Can the financial industry cure cancer?
MIT Sloan Prof. Andrew Lo and his team1 have developed several financial engineering strategies that reduce the volatility in biotech/pharma investments by greater than an order of magnitude. In a highly attended event, Lo recently pitched his strategy to the MIT Biotech Group. We reproduced the main points here along with some of our favorite questions from students.
The uncertainty of early stage biomedical research scares investors
Although a great investment in the 1990’s, the pharmaceutical industry flatlined in 2000-2010, losing hundreds of billions of dollars in market value. Investors lamented that the billions of dollars spent on research weren’t producing results. Looking at the basic proposition for research investment, it’s clear why. Investors put up $200 million to develop a drug on a time scale of over 10 years, all with a low probability of payoff (~5%). While a successful drug can generate profits of tens of billions of dollars, the fact that >90% will fail to generate any revenue makes for an unappealing risk-reward ratio.
In 2010, Morgan Stanley published a very influential report urging pharmaceutical companies to replace “research” with “search:” buy licenses for clinically validated drugs rather than risking time and money on early stage research. Other analysis showed that the cost of developing new compounds was doubling every 10 years, coining the term “Eroom’s law” (Moore’s law backwards).
The industry reacted strongly. Between 2008-2013, pharmaceutical companies laid off 150,000 employees, a large fraction in R&D. In the same period, the number of venture capitalists in biotech declined by 25%, and the number of startups receiving their first Series A financing reached a ten-year low.
Increasing the shots on goal could mitigate the risk
In an environment that so many other investors find intimidating and unpredictable, Andrew Lo and his team of financial engineers see an opportunity. Individually, early stage research can be a scary investment: flipping a heavily weighted coin where landing tails could mean losing $200 million…but a heads is worth $10 billion. Lo notes that if you flip a hundred coins, you only need 2 heads to break even. Each additional heads beyond the first two is an extra $10 billion for investors.
Taking into account historical data on early stage drug development outcomes, Lo predicts that an investment of $30 billion over a pool of 150 drugs could achieve an expected return of 12% +/- 30%, approximately equivalent to the return and volatility of small market cap stocks. In such a pool, the probability of generating at least 2 viable drugs and >$20 billion in revenue is over 99%. These results suggest that $20 billion of initial funding could be raised through high-grade (AA-rated) debt. Lo’s results also suggest that other financial engineering devices, such as securitization and third party guarantees can raise the remaining $10 billion.
A key assumption is that the developed drugs are significantly diversified. If the outcomes are correlated, the risks aren’t as easily mitigated by increasing the number of drugs in the pool. Lo says it’s absolutely necessary that a panel of experts in different biomedical fields choose to fund a portfolio of drugs as diverse as possible in target, mechanism, and delivery. Lo noted that currently the pharmaceutical industry tends towards the opposite of this strategy, with many companies flocking to the same hot new field instead of diversifying.
How do you look for the investments?
I’m not a biomedical expert, but imagine if projects were picked by a panel of experts like Eric Lander, Bob Langer, and Phil Sharp coupled with the business acumen of Warren Buffett, Bill Gates, Jim Simons, etc.
It’s key to invest in projects rather than companies, because the resources can be highly redundant. I envision creating a central platform that can deal with a lot of the issues that entrepreneurs don’t want to or know how to deal with, such as animal models, toxicology, pharmacodynamics, etc. We can fund lots of projects with different mechanisms, test them out on our shared resources, and kill the projects as soon as we realize that the mechanisms don’t work.
Drugs for orphan diseases could have a smaller return on investment. How do you financially justify it to investors?
By definition, orphan diseases means a small population of patients, but actually the economics are tremendously rewarding for investors. The poster child for this industry is Alexion Pharmaceuticals. They make a drug that treats a blood disorder for only 30,000 people in the U.S., but they generate billions per year in revenue. They were just added to the S&P 500 index.
As some projects end, would you continue to fund more projects to stay stratified?
This strategy would require assets at each stage so that you’re diversified across different kinds of risks at both early and clinical phases. When a project finally makes it onto the market, you can recycle the cash from the later stages to the earlier stages and pay back investors/bond holders.
How would you incentivize people to work on these projects?
Here’s a hypothetical pitch. Suppose a megafund offers you a fellowship that pays $1 million a year for the next five years, and the application is a 5-page proposal and 3 letters of recommendation. The money will fund your lab but you can decide how to use it, and the megafund gets 10% of anything that comes out of your lab. Moreover, the megafund can help you commercialize your research by providing animal models, toxicological studies, medicinal chemistry, and other things that you have no idea how to do and don’t want to do. And in exchange for your active participating in the commercialization, you’ll receive 6% ownership in the subsequent commercial venture.
If the megafund gives out 200 of these fellowships, that’s $1 billion. Can we produce 1 or 2 hits from such a fund? The chances are excellent, especially given the talent pool we have in this country! And in some areas of the finance world, $1 billion is rounding error. I’m in the process of socializing this idea with a number of key stakeholders.
The real question is for you: how many ideas can you come up with to cure cancer? Do you have the creativity and energy? If you can come up with projects, then trust me the money is there—if you can invent the cures, we can get you the money.
Thanks to Prof. Andrew Lo for joining us and MIT GSC for funding! You can download the slides from the event here, or watch the TED talk here! The team also organizes a yearly conference to bring scientists, policy makers, and financial engineers together. Check it out here.
.1Lo worked jointly with Jayna Cummings, David Fagnan, Jose-Maria Fernandez, Carole Ho, Austin Gromatzky, Ken Kosik, John McKew, Vahid Montazerhodjat, Roger Stein, Richard Thakor, and Nora Yang
Image credit: Chris Ng