Biopharma Credit — Oversubscribed offering fuels further growth

BPCR is a UK-domiciled fund incorporated in October 2016, which completed its IPO in March 2017 issuing new shares in exchange for a portfolio of seed assets and additional cash contribution from investors (total gross proceeds of US$762m including a US$339m seed portfolio). It is now listed in the specialist funds segment of the LSE. Subsequently, BPCR completed a placement of ordinary shares in December 2017 with US$154m of gross proceeds, and completed a C shares offering with US$163.8m of gross proceeds in April 2018. These funds, together with the value of already amortised seed assets (nearly US$240m or 70% of initial amount outstanding as at end-August 2018), were already reinvested in five new loans and a priority royalty stream representing US$987m.

BPCR’s portfolio is composed of debt assets in the life sciences industry in the US, Europe and Japan, covering pharmaceuticals, bio-pharmaceuticals, medical devices and clinical diagnostics. This includes in particular senior secured loans (currently 88% of the portfolio) granted to life sciences companies, which are secured by all or some of the company’s assets and may include royalty collateral as well as other IP and marketing rights. Other portfolio constituents may include royalty debt instruments, where the borrower is an owner of royalty rights whose obligations are secured by royalty collateral, and priority royalty tranches, where BPCR obtains the right to receive all or a fixed percentage of future royalty streams from the sale of a defined set of commercial-stage drugs.

BPCR aims at generating long-term returns mostly in the form of sustainable income distributions, with a targeted medium-term annualised dividend of US$0.07 per share and a net total NAV return of 8–9% per year. The coupon rate on senior secured loans within BPCR’s current portfolio ranges from 9% to 12% and originally represented predominantly fixed coupons. Since then, he company has advanced three loans (Tesaro, Sebela and Amicus Therapeutics) representing US$660.7m with coupons based on USD LIBOR plus a spread. Potential upside to BPCR’s return on individual investments may come from prepayments of senior secured loans, as the loan agreements often include a make-whole call provision covering two to three years of coupon payments and/or a prepayment fee of c 1–3% (the exact rate depends on the remaining time to maturity). BPCR aims at an average maturity of debt instruments at five years. However, borrowers from the life science industry often have the motivation to prepay the debt to refinance it on more attractive terms (extended maturity or lower interest), as exhibited by the recent Novocure transaction (see the current portfolio positioning section for further details).

BPCR is managed by Pharmakon Advisors (established in 2009), which is run by Pedro Gonzalez de Cosio (co-founder and principal), Martin Friedman (principal) and Pablo Legorreta (co-founder and principal, who is also the founder and CEO of Royalty Pharma). Since inception, Pharmakon has invested US$3.2bn across five biopharma funds (including BPCR), whose historical and estimated performance is illustrated in Exhibit 2. BioPharma I was launched in June 2009 and made its final distribution to investors in April 2014, realising a gross IRR of c 15% (net IRR of 11.3%, cash-on-cash return of 1.3x). BioPharma II has also reached life-end, with a realised net IRR of 6.8% compared to the initial target of high single digits. The performance of this fund was somewhat below Pharmakon’s target due to weaker than expected return on a capped royalty, where the underlying drug’s revenue growth was below expectations. BioPharma III and IV have reached the end of their investment periods; BioPharma III has already started returning capital to investors. Importantly, Pharmakon has not experienced any defaults in its portfolio since it was established.

In our initiation note (May 2018) we discuss several key factors translating into new debt investment opportunities for BPCR. These include:

The availability of attractive lending opportunities for BPCR is to some extent determined by the equity valuation levels of biotech companies. The higher the market multiples, the more willing companies are to raise new equity and the more limited the pool of potential transactions for BPCR. Conditions on the US stock market have remained relatively stable, with the NASDAQ Biotechnology TR index rising by c 2% in the year to date (after growing 21.6% in 2017). The current LTM P/E ratio for the index (based on profitable companies only) stands at c 17.4x compared to 18.4x as at end-2017 (based on Bloomberg data). As a result, both equity and convertible issuance increased in H118. According to BPCR data, global issuance by life science companies stood at US$35.7bn compared with US$27.2bn in H117, while US issuance of life sciences convertible bonds reached US$5.2bn vs US$2.3bn in H117. Despite these positive developments in the equity and convertibles markets, BPCR has been able to invest c US$640m so far this year (including the US$100m to the second tranche of the Tesaro loan committed last year).

