Breakingviews: Royalty Pharma merits private equity drug discount

Royalty Pharma deserves its pharmacy discount card. The private equity specialist, which buys up revenue streams on potential blockbuster drugs, persuaded investors to value it at $16.7 billion, making its initial public offering priced on Monday the biggest on a U.S. stock exchange this year. The firm led by Pablo Legorreta has ballooned in size, as it has largely operated in a buyers’ market with limited competition. Yet concentration and rising political risk warrant a big discount to more diversified peers like Blackstone.

As with all good private equity stories, Royalty Pharma’s revolves around buying assets with leverage from sellers with few other options. The rights to profit from prescription drugs can be messy, as the process from development to market can take a decade, with many parties involved. Research institutions and biotechs are often hungry for cash and will sell the promise of future streams of revenue cheaply. And when a pharmaceutical firm buys a rival, the acquirer often sells off royalty streams for non-core drugs.

With limited competition – the company has spent $18 billion since inception, which it says is over half of the $36 billion of drug royalty transactions which have taken place since 1996 – the result since 2012 has been 11% annual growth in adjusted cash receipts, its preferred metric of how well the business is doing, which totaled $2.1 billion in 2019.

It has been a profitable ride for former Lazard banker Legorreta. At this price, his stake is worth nearly $2 billion. And his continued involvement could earn substantial performance fees. Bringing outsiders in gives insiders a way to cash out, which can be tricky considering royalty streams on drugs are difficult to sell and are usually of limited duration, given that revenue on a drug can quickly evaporate once patent protection is lost.

The longer-term problem for Royalty, and prospective investors, is the company’s concentration in a sector with huge political risks. Prescription drug pricing is a hot-button issue among U.S. voters, and a sweeping win by the Democrats could bring price controls – which would especially hurt indebted players like Royalty. At the IPO price, Royalty shares are priced at less than 9 times 2019 earnings. That’s a big discount to generalist rivals like Blackstone at 25 times, and Carlyle at 19 times. Royalty is a good business, but it’s cheap for a reason.

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