conveys an ownership right in inventions that quite often serve as the foundation upon which entire businesses are built.

Given the legal standing of IP assets and their centrality to the ongoing process of building, managing, and leveraging value that private sector leaders are responsible for stewarding, IP is the primary focus here. If what is posited above is indeed true and IP is the critical source of value for new economy companies, it is important that we understand how these intangible assets are perceived, valued, and leveraged relative to the hard assets that were so vital to industrial era growth. Specifically, the way in which the capital markets view IP assets and the means by which IP is emerging as the currency of the new economy will be considered.

Traditional Lending and IP's Early Emergence As an Asset Class

While there is still a large hangover of industrial era perceptions regarding the real sources of value in today's businesses, nowhere are these perceptions more entrenched and antagonistic to corporate growth than in the credit policies of traditional commercial lenders. Traditional lender credit policies have historically viewed IP as 'boot collateral' ' entirely unsuitable as a form of collateral to support a loan but nonetheless susceptible to encumbrance as part of the blanket lien requirements that persist to this day.

The historical resistance to lending against IP has been attributable to:

• Perceived challenges associated with valuation.
• Perceived challenges associated with monetization of IP collateral in the event of a default and foreclosure.
• Limited motivation on the part of the lending community due to the fact that the IP assets would otherwise be encumbered and there was little or no incentive to take risk through lending money against the IP or unencumbering it so that a third-party lender could lend against it.

Throughout the history of banking and asset based lending ('ABL'), credit based on asset classes such as accounts receivable; inventory; and property, plant, and equipment have evolved over time, so in some respects IP's emergence as an asset class is following a well-established pattern. Those in the vanguard of the lending business who were capable of assessing and managing risk associated with tangible assets such as accounts receivable and inventory when others found these risks unknowable drove the expansion of traditional lending beyond real property lending.

Similarly, a group of innovative players came forward beginning in 1997 to enable IP to serve as an acceptable form of collateral in asset-backed transactions. Initially it was the so-called 'Bowie-bond issue' conceived and led by David Pullman that raised awareness among the lending community as to the latent value of intangibles such as copyrights. Charles A. Koppelman's finance firm, CAK Universal Credit Corporation, then proceeded to serve as arranger of several transactions which enabled similarly cash flowing IP assets to serve as a source of cost-effective debt capital.

In addition, the lead specialty lenders involved in 'factoring' pharmaceutical royalty streams such as Paul Capital, Royalty Pharma, and Drug Royalty all entered the market with issues whereby their portfolios of cash flowing IP were securitized. Leading investment bank securitization businesses that had cut their teeth on mortgage backed securitizations and then migrated to credit card and student loan facilities discovered IP during the late 1990s as well, as reflected in the sample listing of early stage IP transactions summarized in Table 1.

[IMGCAP(1)]

In mid-late 2003 and early 2004, IP lending was extended to non-cash flowing IP for the first time. Firms like the Principal Financial Group-sponsored IP finance firm, IPI Financial Services, entered the market during this period and extended debt capital against naked IP irrespective of cash flows from licensing. Prior to this time, the cash flows that derived from IP as an underlying asset were utilized to support securitizations and bond issues. The sustainability of the cash flows and the ability to model them enabled rating agencies like Standard & Poor's and Moody's to rate these transactions and facilitated the extension of partial guarantees or 'wraps' by firms like MBIA, FGIC, and AMBAC. In a very real sense, these deals borrowed from structures used with great success for other asset classes (mortgages, credit cards, auto loans) and were completed and sold down into the market with an almost agnosticism toward the IP that served as the underlying asset. In such transactions, the IP can be viewed as a means to an end; but it is not
necessarily IP risk that is being taken by investors but instead investors looked to historical cash flows to give them comfort with future flows that would be used to pay down their notes. Obviously, this kind of approach does not require an in-depth understanding of IP and the risk associated with it.

Instead of using a sophisticated and costly sale-license back structure and the bankruptcy-remote special purpose entities that were commonplace in securitizations but unnecessary in more straightforward asset based loans, IPI established itself as the first pure play IP lender and the first to simplify the lending process by requiring only a senior secured position in borrower IP. In this way, IPI's approach to IP lending was greatly simplified and, by design, made fully complementary to loans offered against a company's hard assets offered by traditional hard asset lenders.

Included in Table 2 is a graphic representation of the structure of a senior secured IP-based loan as conceptualized and implemented by IPI and, more recently, by Paradox Capital.

[IMGCAP(2)]

IPI did the pioneering work in establishing senior secured IP lending and drew on the $40MM fund that it raised from Principal Financial Group to essentially refine this lending model. During its existence, IPI extended debt capital against the IP of Wise Foods (maker of Wise branded potato chips, Cheez Doodles, and Quinlan pretzels), Cambridge Display Technology (owner of a fundamental patent portfolio in next generation flat panel display technology ' OLED), and BCBG Max Azria (leading fashion designer in women's contemporary), among others.

