5.8 / 21 - Investing in Intellectual Property

Question 1

LO 21.1: Demonstrate knowledge of the characteristics of intellectual property

Answer 1

• Describe the characteristics of intellectual property (IP) asset

Question 2

What is the definition of Intellectual Property (IP)?

Answer 2

an intangible asset that can be owned.

Examples of intellectual property include patents on new technologies and copyrights on written works.

Question 3

The two major types of IP are:

Answer 3

• Unbundled IP
• Mature IP.

Question 4

Describe Unbundled IP

Answer 4

Historically, IP was bundled with other corporate assets. An investor who bought stock in a company was investing in the firm’s IP, as well as the tangible assets. However, in recent years, institutions and firms have begun unbundling the IP and selling or licensing technologies and inventions on a stand-alone basis. Investors can buy, sell, and own IP outside the corporate umbrella. Investors can invest at different stages of development. Like venture capital investments, investors often lose all their capital, particularly when investing in IP at an early stage of its life but, in some instances, earn extremely large returns.

Question 5

Describe Mature IP

Answer 5

In the case of mature IP, the IP has been fully developed and its usefulness to the market has been established. Cash flows are more predictable and valuations are more certain. An example of a mature IP is a motion picture already in distribution. A film may have a lifespan of 80 years or more. According to Soloveichik (2010)1, a film loses approximately half its value in the first year after release and then depreciates approximately 5% per year in subsequent years. This means IP (or at least some IP) suffers from declining marginal returns to scale. Also, a 2004 study2 finds that DVD sales and licensing revenues have a correlation of 0.97 and 0.99, respectively, with domestic box office revenues, although the correlations might be artificially high due to nonrobust statistical test

Question 6

R&D Returns (rates)

Answer 6

Private, pre-tax returns on research and development (R&D) expenditures are estimated to be 20% to 30% (although returns are difficult to measure with any precision).

Spillover effects (i.e., externalities) represent effects of one firm benefiting from the R&D of another firm. Spillover effects can increase IP returns significantly.

Question 7

LO 21.2: Demonstrate knowledge of the investment properties of film production and distribution.

Answer 7

• Discuss historical revenues for film production and distribution.
• Recognize the four stages in the film production and distribution life cycle.
• Describe the costs and financing structures associated with film production and distribution.
• Recognize the four key evidence-based conclusions regarding film production profitability.
• Describe the factors and variables involved in estimating the relationship of returns to film production.

Question 8

Characteristics of dilm production and distribution

Answer 8

• One of the most studied forms of IP because of substantial accounting data
• within IP framework, Film is considered artwork
• Total fil revenue, including home media license, was $37bb in 2007 (vs. $285bb for all copyright artwork).
• Key changes affecting mix of revenue sources:
• Increasing importance of non-U.S. revenues to the total revenue stream.
• Rapid rise and then subsequent fall of revenue from DVD sales and other similar technologies.
• Downloading and watching movies on devices such as phones and tablet
• Films move from theaters to home video and pay per view, to network and basic cable, and ultimately to television syndication over a period of six months to 5 years. Syndication can last for 10 or more years after the release of a film.

Question 9

The film production life cycle consists of four key stages:

Answer 9

1. Acquiring the rights to the story. Filmmakers must pay to license books, screenplays, and concepts.
2. Preproduction period. Writing the script, casting the film, designing the sets, scouting a location, creating film production stages, and budgeting the film are part of the preproduction process.
3. Production of the film (principal photography). Expenses in this stage include paying actors, producers, and directors, as well as sound-stage, catering, set construction, lodging, and other expenses.
4. Postproduction period. Editing and scoring the film, creating titles and credits, special effects, and acquiring the rights to music that will be featured on the soundtrack are captured in this stage of production.

Question 10

Negative costs (Film)

Answer 10

combined costs to create the film. The word negative does not refer to the sign of the cash flow but rather to the costs to create the negative images of the film in the predigital era.

In addition, there are the costs associated with printing the film to distribute to theaters and the costs to market the film (called P&A costs for print and advertising).

Question 11

Equity financing structures to fund films include

Answer 11

• Slate equity financing. Outside investors, such as hedge funds and investment banks, fund sets (i.e., slates) of films. The films satisfy certain parameters in terms of risks, film budgets, and so forth. This structure spreads financial risks across several films, limiting the impact of financial losses of any one picture.
• Corporate equity. The activities of a production company are funded by corporate equity either through private placements or public stock offerings.
• Miscellaneous third party. More common for smaller, independent (i.e., indie) films, third-party investors (e.g., high-net-worth individuals and institutions) fund film costs not covered by other types of financing.
• Coproduction. Two or more companies produce a film, sharing the equity financing responsibilities, the returns, and the risks.

