- We assess the case for BioPharma Credit, a specialist lending fund with impressive returns
- Does the high yield justify a delve into specia;ist assets?
The list of investment trust ‘winners’ from 2022 is both short and full of niche assets. Less than a third of UK trusts (excluding VCTs) ended the year with a positive share price total return, according to FE data, and many of these are pretty specialist vehicles, from energy and Latin America funds to BH Macro (BHMG) and ship leasing trusts.
Turning to more conventional assets, while certain bond and equity valuations have reset to more appealing levels, 2022 does remind us that investment trusts with a focus on niche, illiquid asset classes can sometimes come through in a pinch – provided we also understand the risks. Some of these names, while highly specialised and idiosyncratic, have continued to do what they say on the tin in difficult times. BioPharma Credit (BPCR), a niche debt vehicle with a recent yield of around 7 per cent, ticks that box.
Enter the obscure
The investment trust space is awash with esoteric vehicles and BioPharma Credit is no exception. The fund invests in the debt of different life sciences companies, with recent examples including Collegium Pharmaceutical (US:COLL), which focuses on developing and commercialising new medicines for pain management, LumiraDx (US:LMDX), a UK-based diagnostics specialist that has developed rapid Covid-19 testing kits, among other products, and Coherus BioSciences (US:CHRS), a firm that has focused on developments in cancer care.
The fund invests in debt in different forms. In the case of corporate debt, it tends to invest in a loan secured against the assets of a company with a first priority charge against royalty collateral, marketing rights or other intellectual property. Another form, royalty debt, is secured by cash flows from the sale of approved life sciences products. Loans tend to be of a floating-rate nature and typically have pre-payment conditions to protect against the company making an early repayment or getting taken over.
As Edison financials director Milosz Papst put it in a note on BioPharma Credit published at the end of November last year, the trust “benefits from the shift from the traditional fully integrated pharmaceutical company model to greater market fragmentation” – meaning in practice that more small entities need a source of cash to fund their research and development, a trend the trust is designed to take advantage of.
|The portfolio, as of 30 November 2022|
|Investment||Type of exposure||Position size (%)|
|BMS||Purchased agreement for 50% stake in payments linked to certain product sales||11.1|
Figures cited by the BioPharma Credit investment manager, New York-based Pharmakon, state that smaller pharma companies originated some 56 per cent of newly approved drugs between 2017 and 2020, up from 45 per cent between 2009 and 2012. As Edison’s Papst adds: “The vast number of spin-offs or new biotech companies being set up, which do not have the older mature cash-generating products to fund their research pipeline, greatly changes capital requirements and significantly increases the number of capital-seeking entities.”
This comes alongside an expected increase in research and development spending across the industry, and an assumption that smaller entities have greater need for capital. BioPharma Credit seems to have carved out a lucrative niche in this space, given traditional lenders often lack the expertise to assess a borrower in such a specialised industry while also having more conservative lending practices. It also appears to be a beneficiary of the fierce biotech sell-off of recent times: with the industry struggling to raise money via the issuance of equity at a time of depressed valuations, firms are more likely to use debt as a source of funds.
Without fixating too much on past returns, it’s worth noting the trust has tended to produce some strong share price performance since its 2017 initial public offering (IPO) – although having its revenue and share price in dollars has sometimes meant currency effects provide an artificial boost. The shares have tended to offer a high dividend yield and continue to yield around 7 per cent. What’s more, the investment team uses a high discount rate to value the portfolio – meaning they take a prudent approach to the way in which rising interest rates might affect valuations – and the portfolio has not suffered a single loan default yet. As with some other alternative asset classes, the portfolio appears to exhibit a low correlation to equity markets, a quality that certainly stood out last year. The trust’s shares traded at a 4.5 per cent discount to portfolio net asset value (NAV) on 17 January, slightly wider than the average of 3.4 for the preceding 12 months.
