They don’t usually contain sentences like this:
“The special-purpose vehicle’s capital structure, priority of payments and various coverage tests and credit enhancements are collectively known as the ‘cash flow waterfall’—a reference to the manner in which cash flow from the special purpose vehicle’s assets spills over from senior to junior tranches…”
Nothing to be found in that sentence or the rest of the article about the minutiae of monoclonal antibodies, RNA interference or the Nobel-winning biology of induced pluripotent stem cells.
The article in the October issue of Nature Biotech arrives replete with esoterica about cash flow waterfalls and junior tranches, and includes that sentence penned by Andrew Lo, a prominent MIT professor of finance, and colleagues, Jose-Maria Fernandez and Roger M. Stein, also from MIT’s Sloan School of Management. In fact, in reading the article I came away with the impression that maybe Nature Biotech needs more articles like this one. (Scientific American is part of Nature Publishing Group, but it might also be worthwhile for Science Translational Medicine to also follow suit with more coverage.)
Biotech has always been as much about showing the money as it has been about quantitative secretome analysis. The article “Commercializing Biomedical Research Through Securitization Techniques” by Lo and colleagues makes the point that cash waterfalls these days aren’t flowing to the right places.
The doubling of pharmaceutical R&D from 2002 to 2010, from $68 billion to $127 billion, has had scant impact on the number of new drugs approved. The venture capitalists who are putting up the funding for biotech startups have come away with a negative one percent return over the 10-year period from 2001 through 2010. Yet the shortfall in drug therapies comes at a time of fecund research that points toward prospects for gene therapies, cancer drugs aimed at molecular targets, new methods of medical imaging, diagnostic markers for cancers and heart disease, among others.
The authors offer explanations for the disparity between innovation and an absence of new medicines and technologies. The increasing complexity of the science has created a multitude of molecular markers that can be investigated for possible drugs. The cost of undertaking research on so many targets—combined with less tolerance for risk because of declining R&D, increased regulatory uncertainty, patent expirations and the like—has meant that the industry lacks the wherewithal to pursue all of these leads. Health-care finance professionals sometimes refer to the gap between research and latter stages of clinical development as the “valley of death.”
Into the breach, Lo and company propose using financial engineering—yes, some of the same techniques that provoked the financial crisis about five years ago—to cope with this disconnect between invention and product.
Specifically, they suggest setting up a megafund, issuing stocks and bonds worth as much as $30 billion, to support dozens or hundreds of drug and other biomedical programs— the diversification here intended to decrease the risk of the overall portfolio and thereby enhance the ability to raise money. Also, relying on bonds more than stock would enable the raising of the huge sums cited, as the debt markets dwarf stock sales.
The money would be raised through securitization: an investor in a stock or bond in the megafund would be buying a little piece of all of the multitude of projects in which the fund is invested, in the way that mortgage securities gave the owner a partial stake in a package of mortgages. The way the fund is structured, the authors contend, would allow unparalleled investment flexibility for projects at all stages of the development cycle. Big drug companies, by contrast, avoid early-stage development and biotech companies are restricted by financing constraints to only a few projects.
Many of the projects would fail but the diversification would mean that, in a few cases, the fund would likely hit the jackpot. A simulation carried out by the authors showed that a cancer megafund with assets of $5 to $15 billion could reap returns of 8.9 to 11.4 percent for equity holders and 5 to 8 percent for bond, or “research-backed obligation,” holders, insufficient for venture investors but enough to attract more patient capital from pension funds and insurance companies.
I asked Lo whether he had met with any skepticism from colleagues in academia or on Wall Street. Here is what he said in an e-mail:
“Yes, at first we received a great deal of skepticism from all quarters: pharma companies, biotech VCs, and academics. Much of this skepticism came from the ridiculously large numbers we were quoting ($30 billion??), but that’s what the problem calls for given the cost of developing a single compound into a drug. But once they saw what our arguments were, and then looked at our historical simulations, and considered all that seems to be wrong with the existing business models of the biopharma industry, they usually become much more receptive.”
The article itself addresses the question of whether it’s crazy to use a form of financing that was responsible, in part, for the greatest financial crisis since the Great Depression. The authors emphasize that securitization was developed originally as a means to diminish risk and got hijacked during the Great Recession because of poor corporate governance, inadequate disclosure and shoddy sales practices. Structured properly, the authors contend, a megafund might be viewed as another example of the type of venture philanthropy practiced by, say, the Gates Foundation. Lo said that he and his colleagues now want to assemble a collection of leaders from Wall Street, biotech, pharma, the NIH, the FDA and non-profits to explore further the feasibility of the concept.
Will it work? Hard to say.
But the industry needs some new thinking about ways to traverse the precipitous chasm of the Valley of Death.
Image Source: Tibor Kádek