Published: January 7, 2014
Andrew Lo had a personal epiphany. The MIT Sloan professor of finance and director of the MIT Laboratory for Financial Engineering and co-director of the MIT Sloan Center for Finance and Policy had prospered following the sale in 2007 of the hedge fund he had launched just eight years earlier. Then, several close friends and a family member were stricken with cancer.
Lo came to realize that his highly regarded research into financial asset pricing models could make a difference in the funding of drugs for cancer and other deadly diseases. He buried himself in the medical literature, with a clear eye focused on treatments for cancer and rare, so-called “orphan” diseases affecting small populations of people. He was struck by an odd conundrum.
While scientists had made tremendous progress over the past decade in understanding the molecular basis of many kinds of diseases, producing many life-saving therapies, the average rate of investment return in startup biotechnology companies was a dismal -1 percent. It made no sense that investors did not make more money from their investments in these various breakthrough drugs.
One such therapy, Gleevec, marketed by Novartis to treat chronic myelogenous leukemia, was among the first generation of these “designer drugs,” developed after scientists mapped out the disease’s genetic pathway and created the proper compound to suppress its progress, turning a deadly disease into a manageable chronic condition.
Lo learned that while scientists had greatly improved their understanding of the biological mechanisms of many diseases, and many companies had promising drugs in the pipeline, investments in biomedical research were drying up. Venture capital investors had pulled back and pharmaceutical companies were reporting difficulty raising new money. Several were paring their research and development efforts. Perplexed, Lo was determined to make sense of the impediments and find a way to clear them.
Certainly, Lo’s background prepared him for this personal journey. He had published numerous articles in finance and economic journals; co-authored several books, including The Econometrics of Financial Markets; and was the author of the book Hedge Funds: An Analytic Perspective.
His awards included an Alfred P. Sloan Foundation Fellowship, a Paul A. Samuelson Award, an American Association for Individual Investors Award, and a Guggenheim Fellowship, among many others. A research associate of the National Bureau of Economic Research, Lo is also a member of the OFR Financial Research Advisory Committee, the New York Federal Reserve Board’s Financial Advisory Roundtable, and several other prestigious financial and economic organizations. In 2012, Time magazine named him one of the world’s 100 most influential people.
One of Lo’s early conclusions was that the complexity of the drug development process had grown exponentially as researchers became more knowledgeable about disease pathways. The complexity added time and uncertainty to the process of commercially developing a drug, which, in turn, created greater financial risk.
Since risk appeared to be the underlying problem, Lo reasoned that financial engineering could provide a solution. He concluded that investors needed multiple “shots on goal,” whereby many different drug trials would be conducted simultaneously. Far from all would score, but some inevitably would. By accumulating many varied drug development projects in a single investment portfolio, the aggregate risk would be reduced, and one or two successful shots on goal would more than compensate for the failure of the remainder.
With a portfolio that combined equity and debt, investors could also realize other benefits. In much the same way that sophisticated debt contracts like collateralized debt obligations were constructed to draw money from the vast global investment pool into the real estate market, similar financing techniques focused on curing cancer and orphan diseases could be designed. The idea was to create a way for investors to own a piece of a portfolio of drug development projects, rather than a bundle of mortgage loans.
As he mulled the optimal structure for the securities, Lo conducted research into a little-known corner of the biopharmaceutical industry—drug royalty investment companies. Such entities acquire revenue-producing intellectual property, mainly the royalty interests in late-stage or marketed biopharmaceutical products. By investing in these patents, the companies receive a royalty stream from the commercial sale of the approved drugs.
An example of such a transaction: the drug royalty investment company approaches a hospital that has just received a patent for a new, FDA-approved drug. It offers to buy 10 percent of the drug’s eventual royalty stream for $20 million. The hospital now has $20 million for new drug research and development, and the company has a ten percent stream of future royalties—a win-win if the drug becomes widely used.
In contrast with the abysmal rates of return investors were realizing on their stakes in startup biopharmaceutical companies, drug royalty investment companies were doing quite well, Lo discovered, generating double-digit returns in some cases. One, Royalty Pharma, owns royalty interests in 38 approved and marketed biopharmaceutical products, and in two products in late-stage clinical trials. The firm has more than $10 billion of assets under management, and is funded not by traditional biotechnology investors but by pension funds, endowments, and other institutions.
Royalty Pharma’s structure is similar to that of a hedge fund, a structure with which Lo was familiar. The problem was that the royalty investment companies invested only in patents on FDA-approved drugs or those in the last stage of the three-phase clinical trial process. Since only the most efficacious drugs reach the FDA’s third phase, the investment risks are much less compared with investing in phase I or phase II—the part of the pipeline most in need of funding.
There was plenty of money funding late-stage drug development, and adequate government funding for pre-clinical research. In between was the problem, which industry insiders refer to as the “Valley of Death.”
With a large pool of diversified assets to reduce aggregate risk, investors would receive a greater return on their capital than they would picking individual drug companies, Lo predicted. He and his colleagues at MIT Sloan coined a term for this portfolio: a megafund. It would be financed through a combination of debt and equity invested in a broad range of drug development projects, from a few at the earliest stages of research to several others at later stages.
Theoretically, some projects would take a long time to pay off, while the payback on others would be relatively fast. The right financing structure could address these timing risks.
A team of investment professionals and scientific researchers would make the judgments on which projects to include in the portfolio, much like at the royalty investment firms. The scientists would be experts in the various biological pathways of disease who could help create a highly diversified pool of projects, with different projects at varied stages of development.
For instance, the portfolio might include projects involving immunotherapy, angiogenesis inhibitors, stem cells, and other therapeutics aimed at curing cancer. If the scientists identified 15 promising pathways, the portfolio might include investments in five different companies per pathway, or 75 projects in all. This oncology “index fund” would likely produce more shots on goal—and at least one or two game-winners.
Lo’s determination to solve the drug financing conundrum progressed rapidly, following a chance conversation with the CFO of a biotechnology company. Lo asked the CFO if his company’s financing had any effect on the scientific agenda undertaken by its researchers. He expected to hear a negative response—that “the science was the science.” He was surprised to learn that the availability of funding determined which pathways the company could afford to explore.
When funding was scant, the CFO pointed out, capital was directed towards short-term projects, rather than those that were longer-term and might be truly transformational. Lo later confirmed these assertions with scientists at the company, who told him that a particularly promising pathway they had identified required at least another six years of research to confirm their hypotheses. As they had only two years’ worth of financing, they needed to focus their energies elsewhere.
Lo does not fault Big Pharma for this dilemma, noting that most large pharmaceutical companies are public companies entrusted with a fiduciary duty to generate returns for shareholders. Nor does he blame venture capitalists, as they are not in business to risk a $30 million investment in one company’s projects. It appeared that neither public nor private equity was the best vehicle to fund biomedical innovation.
The alternative is what Lo and his colleagues at MIT Sloan have devised, a $30 billion megafund to develop drugs treating cancer, and a smaller, less-than-$1 billion investment portfolio targeting orphan drugs. The large amount of the megafund is based on evidence that it requires at least $200 million in out-of-pocket costs to investigate and develop a single therapeutic compound, from beginning to end. For a high rate of success, the fund would need at least 150 of these shots.
The smaller portfolio for orphan diseases recognizes the significantly higher odds of a new orphan drug receiving FDA approval versus those aimed at curing cancer—22 percent versus 6 or 7 percent.
Both portfolio financing strategies are in the proposal stage, and Lo is confident of their eventual success. Until then, his campaign to apply financial tools to curing deadly illnesses continues. It’s worth a shot.