Alongside decent capital returns last year, investors will have been pleased with the payment of another special dividend in late 2022. As Edison’s Papst put in his recent note, the trust “has been able to adhere to its dividend policy of paying a 7 cent annualised regular dividend since becoming fully invested in the second half of 2018, with an additional special dividend paid in each of the past three years. Given its net asset value (NAV) per share has been close to $1 (81p) since inception, as the trust pays basically all its net income in dividends, this represented a solid dividend yield on NAV of 7 per cent plus.” He believes the trust should be able to regularly pay a dividend in excess of 7¢ once it fully deploys prepayment proceeds.
These are fees paid when a borrower repays its debt ahead of time – which can often happen if its product proves successful and it wishes to refinance on more attractive terms. These fees can provide an uplift to portfolio returns, and help fund special dividends. But they also mean the trust must constantly look for reinvestment opportunities, and – at times when payouts and redeployment do not keep pace with pre-payment levels – there is the risk of high cash levels dragging on performance.
The trust entered the premium segment of the London Stock Exchange in 2021, removing the frustration some investors have when trying to buy funds listed on the specialist market segment. The fund should also continue to benefit from the investment team’s ability to source good deals, and a level of due diligence that has helped it avoid any defaults so far.
In what may sound like a technical tweak that could nevertheless have an effect on returns, the trust announced changes to its discount control mechanism in November. Under the former terms of the mechanism, if the shares traded at an average discount of more than 5 per cent to NAV over a three-month period the trust would have to use up to half of proceeds from debt repayments to buy back shares until the two-week average discount came to less than 1 per cent.
Additionally, if the discount exceeded 10 per cent over six months, the trust would be required to use up to 100 per cent of debt repayment proceeds to bring the two-week discount under 1 per cent. These terms have been amended so that the trust still has to carry out buybacks under the same conditions, but only until the two-week discount is brought under 5 per cent, rather than 1 per cent. The trust has argued that holding back cash to fund future buybacks, as opposed to investing in new loans, was creating a “significant opportunity cost” while also leading to additional expenses.
The announcement noted, for example, that the three-month average share price discount to NAV had exceeded 5 per cent as of the start of September 2022. “Following that date, the company received $499mn in repayments, so the company would have been required to use up to $250mn to repurchase shares, until such times that the two-week discount became less than 1 per cent,” the trust said. “The company has invested approximately $28mn buying back shares since the discount control mechanism was triggered, leaving approximately $222mn that would not have been available to be deployed in new investments until such time that the two-week discount is less than 1 per cent.”
The change could, of course, have pros and cons for investors. The discount may be allowed to drift out slightly wider, hurting some existing investors in the short term. But that could provide buying opportunities for those looking to invest, while using more cash on investments rather than buybacks should bode well for future returns.
Killik & Co head of managed portfolio services, Mick Gilligan, who has a small position in the trust, notes that other risks are certainly worth bearing in mind. One issue is concentration risk: at the end of November there were just 10 loans in the portfolio, and Collegium debt made up 28.9 per cent of the fund at that point. Other positions also looked pretty chunky, with the LumiraDx exposure amounting to 14.5 per cent and Insmed (US:INSM) debt making up 13.5 per cent of assets.
Currency risk is another issue, given that the trust’s revenues and share price are in dollars. Other dangers include the possibility of there being insufficient product sales for a company to meet its loan payments, or the trust being unable to recoup any shortfall were a company to default on its debt. On another note, the fund comes with what Gilligan describes as a “high fee burden”, with a 1 per cent annual management fee and a 10 per cent performance fee subject to conditions.
BioPharma Credit, like some of its peers, does therefore look pricey compared with most funds operating in more conventional asset classes – although the idea is for income generation and positive net returns to offset such concerns. As always, however, investors should remember that a complex, highly specialist asset class such as this can run into unexpected idiosyncratic risks, be they industry changes or regulatory threats. So investors may want to size such specialist positions accordingly.
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