Now, here’s a big idea. Thirty billion dollars worth of big idea. Andrew Lo, professor of finance at MIT (Sloan) and hedge fund manager, along with Jose-Maria Fernandez (Sloan) and Roget Stein (Sloan and Moody’s) propose raising that much money for discovery-stage oncology research. But he’s not running a fund-raising appeal for a charity; he wants to raise that money as an investment:
Here we propose a financial structure in which a large number of biomedical programs at various stages of development are funded by a single entity to substantially reduce the portfolio’s risk. The portfolio entity can finance its activities by issuing debt, a critical advantage because a much larger pool of capital is available for investment in debt versus equity. By employing financial engineering techniques such as securitization, it can raise even greater amounts of more-patient capital. In a simulation using historical data for new molecular entities in oncology from 1990 to 2011, we find that megafunds of $5–15 billion may yield average investment returns of 8.9–11.4% for equity holders and 5–8% for ‘research-backed obligation’ holders, which are lower than typical venture-capital hurdle rates but attractive to pension funds, insurance companies and other large institutional investors.
Here’s a Boston Globe story on the idea. Lo and his co-authors note the low productivity of drug research in recent years (which he doesn’t seem to think is a scam!), and its increasing costs. At the same time, there have been many scientific advances in areas that you might have thought would have helped, but here’s how he reconciles these trends:
Here we propose one explanation for this apparent inconsistency and a possible solution. Our proposed explanation is the trend of increasing risk and complexity in the biopharma industry. This trend can be attributed to at least two distinct sources: scientific advances and economic circumstances. That biomedicine is far more advanced today than even a decade ago is indisputable, but breakthroughs such as molecular biomarkers for certain diseases generate many new potential therapies to be investigated, each of which requires years of translational research at a cost of hundreds of millions of dollars and has a substantial likelihood of failure. Although such complexity offers new hope to the afflicted, it also presents an enormous number of uncertain prospects that must be triaged by researchers, biopharma business executives, investors, policymakers and regulators. . .the lengthy process of biomedical innovation is becoming increasingly complex, expensive, uncertain and fraught with conflicting profit-driven and nonpecuniary motivations and public-policy implications. Although other industries may share some of these characteristics, it is difficult to find another so heavily burdened by all of them.
Hard to argue with that. He then goes on to one of the same questions that’s been discussed around here – the effect of the stock market on a drug company’s behavior. If the quarter-by-quarter focus of most investors is inappropriate (or downright harmful) when applied to an R&D-driven company with timelines like the drug industry’s, and if private equity doesn’t have the cash to invest on that scale (or the willingness to take the expected returns even if things work out), what’s left?
That’s the idea here, to provide something that currently doesn’t exist. The idea is to finance things via securitization:
Our approach involves two components: (i) creating large diversified portfolios—’megafunds’ on the order of $5–30 billion—of biomedical projects at all stages of development; and (ii) structuring the financing for these portfolios as combinations of equity and securitized debt so as to access much larger sources of investment capital. These two components are inextricably intertwined: diversification within a single entity reduces risk to such an extent that the entity can raise assets by issuing both debt and equity, and the much larger capacity of debt markets makes this diversification possible for multi-billion-dollar portfolios of many expensive and highly risky projects.
These debt instruments will have longer time horizons, which can be tailored a number of different ways. Securitization can provide a whole range of different bonds to be issued, with different maturities and different levels of risk. The fund itself would earn its returns from the sale of whatever assets its funded projects generate – outright purchases by larger companies, milestone payments, royalties, whatever. With enough diversification, Lo et al. think that this could work, if some cost savings kick in as well:
Compared with the plethora of small pharmaceutical companies currently pursuing just one or two projects, these savings are especially important for a megafund. It is considerably harder to cull compounds efficiently in a small company because the livelihoods of the employees and management depend on the continued development of the company’s few compounds—in these cases, development tends to continue until the money runs out. With a megafund, this conflict is greatly reduced—capital can be more efficiently allocated to projects that are likely to succeed, and failing projects and compounds can be abandoned rapidly. In fact, for megafunds that have invested in a sufficient number of early-stage projects, it may be worthwhile to build and operate shared facilities for conducting preclinical studies motivated by the megafund’s projects. Such a ‘preclinical incubator’ could provide the megafund with valuable economies of scale as well as reduce duplicative costs in the industry.
Now, this idea is fascinating, but it raises several big questions. Readers with some knowledge of the financial markets will have noted that this whole securitization-and-repackaging process was one of the main engines of destruction during the recent financial crisis. (I continue to recommend Michael Lewis’s The Big Short for details on this). Vast amounts of mortgage-backed securities were generated, and their risks were, it is fair to say, poorly evaluated. The paper explicitly addresses this problem, with suggestions on how to keep things from getting out of hand, but this is something that will have to be watched carefully. Securitization, the authors note, can almost be too efficient a way to raise capital.
The rest of the article is a detailed look at the idea through the lens of portfolio theory, along with some simulations of how it might have worked in the past. I strongly recommend that anyone who finds this idea interesting check out these details, but they’re beyond the scope of an already-lengthy blog post. I note that Felix Salmon has looked at this from a financial writer’s point of view. His take is that this is quite possibly a worthy idea, but he has doubts. For one thing, the proposed “megafund” might find it difficult to pay investors in its early years, and might be forced to make some bad decisions in order to do so. He’s also skeptical that the training-set period used for Lo’s simulations is representative of what we might expect in the future.
But Salmon’s biggest objection is that the idea might well prove unworkable even to test. A smaller version of such a fund would lose many of its advantages; it has to start off large or not start at all. And he’s not so sure that anyone can raise that kind of money for something that’s as big a change as this would be. There is, in chemical terms, too high an activation barrier.
I’m still thinking about all this myself; there’s a lot to think about. Take a look and see what occurs to you – I think that I can guarantee that you’ll have some strong opinions, because this is one of those proposals that it’s hard to be neutral about.
Update: Nature Reviews Drug Discovery weighs in with a detailed assessment. The article is cautiously optimistic, but wonders if more money will really do the trick.