When bond yields are at record lows and large dividend payouts seem like a thing of the past, finding resilient recession-proof income amidst a global pandemic can be a difficult task for investors, especially when the economic outlook seems increasingly bleak.
In the midst of the global financial crisis of 2009, when the economy and financial system looked like it was on the brink of collapse, there was one asset class that cash-hungry hedge funds refused to let go of, according to fund manager Pedro Gonzalez de Cosio.
Gonzalez de Cosio (pictured), who oversees the £1.4bn Biopharma Credit investment trust, said he started a business lending to the life sciences market after seeing how valuable hedge funds considered these income streams during times of crisis. 
He said: “Before we were around there was an investment bank that was structuring notes backed by royalty streams of pharmaceutical products and selling them off to hedge funds.
“The hedge funds didn’t have the individual expertise, but if they diversified them into a big portfolio, they thought ‘why not?’”
Some of these hedge funds then approached Gonzalez de Cosio and his colleagues in 2009 to sell the loan notes, of which he decided there were about five he wanted to buy.
The manager continued: “We went to the hedge funds that had put up gates telling investors they can’t redeem their capital because they didn’t want to be forced to sell assets at distressed prices.
“We told them ‘we will buy your notes at par’, which – last time I checked – was not a distressed price. But they would not sell.
“All they were interested in were our bids, so they could tell their prime brokers that there was somebody willing to pay par, and that’s all they wanted.”
This made Gonzalez de Cosio realise that the sales of drugs were uncorrelated to the wider economy, and more importantly, the loans themselves were also completely uncorrelated to the wider economy.
He pointed out that there hasn’t been a single year of declining oncology drug sales since 1990, adding: “The cash flows that service our loans are linked to sales of drugs.”
The manager also highlighted the zero correlation between oncology drug sales and the major US equity and high yield indices, noting: “even during the depths of the financial crisis, drug sales continued to grow”.
People still get sick and need medicine, regardless of how the economy is doing, and insurance companies and governments will continue to pay for drugs.
The Biopharma Credit manager continued: “20-some years ago the only companies that were involved in discovering and marketing drugs were big pharmas that didn’t need people like us to raise capital. They were the better-rated credits in the respective markets.
“Our market started to evolve 10 years ago with the advent of biotech. You started to see companies having either royalties on approved products or reaching the market with their own products.
“These were smaller companies, no longer just Pfizer. These were new companies, that didn’t have other products and didn’t have past cash flows coming to market with their new products.”
He described the majority of these companies as ‘asset-rich, but cash flow-poor’, meaning banks and the bond market cannot serve them.
Launching a first drug product involves spending on selling, general and administrative (SGA) expenses as well as research and development (R&D) costs, which often amount to more than their sales, making them loss-making companies.
Nevertheless, the manager feels comfortable lending to these companies.
He explained: “We can understand what the real value of the product is, its future ability to generate cash flows to pay you back, and its value to other pharmaceutical companies in a market where M&A is very frequent.”
If a drug product disappoints or is unable to support a new company’s SGA and R&D expenses, the recovery rate for bankruptcies in the industry is often 100 per cent. This is because selling a bankrupt company’s drug intellectual property and infrastructure to a company with more than one product can be cash flow generative from day one.
“If you take a drug that is generating $50m in gross margin, but it has to support $100m of SG&A, take this to a company which is already spending $100m in SG&A, and $50m will pretty much drop to the bottom line,” Gonzalez de Cosio explained.
“These drugs are extremely valuable and there is a very liquid market for these drugs.”
Yet, before underwriting a loan to a biotech company due diligence is essential and the most important first step to managing risk, he said.
Gonzalez de Cosio said:“It is crucial to understand the biology of the drug, the disease, what other drugs are available, the safety, the future competition, etc., which makes it a highly specialised endeavour.
“You need a highly specialised team of people that can really understand whether these products are good collateral for loans, how to size these loans, and how to structure these loans.”
Often many successful biotech companies want to continue developing products after an approved product and in the past they could only do this by raising more equity, diluting shareholders, or by issuing convertible bonds, which is more often more expensive than straight debt.
“The need for capital hasn’t changed, what has changed is that there are now non-dilutive alternatives available like the loans that we provide,” the manager finished.
Performance of trust vs sector since launch
Source: FE Analytics
Since inception in 2017, BioPharma Credit has delivered a total return of 19.78 per cent compared to its average peer in the IT Debt – Direct Lending – a 10-strong sector of broad lending strategies –which returned 1.23 per cent.
The trust is trading at a 0.5 per cent premium to net asset value (NAV), is not geared , and currently yields 7 per cent (as at 25 September). It has ongoing charge plus performance fee of 2.09 per cent, according to data from the Association of Investment Companies.