Can financial engineering save cancer research?
Paul Solman: Here in the Boston area, cancer researchers abound. But there is something of a crisis in the field.
As a professor/friend of mine who runs a lab here in town tells me, research has identified a host of therapeutic targets, but “results from the clinic have not produced encouraging outcomes and, to date, there have been no reliable lasting responses to therapies against many malignancies.”
It seems that cancer cells are proving better than researchers thought at evasion. They evolve, adapting to treatments and circumventing them. Out-of-the-box thinking, and funding, may be what’s necessary.
Or as my friend puts it, more technically: “The complexity of cancer demands substantial increases in funding for multidisciplinary research to elucidate the mechanisms that initiate and drive malignancies. At the same time, meeting the challenges of combating cancer will require changes in the current thinking paradigms to embrace innovative strategies to cure this disease.”
As the director of the MIT Laboratory for Financial Engineering, Andy and his colleagues have been working on a financial innovation to fund cancer research, using the much-maligned technique that led to the housing collapse: “securitization.” He explains it in detail in a lecture here.
Because of budget battles and the Federal debt, government funding for basic research is in dangerous decline. So Andy has been working on an alternative approach — a way to achieve the ultimate goal of “capitalism”: assembling the accumulated wealth of a society to achieve its highest aspirations.
That is what the “capital markets” are all about: to channel wealth toward our most worthwhile but otherwise unaffordable projects, from trade with the Indies half a millennium ago to the Internet start-ups of today. “Financial engineering” is the term for innovations in the capital markets to facilitate the movement of capital.
After the crash of ’08, the term “financial engineering” became a curse; “securitization,” a red flag for regulators and investors alike. But however abused they may have been in the housing market and elsewhere as sophisticated brokers took advantage of naive investors, these are vital, necessary techniques for funding expensive and important projects. And they can be used — should be used — to revive something as important as cancer research when traditional sources of funding have fled the scene.
Securitization is simply the pooling of a group of assets, typically loans like mortgages, student debt, credit card contracts or auto loans. Once the pool is created, it becomes an independent asset against which further loans (“securities”) can be issued. Thus if you owned a “mortgage-backed security,” you owned an IOU or bond, backed by a pool of mortgages. So long as the mortgage payments were made into the pool, you got your interest payment on your bond. Then came 2008, and all too often, payments stopped, tarnishing the very notion of securitization.
Portfolio theory is even simpler: the concept of spreading risk through diversification via a portfolio of investments.
Combining portfolio theory with securitization is a new approach for addressing the dearth of cancer investment.
Instead of mortgages, why not assemble a large and diversified number of drug discovery and translational medicine projects within a single investment entity (a “megafund” portfolio or pool)? Borrowing a concept from soccer or ice hockey, Andy calls it a “multiple shots on goal” approach. The size and diversity of the megafund will reduce investment risk to the point where the expected rewards will outweigh it. And that will attract investors, most importantly, the investors with most of the world’s savings such as pension funds, sovereign wealth funds and insurance companies; investors, that is, who have previously never considered investing in translational medicine because of the risk inherent in individual companies and therapies.
But enough. Andy has conscripted two distinguished colleagues to make the case here on Making Sen$e. Edward Benz is president of the Dana Farber Cancer Institute and Richard and Susan Smith Professor of Medicine and professor of pediatrics and pathology at Harvard Medical School. Michael Goldberg is assistant professor of cancer, immunology and AIDS at the Dana Farber Cancer Institute and assistant professor of microbiology and immunobiology at Harvard Medical School.
As the leading cause of death for individuals under 85, cancer represents one of society’s biggest challenges. Though vast amounts of money have been invested in cancer research since President Richard Nixon declared war on cancer in 1971, we are only now beginning to reap the benefits of this long-term investment.
Thanks to the “omics” revolution and other technological breakthroughs, major progress in cancer therapeutics over the next decade is within reach. Yet, because of disappointing biopharma investment returns in recent years, financial capital is leaving this industry at the worst possible time, and federal funding for basic research — a critical input to translational medicine — is also declining.
Financial engineering — specifically portfolio theory and securitization — is a new approach for addressing this conundrum. By combining a large number of drug discovery and translational medicine projects within a single investment entity (i.e., a “megafund” portfolio), the “multiple shots on goal” will reduce the investment risk of the megafund to the point where its risk/reward profile will be attractive to a much larger pool of investors, including investors who have previously never considered investing in translational medicine, such as pension funds, sovereign wealth funds and insurance companies.
A key implication of this portfolio approach is the ability to finance a portion of the megafund’s assets with long-term bonds — similar to homeowners financing the purchase of a home with a mortgage. Investors in long-term bonds are, by definition, more patient and, therefore, better suited than venture capital (VC) or public equity to the longer time horizons of biomedical projects.
