It is a social good and a financial disaster. An era of remarkable medical breakthroughs has coincided with a period of collapsing returns from listed pharmaceutical firms and from venture-capital funds investing in medical research. The share prices of firms such as Pfizer and Merck trade at half their levels in 2000; venture funding has all but evaporated.
The reasons are manifold. A host of new therapies based on genetic markers have smaller potential markets than old-fashioned treatments but remain very costly to develop. That reinforces other sources of uncertainty, like the path of health-care reform in America. The resulting shortfall in available funding for the period between basic research (often government-funded) and the final approval of new treatments is sometimes known as the “valley of death”.
An answer to this funding gap was outlined in a paper, “Commercialising biomedical research through securitisation techniques,” published last year in Nature Biotechnology by Jose-Maria Fernandez and Andrew Lo of MIT’s Sloan School of Management and Roger Stein of Moody’s, a ratings agency. The paper notes the emergence of three investment vehicles—Royalty Pharma, DRI Capital and Cowen Healthcare—that invest in the royalties of approved drugs, thereby providing capital to pharmaceutical companies in exchange for a return that has similarities to a diversified debt portfolio.
Taking these firms as a starting-point, the paper suggests a far broader approach that uses some of the techniques that were at the centre of the financial crisis. The authors propose creating a series of “megafunds” of up to $30 billion, financed by securitised debt and equity. Unlike a company, a megafund would have no operating subsidiary. Unlike a venture-capital fund, it would not have a short cash-out period. Unlike a mutual fund, it would hold illiquid investments in a range of private companies, products, patents, licences, royalties—anything in medical research that may eventually produce a cash flow.
Although the odds of any single medical innovation succeeding are low, the chance that one of them will is high. Scale and diversity should minimise risks. The authors are forecasting nominal returns of 5-8% for the debtholders and 8.9-11.4% for the equity holders. These numbers are broadly in line with average equity and debt returns, and very different from the usual uneven distribution of investments in medical research between a few huge successes and many duds.
Since the paper’s publication in October, the idea of specially constructed megafunds has attracted the interest of regulators, scientists, pharmaceutical firms and venture capitalists. The authors have received lots of suggestions: proposed refinements include the use of credit-default swaps and government guarantees to encourage investors. They have also posted a piece of open-source simulation software so that people can model the fund’s risks.
Getting the first fund off the ground will nonetheless be an enormous task. Thanks to the crisis, a combination of securitisation, credit-default swaps and government guarantees sounds like a recipe for disaster. But unlike the horribly botched financing of the boom-era American housing market, where all of these financial techniques were used, no one is suggesting this set of underlying assets is safe.
© The Economist Newspaper Limited, London (January 26, 2013)