Question 12

Debt financing structures to fund films include:

Answer 12

• *• Senior secured debt.** These include loans from banks and other institutions to fund production or postproduction activities such as P&A. Loans can take on several forms, including negative pickup deals (i.e., a distributor agrees to buy the film for a fixed price upon completion), foreign pre-sales (i.e., the producer sells foreign distribution rights before the film is made and payment is due upon completion of the film), and tax credits/grants [i.e., producers receive tax credits (saleable) and grants from the government for filming in a specific locale].
• *• Gap financing.** These loans finance the difference between the production budget and the senior secured debt. The loans can be collateralized by sales of unsold distribution territories.
• *• Super gap financing/junior debt.** The second level of gap financing covers the final amount that senior and gap lenders will not cover. These loans are often syndicated.

Question 13

studies have identified four key conclusions when predicting revenue or profit for film in exhibition:

Answer 13

• Large-budget films generate more total revenue but less than average profit.
• Some stars may increase revenue, but most do not. There is evidence to suggest revenues are related to directors.
• Movie sequels generate higher revenues and lower risk than nonsequel films.
• The risk and return characteristics differ across film genres.

Opening box office revenues are not necessarily shown to predict revenues accurately, but De Vany and Walls (1999) identify a six-week inflection point after which audience numbers either disappear or notably increase.

Question 14

“cash in” to “cash out” ratio

& Film returns

Answer 14

a simple return metric used for film that ignores the time value of money but is easy to understand.

A ratio of –1.0 implies no revenues, 0 implies a breakeven film, and a positive ratio indicates at least some profit.

• returns are similar to venture capital returns. That is, most films generate little or no profit while very few generate exceedingly high profit; returns are asymmetrical
  *

Question 15

Film Return Models

Answer 15

• academics initially adopted the fat-tailed stable Paretian distribution to model film returns because it does not have second or higher-order moments and therefore mimics the highly uncertain box office returns. However, this distribution is unable to account for the high level of skewness associated with film returns
• The four-parameter kappa (K4) distribution developed by Hosking (1994)4 is also used to model distributions with fat tails. The K4 distribution is able to assume many shapes with fat tails.
  
  • Using film returns from 2005 to 2010, the K4 distribution is used to model probability densities of returns. The four parameters are econometrically estimated and used to form graphs that approximate the relationship between probability and return.
  • The results indicate that action films, drama films, and the catch-all “other” category have the most skewness
  • horror films had the lowest probability of loss (37%)

Question 16

LO 21.3: Demonstrate knowledge of the investment properties of visual works of art.

Answer 16

• Discuss reasons for considering art as an investment.
• Describe the empirical evidence on the investment performance of art as an asset class.
• Discuss characteristics of art that are hypothesized to drive returns to art investments.
• Evaluate the historical risk-return profile and correlation of the art market.

Question 17

why art has become increasingly popular as an investable asset class include:

Answer 17

• High-net-worth individuals see investing in art as a strategy for accumulating wealth.
• The demand for art from both consumers and investors has been generally strong through time.
• Investors may profit from inefficiencies due to private valuations and illiquidity in the market for art.
• A lack of transparency in auction markets, because while auctions are public, clearing prices for works of art are not.

Question 18

hammer prices.

Answer 18

The hammer price is the final auction price but does not take the commission to the auction house into consideration. Commissions are significant and can amount to up to 25% on a round-turn transaction (i.e., commissions are paid when you buy and then when you sell the artwork).

Question 19

What two characteristics might help investors develop an investment strategy based on purchasing art?

Answer 19

1. masterpiece effect - The theory that expensive art is different from the rest of the market and returns will differ as well. However, ex ante, there is no clear indication of whether masterpieces should perform better or worse than the market. In a review of the related academic literature, only one study out of six found a positive masterpiece effect.
2. Question of whether law of one price in art markets is important to investor’s strategy. There is only weak evidence to reject the law of one price in art markets. In other words, prices do not vary significantly across geographic markets. A Picasso in London is priced similarly to a Picasso in New York. This means investors cannot arbitrage differences across locations and auction houses

Question 20

quality effect (art)

Answer 20

Describes how higher-quality paintings earned higher returns and had higher volatility of returns (Spaenjers study). In the study, Spaenjers finds that art prices are significantly explained by wealth effects (proxied by GDP growth), income inequality, and lagged equity market effects. Unfortunately, high-net-worth individuals are already exposed to these factors, reducing the diversification benefits of art.

Question 21

LO 21.4: Demonstrate knowledge of the investment properties of research and development (R&D) and patents.

Answer 21

• Discuss theoretical and empirical evidence regarding the returns to R&D and patent expenditures.
• Identify strategies for accessing R&D through the acquisition and monetization of patent-related intellectual property.
• Discuss patent enforcement and litigation strategies and how these processes affect returns on patent investments.
• Describe the patent sale license-back (SLB) strategy.
• Recognize patent lending strategies.
• Discuss potential buyers for patents and the concept of patent pooling.
• Describe the risks involved with patent investment

Question 22

List the ways investors can invest in patents and monetize:

Answer 22

• Acquiring or licensing patents.
• Enforcement and litigation of acquired or licensed patents.
• Sell and then license-back patents (SLBs).
• Lending strategies.
• Sales and pooling.

