Research

CA Answers: In an Environment of Declining Demographics and Slow Productivity Growth, What Investments Look Attractive?

Celia Dallas

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

Investments with the potential to earn returns competitive with equities—without a dependence on economic growth—are especially valuable diversifiers for portfolios. Such investments are varied, sometimes niche, and require skilled implementation. Many require some illiquidity, but may compensate by distributing income. Headline risk is also often a major consideration, so such investments are not for everyone. We profile two of these strategies, life insurance settlements and pharmaceutical royalties, below.*

Life settlements are the sale of life insurance policies by the original owner to a third party. The third party becomes the new owner, is responsible for payment of premiums, and becomes the beneficiary. From an investor’s perspective, investments in pools of diversified, carefully selected life settlements provide the opportunity to earn net low- to mid-teens returns that are uncorrelated with typical portfolio exposures, having little, if any, sensitivity to economic conditions. For policyholders, the life settlement market provides a means for individuals to cash out of their policies at a value higher than the cash surrender value, but less than the net death benefit. Predatory practices—where promoters would encourage seniors to take out life insurance policies, only to surrender them for much less than market value so that they could be resold for full market value in the secondary market—are now rare.

Estimating longevity is a key determinant of returns and, as such, underwriting skill is critical. Portfolio managers can mitigate risk by diversifying across medical conditions, age of insured, policy vintage, life expectancy, insurance carrier, and policy size. Other potential risks include legal risks (e.g., chain of title, adhering to state regulations, potential policy fraud) and possibly premium financing risk, which can be avoided or mitigated by specialized managers. One risk that may be somewhat economically influenced is the potential for insurance companies to raise premiums under threat of losing their credit rating following poor financial performance. Managers seek to lessen this risk by reflecting potential premium increases in the underwriting process and by limiting their exposure to any one issuer.

Pharmaceutical royalties, or other synthetic royalties that link cash flow payments to pharmaceutical net sales, offer another attractive investment opportunity. Such investments can provide low double-digit net returns to investors with general resilience to economic conditions. Royalty transactions are structured in a variety of ways. The simplest is a traditional royalty in which the manager buys all or part of a royalty contract from the intellectual property owner (e.g., biotech companies, hospitals, inventors, pharmaceutical companies, research institutes, universities). The transaction gives the purchaser the right to receive future royalty cash flows. Sellers will monetize their royalty licenses for a variety of reasons, including: using proceeds to fund large capital projects, contribute proceeds to endowments, fund additional research, or offset operating deficits. Corporations, such as pharmaceutical and biotech firms, will sell royalty interests to fund research or sales and marketing of products either as a complementary source of financing that is non-dilutive, or because they cannot otherwise gain access to capital.

The strategy has been supported by an upward trend in pharmaceutical revenues, as prescription drug penetration has increased and the population has aged. However, the flip side of the rising revenue coin is escalating health care costs. As such, one critical risk to this strategy is the potential for the regulatory framework to change in a way that lowers pharmaceutical pricing. Experienced managers with a deep understanding of the complex pharmaceutical market and strong financial and underwriting skills can mitigate these risks through conservative and carefully evaluated revenue estimates. The strategy also involves risks related to financial structures. For example, US bankruptcy rules specifically exclude patent license agreements from bankruptcy proceedings, and require that royalty payments continue to be made even if the asset is sold to a new firm. In contrast, structured royalties often take the form of senior-secured loans issued against less proven products and/or small, non-investment-grade companies. In a downside scenario, poor management execution could result in a royalty manager taking control of assets.

Clearly such investments are not without risk, but capturing risk premiums that are not as influenced by economic conditions is valuable. Successful implementation provides attractive expected returns and diversification for those that can afford to take some illiquidity, behavioral, and headline risk.

Celia Dallas is Cambridge Associates’ Chief Investment Strategist.

Originally published on May 9, 2017

* For a more complete discussion of such strategies, please see 2Q 2017 VantagePoint.

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