Increased M&A activity in the sector provides BPCR with more lending opportunities. According to the company, global life sciences M&A volume rose 13.7% y-o-y to US$126.6bn in H118, which is an illustration of a broader increase in M&A activity across industries triggered, among others, through the improved visibility associated with the completion of the US tax reform. In its recent Q218 Global Pharma & Life Sciences Deals Insights, PwC is indicating there is a positive outlook for the M&A activity in the biotech sub-sector in Q318, driven by companies expanding their pipelines with smaller acquisitions of high-quality assets. Additionally, record-high levels of FDA approvals should support activity in this area.

BPCR’s investment strategy relies on ongoing screening of a large number (>200) of potential opportunities. Individual investment selection is based on detailed analysis of the underlying product collateral, including the clinical utility of the product, competitive landscape, IP situation, pricing, reimbursement (insurance and Medicaid/Medicare coverage), the marketer’s strength, as well as the opportunity’s safety record, physician adoption and sales history. In performing this analysis, Pharmakon Advisors relies in part on Royalty Pharma’s internal analyst team (seven analysts with a medical degree or background in biochemistry, biology or material sciences) based on the shared services agreement it has signed with Royalty Pharma. Importantly, in some instances, it may benefit from Royalty Pharma’s solid understanding of the underlying asset. This is developed through its acquisition of a royalty interest at an earlier stage than BPCR’s investment. Pharmakon will conduct primary market research and may also use third-party market research. The future sales potential of respective drugs is evaluated based on direct discussions with external experts and leading physicians. Moreover, the investment manager may rely on market research in the form of physician studies to examine safety, familiarity, usage and acceptance of respective products by practising doctors, as well as engagement of regulatory and manufacturing consultants. Finally, outside counsel may be leveraged to evaluate IP rights and the patent estate of the royalty collateral.

Pharmakon Advisors also examines the structure of royalty investments. It pays particular attention to the expected yield and duration, quality (ie, strength and enforceability) of collateral, coverage ratios (calculated as commercial licence value to the amount of debt outstanding), priority of payments, as well as cash flow projections and their impact on expected maturity and duration.

In the case of senior secured loans and unsecured debt, apart from examining the products marketed by the borrower, the fund manager also evaluates its credit profile and how the potential investment is structured. In terms of the borrower’s credit metrics, it takes into consideration expected product margins, coverage ratios (projected free cash flow to total debt and/or EV to debt), access to equity markets to raise fresh capital, quality of the management team, production capacity, as well as overall capital structure and other existing liabilities. The analysis of the investment structure is largely concentrated on the expected yield and duration, quality of collateral, covenants, call protections, structural yield enhancement (eg, additional coupons linked to sales) as well as access to liquidity in the case of listed stocks.

BPCR seeks investments with predictable cash flows and significant downside protection. Importantly, when evaluating new investment opportunities, BPCR is solely focused on approved products, thus avoiding the risks associated with drug development and clinical trials. If the borrower, in addition to approved drugs, also has products in late-stage clinical trials, these are not assumed to reach the market, hence giving BPCR a safety margin. To further minimise the risk, BPCR may include revenue and profitability covenants to loan agreements or provide debt funding in tranches depending on product sales ramp-up. Following investment, BPCR monitors its assets regularly and remains in contact with the borrower’s management. Moreover, the investment manager and BPCR’s board hold quarterly meetings to discuss the level of exposure to market risk at a portfolio level.

BPCR’s portfolio structure at end-September 2018 is presented in Exhibit 4. Following the recent Amicus Therapeutics deal, BPCR became fully invested (although it has recently completed a new placing raising US$305m of gross proceeds). Importantly, we appreciate BPCR’s efforts to increase the exposure to floating-rate loans. Following the Amicus deal (concluded-post balance sheet date) and advancement of the Sebela loan as well as the second tranche of the Tesaro loan, floating-rate debt investments represent around 62% of BPCR’s portfolio. For a detailed examination of the underlying drugs, please see our initiation note.