Subsequently, the core operational team from IPI formed Paradox Capital and raised a dedicated $280MM IP fund through its relationships with the global investment bank, Babcock & Brown, and the structured products team at West LB. Since closing on the fund in Q406, Paradox has extended IP loans against the IP of Rachel Ashwell (home products/interiors designer and author of the Shabby Chic style), Cranium (leading board game), California Tan (premium indoor/outdoor tanning products), Robbins Brothers (retail jewelry chain), and Betsey Johnson (leading fashion designer in the vanguard of women's contemporary apparel), among others.

IP Finance Landscape

While the market entry of pure play IP asset based lenders like IPI and Paradox Capital clearly signaled maturation in the IP finance market, it is important to understand the larger context of IP finance into which IP ABL fits. Toward that end, Table 3 provides an overlay of the IP finance landscape and provides a jumping off point for discussion of some of the other businesses active in the space.

[IMGCAP(3)]

To round out the discussion of the evolving IP Finance landscape, it bears mentioning that significant pools of capital are being raised and/or allocated to support new factoring businesses, litigation finance, and IP aggregation and licensing.

For example, it has been reported that Altitude Capital has raised in excess of $200MM in capital to finance IP-based litigation and other high-yield IP finance activities (i.e., mezzanine and equity investment in IP-centric companies). IP aggregators such as Rembrandt, Intellectual Ventures, and Acacia have apparently raised capital to support the acquisition of largely orphan technologies. Venture debt providers like NewLight Capital and the more traditional banks active in this arena (e.g., Silicon Valley Bank) continue to deploy debt capital secured in large measure by the IP assets of venture-backed businesses; though a good number of these transactions are based as much on the credibility and pedigree of the lead venture capital investors in the deal as on the quality and value of the IP, it nonetheless evidences another means by which IP is enabling debt capital investment.

IP collateralization/asset based lending of the type that Paradox Capital is involved in supporting is perhaps the most impactful of all those IP finance businesses in that it permits IP-centric companies to gain access to risk appropriate debt capital. The growing population of middle market new economy companies that are brand/trademark and channel managers often have limited borrowing bases of accounts receivable, inventory and property, plant and equipment. Alternatively, they may be copyright owners with no complementary assets or patent rich companies with significant R&D budgets that support their technology advantage as a licensor to third-party manufacturers. As such, these companies are reliant on highly dilutive equity and/or expensive mezzanine capital to support growth.

Through the emergence of IP (cash flowing or non-cash flowing) as an asset class and a fourth vertical alongside recognized hard assets, middle market IP-centric companies that might hover in the 'B' rated credit range can access cost effective growth capital due to the introduction of IP collateralization/ABL (Table 4).

[IMGCAP(4)]

In essence, the lion's share of what second lien lenders loaned against in the late 1990s and into the early part of this decade was IP. Not directly, of course, but indirectly and incidentally. Leading hedge funds minted during that period such as Back Bay Capital and, to a lesser extent, Fortress and Cerberus started out by recognizing that traditional hard asset lenders could not sufficiently lend up to the debt servicing capacity of borrowers in the middle market. The euphemism for what these hedge funds took second lien positions against in these transactions was surplus 'enterprise value.' In a very real sense, enterprise value is what the hedge funds were lending against, but if one is more granular and analytic it was really the unrecognized and unarticulated value of the IP that makes up much of enterprise value in new economy companies that supported these high-yield second lien loans. IP based collateralization/ABL loans, therefore, represent a natural and logical evolution of second lien lending to an asset based transaction. The same systemic issue regarding traditional lender credit policies and attitude toward IP are addressed by IP collateralization/ABL as second lien loans, but the risk is made cognizable and the pricing of the capital deployed is brought more in line with that risk.

Conclusion

The new economy companies that proliferate in the advanced economies of the world are increasingly IP-intensive. As such, creative sources of capital like IP-backed lending will become increasingly prevalent, and the cost of growth capital will better align with the quality of the tangible and intangible assets that serve as collateral for loans and the underlying credit quality of borrowers.

Current credit policies at the traditional asset based lenders have yielded a seam in the market that is being filled by financial services firms that are in the vanguard offering financing solutions that include IP-backed senior secured loans, IP-based venture debt, securitization structures, IP acquisition/aggregation, and litigation finance. Despite recent corrections in the sub-prime mortgage market, an ample supply of capital remains in search of attractive returns. In such an environment, IP's positioning as a leading form of collateral in the overall category of esoteric assets will garner it an increasing level of attention from investors.

Since the inception of the active era of IP finance in the late 1990s, IP finance has evolved to far more than securitization and bond issues based on cash flowing IP. The quality and value of IP are becoming knowable for a select group of specialty lenders who understand the centrality of IP to enterprise value. IP finance is no longer merely a vision. It is a reality. As a result, IP is increasingly becoming the currency of the new economy and an asset around which capital is mobilizing.

Keith Bergelt is the President & CEO of Paradox Capital LLC, a subsidiary of the global investment bank Babcock & Brown, which focuses exclusively on financing IP assets.