With more patient capital, scientists and clinicians can target more transformational therapeutics — which are often riskier and longer-horizon — rather than focusing on “lower hanging fruit.” Also, the aggregate size of the bond market ($38 trillion in 2012) is much larger than assets in the venture capital industry ($199 billion in 2012), so much larger amounts of capital can be raised to support the multiple shots on goal needed to reduce the investment risk to the point where debt financing is feasible.
Finally, the current low-interest-rate environment is ideal for borrowers, and issuing long-term bonds with returns driven by translational medicine may be especially attractive to investors because of the bonds’ higher yields and lower correlation to more traditional investments.
The optimal scale of a megafund is determined by a combination of parameters including the development costs, potential revenues, failure rates and correlation of failures of the projects in the portfolio. Given the historical parameters of traditional cancer therapeutics, the required scale to achieve such “de-risking” is on the order of $30 billion. However, for orphan diseases — diseases that affect fewer than 200,000 patients, according to the Orphan Drug Act of 1983 — of which cancer is the second most common category, with the largest number of designations and approvals — the required scale is considerably smaller. Because of the lower development costs, higher success rates, lower correlation of failures, and faster FDA approval times for orphan drugs, a portfolio of as few as six projects and assets of only $150 million can still yield sufficiently attractive risk-adjusted returns for investors.
The benefits of megafunds are not simply due to size — the largest pharma companies currently have more than $30 billion in corporate cash collectively — but are related to the financial incentives created by their structure. As publicly traded corporations focused on quarterly earnings, daily stock price fluctuations, and shareholder concerns, pharma companies are constrained in their risk-taking ability. Indeed, these companies hold large cash positions to reduce the risk of their balance sheets and to fund acquisitions of later-stage assets that have been sufficiently de-risked. With sufficient diversification, megafunds can invest in both early and late-stage assets. The incentive to increase diversification will drive megafunds to choose less-correlated projects, expanding the range of therapeutic pathways explored.
Megafunds will source projects from traditional outlets (e.g., academia and medical centers) but may also acquire projects that have run out of funding or have been de-prioritized by pharma companies seeking to restructure their portfolios. The megafund is not a substitute for large pharma companies or biotech VCs; it will work collaboratively with both by channeling new sources of investment capital that will reduce the risk to VCs and also replenish the pipeline of new therapeutic candidates on which pharma companies depend.
A megafund is thus more than a financing vehicle: it fills a gap in the current biopharma ecosystem by motivating new medical and business practices rather than simply adding more dollars to a failing system. Of course, megafunds require that the underlying investments yield an attractive rate of return for investors; otherwise, it becomes impossible to raise sufficient amounts of capital to generate sufficient shots on goal. In this respect, megafunds are not substitutes for government and non-profit-sector funding of basic scientific research, which is the engine that drives translational medicine and the entire biopharma industry.
But can a new model work? Royalty Pharma — an investment company that acquires ownership interests in the royalty streams of approved drugs and, more recently, compounds that are in phase III clinical trials — represents an interesting business model that serves as proof of this concept. It currently possesses more than $10 billion in assets, of which several billion are financed by debt. By acquiring royalty interests from universities and academic medical centers, such funds facilitate the recirculation of financial assets back into early-stage research.
Beyond improving cancer research outcomes, megafunds may have some “macro” implications. A more holistic approach that supports and aggregates projects could lead to enhanced coordination, thereby increasing the efficiency of the entire system, which currently rewards independent achievement. In addition to exploring more sophisticated clinical-trial designs that compare multiple compounds in a dynamic manner within a single clinical trial, a megafund could use such knowledge to inform independent trials. Whereas project managers in industry are incentivized to see their individual programs succeed, the view of the megafund is to see the portfolio succeed.
A megafund could also pursue research programs that often receive less investment than they might deserve. More funding might be allocated to investigating cancer prevention. These studies are too costly to run over lengthy time frames with present funding mechanisms, but a megafund’s time horizon may be decades rather than quarters. More funding could similarly be devoted to improving cancer diagnostics. Both of these examples are consistent with the goal of changing the rules of the game, enabling us not only to treat cancer better but also to alter when we are treating it.
Recently, stakeholders from the relevant communities — including academia, clinics, technology licensing offices, the biopharma industry, health plans, government agencies, patient advocacy groups, investment banks, hedge funds, credit rating agencies, biotech VCs, and investors — assembled at a conference to discuss new approaches to commercializing biomedical research in oncology through financial engineering. The National Cancer Institute and American Cancer Society were notable participants, but we hope the effort will grow if more people collaborate with the investment industry.
While the initial megafund proposal is focused on cancer, it should serve as a model for setting up megafunds for other disease areas that can generate reasonable returns to investors while providing an important funding stimulus to the biomedical community with a view toward generating disruptive improvements in health care.