The trust has recently funded US$100m as part of the second tranche of the Tesaro loan. Originally, BPCR planned to advance US$148m. However, to remain in line with its exposure limits to a single investment (30% of NAV), it has assigned US$48m to other investors. Compared to initial assumptions, this has increased the weighting to the first tranche, which has a slightly higher coupon rate (LIBOR+8.0% compared with LIBOR+7.5% in case of the second tranche). The loan is primarily backed by rights to Zejula, a PARP inhibitor used to treat recurrent ovarian cancer. Zejula’s sales in H118 quadrupled to US$102.8m from US$25.9m in H117, but the company lowered its FY18 sales guidance to US$225–235m from the previous US$255–275m, predominantly following the revision of expectations for market penetration of PARP inhibitors for ovarian cancer maintenance treatment in the US. We understand that the uptake in the case of maintenance treatment products that are not first-line therapies is usually slower in comparison to new products for treating diseases with no prior cure available. PARP inhibitors display a very high adoption rate for ovarian cancer specialists; this is much slower for community oncologists, who are confronted with only a few ovarian cancer cases per year and consequently may not have fully realised the importance of this treatment option yet.

The current Evaluate Pharma consensus for 2018 sales of Zejula stands at US$228m, which is within the range guided by the management and implies a 109% y-o-y increase, broadly in line with what is expected for Lynparza (+106%) and somewhat below the consensus estimate for Rubraca (+132%). Zejula’s consensus for 2020 fell from US$895m at the beginning of the year to US$549m currently. Tesaro recently completed the enrolment to the PRIMA Phase 3 monotherapy trial in first-line ovarian cancer regardless of biomarker status, which is irrespective of BRCA mutations. The interim safety data will be presented at the ESMO conference in October and the final dataset on the PRIMA trial will be published towards the end of 2019. Potential success would significantly improve the sales potential for Zejula. However, it must be noted that BPCR made the loan investment even without taking into account this potential boost to sales given its focus on approved and commercial-stage products and indications. Pharmakon Advisors remain confident that the sales outlook for Zejula’s approved indications more than covers Tesaro’s future obligations under the BPCR loan.

For other recent portfolio developments, the trust has provided additional funding of the total expected purchased payments linked to Bristol Myers Squibb, bringing the outstanding amount to US$46.0m at end-August 2018. Overall, BPCR committed to funding an estimated US$140–160m in 2018–2020 with this respect. Finally, the seed assets (limited partnership interest in BioPharma III and the RPS Note) continue to amortise and represent only c 9% of NAV (vs 24% at end-2017).

On 20 September, BPCR announced it had entered into a definitive loan agreement for a US$150m senior secured loan with Amicus Therapeutics, a biotech company focused on the treatment of rare metabolic diseases. As the five-year loan has a floating coupon rate of LIBOR plus 7.5% (subject to a floor of 1% and certain caps), we appreciate BPCR’s increased exposure to potential further interest rate increases in the US. Additionally, the loan arrangement includes a funding fee at 2%. The loan is interest-only for the first four years.

The proceeds will be used for the acquisition of Celenex, a private clinical-stage gene therapy company that is a spin-off of the Nationwide Children’s Hospital in Ohio, with the worldwide development and commercial rights for 10 gene therapy programmes in Phase I/II, pre-clinical or discovery stage. The loan proceeds will be also spent on development costs spread over several years. However, according to BPCR’s investment policy, the loan investments may be secured solely by approved products. In the case of Amicus, the loan will be permanently backed by commercial rights to Galafold (migalastat), a product used for adult treatment of Fabry disease, a rare X-chromosome linked genetic disease (connected with a defective gene, GLA) occurring predominantly in males with an incidence of about one per 60,000 births. Usually it manifests itself between three and 10 years of age with multiple symptoms including chronic pain and shortens life expectancy by 10 to 20 years with damage to the skin, kidneys (renal failure is the main cause of death), cardiovascular system (heart) and central nervous system (brain and muscle control) with increased stroke risk.

The disease has no cure although gene therapies might potentially be developed in the future (this is not likely to happen within the next few years). Existing treatments are either palliative (pain relief) or involve repeat fortnightly injections of enzyme replacement therapy (ERT), which remove some of the excess glycolipid with a recombinant form of GAL, either Shire’s Replagal (agalsidase alfa) or Sanofi’s Fabrazyme (agalsidase beta). However, injected enzymes cannot access the brain and, as a result, central nervous system symptoms persist.

