“Nowadays drug development is a lengthy and risky process that yields a small number of profitable products. So, it is no surprise that since the 1970s companies have chosen to boost short-term profits by spending more resources on rrketing rather than R&D”. from “the Big Pharma’s Dilemma”, written by Professor Prasad Naik.
There are still too many incurable diseases and too many people that are diagnosed with cancer every year. From now until December 2016, an estimated 1,658,000 new cases of cancer will be diagnosed only in the United States, and 595,690 people will die from the disease. Cancer is a reality and humankind has the duty to invest in the research and development of new therapies and drugs that, one day, will definitely allow a successfully treating every type of the disease.
Drug Development Stages
Before going through the topic of the article, it is very useful to have a look at the chart below, which shows all the phases of a new drug’s development project. It highlights their length in terms of years and the survival rate of the new drug through all the stages, which is actually very low.
The riskiest parts of the projects are those that between discovery to the FDA approval: drug discovery, preclinical and clinical trials. In fact, during these stages, at every moment, the project could be declared a failure, and every single dollar invested in it would be suddenly lost. Once approved, the company will have the patent allowing it to have the exclusive rights to sell the new drug and make phenomenal returns.
A Huge Financial Problem On Pharma
Nowadays, the financial side of the R&D divisions in pharma, which are supposed to continuously study, test and develop new therapies and drugs, are in big trouble. On the one hand, the public spending on Medicare has been drastically reduced in a post financial crisis austerity economic environment and, on the other hand, big pharma companies are investing more in existing and approved product promotion and marketing than in developing new drugs. Why are they reluctant to invest in R&D? Basically, the medical research has seen impressive progress in the last years and now only complex and risky projects are advanced.
According to Reuters, the success rate in bringing new medicines to market in recent years is only about half of what it had been previously. The market of new pharma has become riskier and more expensive than ever before, as shown in the graphs below referred to historical data from 1970 to 2010.
To maintain a constant output in new drugs developed, the investment would clearly have to be higher and higher, but this is not happening. As shown below, from 2008 on, the level of total investments has entered a volatile period and it is now constant, with annual growth rates leaning towards 0%, both for the private sector and the public National Institute of Health. Big Pharma companies can no longer run the danger of investing billions in long, risky and very expensive R&D projects. They simply no longer invest.
This stalemate situation has created a huge “valley of death”, a huge financial deficit in the earlier and riskier phases of a new pharma research, that will cause immobilism and a drastic reduction in the development of new advanced pharma. Humankind needs new studies to continue the battle against cancer and other diseases. Therefore, given the problem, the question is: how can it be solved?
The solution comes from the research “Commercializing Biomedical Research Through Securitization Techniques” made by Roger M Stein at the MIT Laboratory for Financial Engineering. His smart and elegant solution turns a non-financeable sector into a sea of opportunities for institutional investors, such as pension funds, always looking for good risk/return mixes on the middle-long period.
According to the researcher, the model is fundamentally based on the constitution of mega funds, financed both with equity and debt, that would invest directly in several clusters of R&D pharma projects, each cluster composed of several types of research in different developing phases. Therefore, looking at the asset side of a hypothetical mega fund, it would consist of thousands of projects at different stages of life.
The mega fund would be financed through equity (for a minimal part) and securitised long terms bonds with fixed coupons, having as collateral the revenues streams coming from the approved and patented new developed drugs. The bonds would be divided into three classical different tranches: senior, mezzanine and junior, that would be refunded back according to the conventional “waterfall model”. Given the time discrepancy between the approval of a new drug and the imminent need to start paying coupons to bondholders, a percentage of the total assets would not be invested, but kept as a liquid deposit.
The model is an obvious example of applied Portfolio Theory: the total assets risk can be significantly reduced by diversifying the single exposure: the more diversified, the better. This way, by increasing the number of uncorrelated/inverse correlated and independent projects financed, the probability for at least one project to obtain a new approved drug would drastically increase.
The likelihood of securing the rich stream of revenues deriving from patent royalties, which will be used to pay back coupons and principals to the bondholders, will also increase. Moreover, the researcher considers that thanks to the diversification most of the bonds would be rated as AAA. At the end, after some years and paying back all the bondholders, the potential remaining assets will be sold and the equity holders will probably earn generous dividends. This structured financial operation is thought to last for at least 20 years, therefore the bonds are suitable for long term investors, such as pension funds.
Case Study: Empirical Evidences
Consider a hypothetical research aimed to develop a new oncology drug that will require 200 million over a 10-year period during which no revenues are generated and with the realistic 5% probability of success. Moreover, it is safe to assume that, if approved by the FDA, the new drug will generate a net income of 2 billion per year over a 10-year period, with a present value of the stream in year ten of 12,3 billion (assuming a 10% discount rate). Given the probabilities, it is hard to think that a company would invest in it: the failure odds are very high.
However, another scenario is investing in 150 of these projects, for a total cost of 30 billion and each of them independent and uncorrelated/inverse correlated from each other and at a different stage of life. Each can be considered a Bernoulli trial that will assume a value of 0 (default of the project) with a 95% of probability and 1 (success of the project) with a 5% probability. In this scenario, what is the probability of at least one success (total sum of the Bernoulli trials equal or greater than 1) among 150 projects? The calculated probability is equal to 99.95%.
The probability is very high, and the mega fund would be very likely to obtain several projects approved by the FDA, with a revenue stream of 12.3 billion from each one, used to pay back bondholders, that will gain impressive annual returns. If the expected return of the portfolio is not affected by the number of projects (it is the weighted average of the single expected returns), the risk, measured by the standard deviation, can be further reduced by mixing together more and more uncorrelated or inverse correlated projects, therefore strongly increasing the probability of success.
Given the real problem of financial deficit in a sensitive sector such that of new drugs development, the financial engineering, thanks to Portfolio Theory and securitisation, has structured a real and math based solution. It will, on one hand, allow the R&D divisions in pharma to develop new and advanced drugs and therapies to fight against cancer and rare diseases and, on the other hand, create appealing and rich investment opportunities for long-term investors.