Question 23

Key terms between the licensee and the licensor/grantor of the patent include:

Answer 23

• *• Minimum royalty provisions**. The licensor may have the right to terminate the license or make it nonexclusive if royalties do not hit an agreed-upon amount by a certain date.
• *• Reservation of rights provisions**. Often the grantor of the patent will maintain the right to use the patent for noncommercial research purposes.
• *• Field of use provisions.** The licensor may grant an exclusive patent to a party in a particular market or geographic location.
• *• Exclusivity responsibilities**. Although it varies, the licensor is often bound to enforce the exclusivity of the patent and the licensee is required to report patent infringements to the licensor.
• *• Improvement provisions.** These provisions deal with what happens in the event the patent is improved. Improvements may lead to patent infringements. This negotiation is complex because the licensor or the licensee may make improvements.
• *• Auditing/reporting and payment of royalties responsibilities.** The licensor may want to audit royalty payments. The payment for the license is typically a function of the expected revenues that can be generated with the licensed technology.

Question 24

patent sale license-back (SLB) strategy​

Answer 24

• Often a patent holder will sell the patent and then license it back.
• similar to selling and then leasing back a property in real estate markets.
• allows the inventor to monetize a portion of his intangible assets.

Question 25

Two Common lending strategies that use Patents as collateral

Answer 25

• Securitizations - Securitization allows for the separation of the IP owner’s credit risk from the risk of holding the IP.
• mezzanine IP lending - Warrants (and other upside instruments) may be included with mezzanine financing. The collateral value of patents is based on economic value, rather than strategic value.

Question 26

What are the reasons buyers invest in patents?

Answer 26

• Commercial purposes (i.e., patents are purchased for use in the firm’s operations).
• To trade the patent for other technologies or benefits.
• Strategic uses (e.g., negotiating with patent dealers).
• Monetary exploitation by asset managers (a recent development).

Question 27

Discuss Pooling Patents

Answer 27

(i.e., multiple companies cross-licensing patents related to a specific technology)

• somewhat complicated because royalties and revenues must be shared based on some formula
• pooling patents can be useful in some sectors that have large quantities of patented technologies and set standards for these technologies. For example, pooling was very effective in the DVD market
  *

Question 28

What are the risks associated with investing in patents?

Answer 28

• Illiquidity. It may be difficult to monetize a patent.
• Operational/technological risks. Cash flows depend on the successful use of a patented technology. In some sectors, technology changes rapidly, subjecting firms to competitive pressures. Also, specific brands may be subject to tremendous competition.
• Obsolescence. New technology may render the patent worthless.
• Expiration risk. The life of a patent without extensions (which may occur in the pharmaceutical industry) is 20 years.
• Macroeconomic/sector risks. Macroeconomic factors may cause the decline of an industry. This will influence the ability to generate cash flows using the patented technology and will ultimately decrease the value of the patent. Sector/industry-specific factors can have the same effect.
• Regulatory risk. The government controls patents and could change how patents are granted, as well as impose regulations on the use of patented technologies.
• Legal risks. Patents are complex and acquirers must understand the legal implications of acquiring a patent to experience its full value.

Question 29

LO 21.5: Demonstrate knowledge of six characteristics common to both IP and real assets.

Answer 29

• List and describe six characteristics of IP that overlap with the characteristics of real assets.

Question 30

What six charactersitics are common to real assets, and IP

Answer 30

• *• Low operating risk.** Investing in well-established IP is low risk. Established patents or technological IP are similar to tangible fixed assets in that their value results from their use in an established economic process and this value can be transferred between owners.
• *• Positive correlation with U.S. or European inflation**. There is little evidence of correlation between IP returns and inflation. However, this is also true for real estate, which is classified as a real asset. ‘Real’ IP assets would act as a diversifier of inflation risk in a portfolio alongside other traditional assets.
• *• Value preservation during macroeconomic instability.** Although there are exceptions (notably technology and biotech), IP assets have low betas.
• *• Benefit from input scarcity in energy, manufacturing and agricultural sectors.** There is little correlation between input scarcity and IP assets. This characteristic would not support their classification as real assets.
• *• Essential part of economic infrastructure.** The Bureau of Economic Analysis included $560 billion of fixed investment, long-lived IP in 2013. IP has to be considered a significant part of GDP.
• *• Risk and return properties suitable for funding long-term liabilities**. IP products that are transferable, with low operating risks and a long life can produce long-term stable cash flows suitable for funding long-term liabilities.