Galafold (migalastat) was approved for EU-wide marketing on 26 May 2016 and it was also approved for Japan in March 2018. The FDA approved it for sale in the US on 13 August 2018. Some of its key advantages are that it is orally administered and less expensive than ERT, as the drug itself is priced in line with ERT, but the treatment does not involve accompanying expenses such as nurses, injections, and so on). Moreover, the active GLA is produced inside the cell where it is needed and consequently there is no risk of an immune response, which occurred in case of some patients with replacement enzymes, limiting the effective dose. This may potentially prove more effective in the longer term, but this has yet to be confirmed. However, we expect a steady rather than rapid adoption rate, as patients need to be rotated out of treatment therapies that work (even if they are less effective) and because Galafold’s clinical added gains are not yet entirely clear. The latter is underpinned by a comment from the National Institute for Health and Care Excellence, which suggests that there remain ‘important limitations and uncertainties’ over the data set on Galafold; however, we believe this is typical for rare disease trials (due to limited number of patients, high interpatient clinical variability and the lack of clear endpoints). Although no head-to-head trials have been conducted so far, it seems that Galafold’s effectiveness is comparable with ERT.

Sales in FY17 stood at US$36.9m following the mid-2016 EMA approval and 9M18 sales reached US$58.6m. Consequently, Amicus believes it is on track to achieve the higher end of its FY18 guidance at US$80–90m. This compares with current Evaluate Pharma consensus estimates at US$88m (with US$172m and US$237m expected in 2019 and 2020, respectively). We estimate that the global market for Fabry disease in 2017 was worth c US$1.3bn, with Replagal sales at US$472m and Fabrazyme revenues at US$816m. It is important to note that clinical diagnosis can be difficult and needs a confirmatory enzyme test. Any patient on ERT could transfer to Galafold if they have an amenable mutation. Although there is no completely reliable estimate of the number of current ERT patients treatable with Galafold, Amicus believes this figure is around 35–50%. We estimate that even if 20% of patients switch to Galafold (which corresponds to an achievable market of around US$240m), it would suffice to service the loan given low marketing costs (rare diseases are treated normally in specialist centres and there is usually a very engaged patient community) and high repeat, chronic use prescription rates. Moreover, there is additional market opportunity from patients not treated with ERT. In conjunction with the current Amicus cash position at US$564m as at end-September 2018, we believe the deal has a comfortable safety margin for BPCR.

BPCR is targeting a net total NAV return of 8–9% per year in the medium term. All of BPCR’s current debt investments offer a coupon rate of at least 9% per year. The trust’s annualised total return NAV performance since admission (March 2017) stands at 6.2%, as BPCR was adding new investments to its portfolio and thus was subject to a meaningful cash drag. Over the same period, the Credit Suisse HY index generated an annualised 7.7% total return. The fund became fully invested following the completion of the Amicus Therapeutics deal, but has recently completed another placement of new ordinary shares. BPCR’s ordinary share price performance was particularly strong over the six months ended August 2018, while it moderated somewhat subsequently (the price went down from US$1.10 to US$1.05, although this is also because of the ex-date for the 1.8 cent dividend on 31 August).

Over the last 12 months, BPCR traded at a premium to its last reported NAV. The premium declined from 12% in October 2017 to around 2% in February and March 2018 on the back of overall investor sentiment deterioration, but rebounded subsequently to reach 8–10% in August, assisted by the positive market sentiment and recent new loan investments. The current premium to NAV stands at c 1.6%, which we believe reflects tightening spreads on the broader debt markets and seems to discount a certain upside to the return generated by regular coupon payments, which is predominantly associated with prepayment fees on BPCR’s loan investments based on make-whole provisions included in loan arrangements. The premium has narrowed a bit recently which may be associated with the last placement (completed at an issue price of US$1.025).

Pharmakon Advisors receives a management fee equal to 1% of NAV less US$100,000, calculated monthly (ie, 1/12 of 1% of NAV on the last business day of the month minus 1/12 of US$100,000) and payable quarterly.

