Diversifying the Risky Biomedical Business

Thanks to tremendous advances in biomedical research, today it is possible to talk in terms of a cure for some types of cancer. Other debilitating or fatal diseases are now manageable chronic conditions.

Yet at the same time biomedical science is producing these lifesaving breakthroughs, the funding for research is dwindling. This is a frustrating conundrum for financial economist Andrew Lo of Massachusetts Institute of Technology’s Sloan School of Management.  “Why, at the very cusp of being able to cure some of the most devastating diseases known to society, are we pulling back?” he asks.

A large part of the problem boils down to the basic calculus of risk and reward, Lo said. Developing a single drug can cost up to $2.6 billion over a 10- to 15-year horizon—and 95 percent of tested therapies fail to reach the market. Few investors have the appetite for that level of risk.

“Financial engineering can help,” Lo argued in a talk called “Buying Cures vs. Renting Health.”  He made the case for using tested tools from the financial sector to increase funding while reducing risks. As an example, he showed that pooling a large number of independent  drug trials diversified the risks involved, making it feasible to issue bonds to finance this crucial research, with manageable default rates and promising returns.

Lo showed that while biotech firms have seen strong growth since the sequencing of the human genome was completed in 2003, returns to the pharma sector have been basically flat. “For a period of about a decade, the pharma industry has managed to actually destroy shareholder value, with a negative rate of return from late 1990s to the late 2000s,” he said.

“We all know public sector funding has declined, but the private sector pulled back as well,” he continued. “The number of biotech venture capital firms declined by about a third between 2008 and 2014. The biomedical business model in venture cap is broken; it doesn’t work for biotech because [developing therapies] takes too long, is too risky, and takes too much money.”

Lo and colleagues have done some back-of-the envelope calculations on those costs and risks.

In short, to develop a single anticancer drug, firms put down $200 million up front to select a compound and put it through 10 years of trials and Food and Drug Administration approval. There’s a 5 percent chance of a positive payoff; if the drug is effective and approved, “you ultimately get an estimated $12.3 billion; if not, you get nothing,” he noted.

To improve the odds of success, “why not diversify and invest in 150 of these drugs at the same time?” At $200 million per drug, it would take $30 billion to do that. But, assuming the drug development programs are uncorrelated (or independent and identically distributed, an important caveat), the high risk of failure is dramatically reduced. And with the reduced risk, Lo shared calculations showing it’s feasible to issue bonds to raise the $30 billion. The projected default rate would be lower than a typical AA bond.

More dramatically, Lo and colleagues ran their model on a portfolio of drugs developed for rare diseases affecting fewer than 200,000 patients. They simulated a fund that had 38 drug projects, securitized by a financing package comprising low-risk senior debt, unsecured junior debt, and equity.

“The equity tranche earned a return of 21.6 percent. It astonished us. The other thing that shocked us was that you don’t need $30 billion to run these trials, because with rare diseases, the patient populations are so small, you can run clinical trials for much less.”

“If we use all the other tricks of the financial trade—securitization, credit default swaps, collateralized debt obligation, we can do even better than this,” he said. Acknowledging concerns that these kind of financial instruments played a role in the recent financial crisis, he noted, “that’s not because they didn’t work, but because they worked too well. These are incredibly powerful tools for raising large amounts of money over short periods of time for specific purposes.”

Moreover, he added, “There’s nothing new here, from a financial or economic perspective. In this case that’s a feature, not a bug. These methods have been around; they’re not threatening. We’re not doing anything new, so they can be implemented very readily.”

He acknowledged that there are a lot of details to work out, and addressed a few of the many questions that often come up.

First: do we have enough investor capital for this model to work in the marketplace? His answer was an emphatic yes. “In the finance industry, $30 billion is nothing. It’s a drop in the bucket,” he said, citing figures for the amount of debt issuance snapped up by investors and the hundreds of trillions managed by large institutional investors.

Next: do we really need $30 billion for each drug? “The short answer is, we don’t know,” Lo acknowledged.  It depends on many factors: the cost per compound, the probability of success, the duration of trials, the correlation of attempts, the market for the drug and the profits per success. Lo and colleagues have made their source code for their model available, so anyone can plug in their own numbers for specific results. “We need to collaborate with the biomedical community to be able to estimate probabilities, and calculate risk reward tradeoffs.”

Finally, can anyone afford these therapies when they’re priced to reflect their high development costs? Lo acknowledged that is a big issue for patients, insurers, and the government. An $84,000 price tag for a treatment that cures hepatitis C shocks everyone, yet it’s a bargain compared to a $500,000 liver transplant. But an estimated 3 million people need the drug, at a huge total expense to insurers. Lo suggested that the solution was to help patients spread the cost of treatment out over many years with loans. Simulations show that the rate of return for such loans is viable, and the default rates would be similar to that for college loans.

“Of course there are ethical dilemmas, and that is why plain economics is not enough and economists cannot solve these issues in isolation,” Lo said, but he projected that loans to finance medical costs might be available within the year.

Failing to tap into investment dollars to finance biomedical research, improve health, and extend lives strikes Lo as a waste. “Being at MIT, I see incredibly talented graduate students and researchers in the biomedical field. They are struggling and many are leaving the field because they can’t get grants.  They are coming to my MBA class looking for jobs because they can’t follow their dream of curing cancer.”

“I see a stupid situation: we have the money, we have the talent; we just don’t have a pipe to put them together,” he concluded. “That’s what I’m hoping economists can contribute.”

“We can do this, if we invest in a fund that someday cures the illnesses of our grandchildren. That’s the pitch. We can all do this if we find the right financial structure. I think economists do play a role, and thanks to the BFI and all the great work that comes out of the University of Chicago I think we actually can have a real impact on all of these diseases.”

—Toni Shears