Andrew W. Lo, a professor of Finance at Massachusetts Institute of Technology Sloan School of Management, discovered that application of financial engineering can help mitigate risks in biopharma investments.
Eroom’s Law is the number of drugs approved by the FDA each year divided by the amount of investments spent in the pharmaceutical industries. The graph reveals drug development speed declining while costs doubling every 9 years. Fernandez, Stein, and Lo (2012) argue that drug development is becoming increasingly expensive, lengthy, complex, and risky.
The increasing complexity and risk imply that biopharma’s traditional financing vehicles of private and public equity are becoming less effective funding sources because the needs and expectations of limited partners and shareholders are not consistent with the realities of biomedical innovation.
Lo believes that cures for cancers are unique to each patient and therefore require unique drug treatments as opposed to massively scalable compounds. Yet, the pharmaceutical industry cannot recoup its massive investment in research unless it has blockbuster drugs that can generate returns to compensate for massive upfront costs.
Solution: By combining a large number of drug-development projects within a single portfolio, a “megafund,” it becomes possible to reduce the investment risk to such an extent that issuing bonds backed by these projects becomes feasible. Applying portfolio theory to finding a cure for cancer helps increase expected returns and lower expected risks for the capital deployed.
A hypothetical drug-development program requires $200 million in out of pocket development costs (in present value) for 10 years of clinical trials and has 5 percent chance of producing an approved drug. If successful, the approved drug will bring roughly $2 billion in annual revenues over the subsequent ten-year period from years 11 to 20, totaling $12.3 billion in final payout. The annual rate of return for this project is 11.9 percent, but the return standard deviation is 423 percent due to the extremely skewed distribution of success and failure.
But combining this drug-development program into a portfolio consisting of 150 such projects and assume that they are independently and identically distributed (IID), then the expected return of the portfolio remains 11.9 percent, but the return standard deviation becomes 423/√ 150 = 34.6 percent yielding a much more attractive investment.
The biggest advantage of combining programs is the success rate of approved drugs. By having 150 projects running simultaneously, the success rate of at least two approved drugs is 99.6 percent, and three approved drugs at 98.18 percent. Despite the initial cost of $30 billion for the portfolio, just having three approved drugs can generate enough profit of $36.9 billion to pay off the initial cost of the portfolio. Diversification has lowered the cost of capital.
Now, with a portfolio worth $37 billion, the reduction in risk allows a significant portion of this capital to be debt rather than equity. And with success rate of at least two approved drugs at 99.6 percent, the default rate is 100–99.6=.4 percent, giving the bond the yield as seasoned AAA corporate bonds.
Because debt markets are significantly larger and have a much broader spectrum of investors than do private or public equity markets, the issuance of debt dramatically increases the potential funding sources for the megafund. Using securitization techniques, credit derivatives, and third-party guarantees can further increase the megafund’s investor base.
According to 1983 Orphan Drug Act, a rare disease is defined to affect 200,000 patients or less. And more than 30 million Americans suffer from over 7,000 rare diseases often due to mutation in a single gene, e.g. hemophilia, cystic fibrosis, ALS, Gaucher, paroxysmal nocturnal hemoglobinuria.
By applying the portfolio above, the clinical trials for orphan drugs can be successful with only $400–500 million of capital for 10–20 projects to be sufficient. In 2015 paper, Fagnan, Yang, McKew, Lo were able to generate 21.6 percent rate of return with the parameters above. Reason for this success lies in the portfolio’s lack of correlation, which incentivizes investors as the price movement of one asset has no effect on the price movement of the other asset.
Investors are implementing this new business model in biopharma investments. Blackstone Group, a leading global investment business investing capital on behalf of pension funds, large institutions and individuals, has market capitalization of $160 Billion. Blackstone established Blackstone Life Sciences (BXLS) for $4.6 Billion, the largest life sciences private fund raised to date, bringing 114 medicines to market with 86 percent Phase 3 success rate as of 2021.
In 2021, Bain Capital Life Sciences has successfully raised $1.9 Billion for funding projects that involve medical, drug, and biotechnology projects. In 2018, Bain Life Sciences partnered with Pfizer to focus on developing drug candidates that would treat central nervous systems (CNS) disorders, including epilepsy, Parkinson’s, schizophrenia, addiction, and Alzheimer’s.
Dr. Neil Kumar, student of Dr. Lo, co-founded Bridgebio Pharma in 2015, which modeled its portfolio based on Dr. Lo’s research. Currently, BridgeBio has more than 15 drug programs for 20 genetic diseases from genetic dermatology, oncology, cardiology, neurology, endocrinology, renal disease, and ophthalmology. The company provides real-time update on each investigational drug in the pipeline.
Today’s low-interest-rate environment is ideal for issuing long-term debt, and investors around the globe are desperately seeking new investment opportunities that are less correlated with traditional asset classes. More importantly, the burden that cancer causes towards the economy — $263 Billion in estimated economic impact according to American Cancer Society (2011) — must be balanced against the risk of failure. Finance does not have to be a zero-sum game.
“I now measure time in terms of the number of patients that have died each day because they can’t get their therapies that we now know how to create. We actually have the tools to do it. We just don’t have the resources. And that, to me, is unacceptable.” —Dr. Andrew W. Lo