The investment manager is also entitled to a performance fee of 10% of NAV accretion over the respective 12-month performance period ending 31 December, subject to a high watermark and hurdle rate of 6% per year. Importantly, if BPCR's shares trade at an average discount to NAV of at least 5% during a rolling three-month period, the investment manager should use 50% of the corresponding performance fee for market acquisitions of shares.

In addition, BPCR will incur ongoing expenses. These include the fees of the board members, company secretary, administrator and registrar, as well as other operating expenses such as legal, advisory, PR and listing fees. The ongoing expenses ratio at 31 December 2017 stood at 1.2% of NAV per year. This may decline modestly as BPCR’s portfolio grows.

As at 18 October 2018, BPCR held only US$55.4m in cash (unaudited figure). BPCR has recently converted the outstanding C shares to ordinary shares (following the deployment of the proceeds in the Amicus deal) at a ratio of 0.9898. Moreover, the trust announced the results of its placement of new ordinary shares at an issue price of US$1.025. It initially targeted gross proceeds of US$150m to fund further investments (and outstanding potential commitments). However, due to strong investor interest, it increased the offering to US$200m, which was still oversubscribed (the final gross proceeds raised were US$305m).

Currently there is no debt at the BPCR level, but the trust is exploring the option of using debt at trust level. BPCR has a leverage cap of 50% of NAV calculated at the time of the drawdown. However, the fund manager is only allowed to incur indebtedness on behalf of the company of up to 25% of NAV without prior approval of BPCR’s board.

A continuation vote will be put to shareholders at the first AGM following the fifth anniversary of initial admission (27 March 2017) and, if passed, at the AGM held every third year thereafter. Furthermore, a vote will also occur within two months from the end of any 12-month rolling period where BPCR’s shares have, on average, traded at a discount in excess of 10% of NAV. However, BPCR’s board may execute share buybacks as a means to limit the discount volatility and potentially provide an additional source of liquidity at attractive price levels. Please refer to the issue prospectus for more detailed share repurchase guidelines. The trust has not executed any buybacks yet.

BPCR will pay quarterly dividends in US dollars. The trust intends to deliver a US$0.07 annualised dividend per share. BPCR may designate a part or full dividend amount as an ‘interest distribution’ and should be able to deduct this from its income when calculating taxable profit for the relevant period (assuming it generated enough ‘qualifying interest income’). On 19 October 2018, the company announced an interim dividend for the period ended September 2018 at US$0.0175 in the form of an interest distribution.

BPCR is part of the AIC Specialist: Debt sector, which contains funds with a wide variety of investment strategies, although none invest in the life sciences credit market. Nevertheless, we have combined a list of funds investing in various types of debt.

The trust was floated in March 2017 and there is no three- and five-year NAV total return performance available. In Exhibit 6, we thus present the NAV total return for the last six and 12 months, which in the case of BPCR stood at 3.7% (vs peer average of 2.0%) and 7.5% (ahead of peer average of 4.0%), respectively. The trust trades at a 1.6% premium to last reported NAV. This is either ahead or broadly in line with the respective peers, which mostly trade at a low-single digit discount or premium (with the exception of Chenavari Toro Income Fund). Interestingly, apart from BPCR, only Chenavari Toro Income Fund charges a performance fee within the analysed trusts group. In line with the comparative group, BPCR has no leverage at present, although the investment manager is willing to potentially use the limit of 25% of NAV, which does not require BPCR board approval. BPCR’s dividend yield stands at 5.7% on an LTM basis, but the last dividend payment is in line (when annualised) with the trust’s 7% target.

BPCR’s board comprises four directors, all of whom are non-executive and independent. They joined on incorporation of the investment trust. Jeremy Sillem (chairman) has extensive experience in asset management, with 28 years at Lazard and its predecessor entities, as well as Bear Stearns International. He is also the managing partner of Spencer House Partners, a financial advisory company that provides capital to the asset and wealth management industry. Duncan Budge is chairman of Dunedin Enterprise Investment Trust and Artemis Alpha Trust, and is also non-executive director of Lazard World Trust Fund, Lowland Investment Company, Menhaden Capital and Asset Value Investors. He is a former director of J Rothschild Capital Management. Colin Bond is the CFO of Vifor Pharma, a specialty pharma company based in Zurich and a former CFO of Evotec. Harry Hyman is the founder and managing director of Primary Health Properties.