In 2012, Fernandez, Stein, and Lo (MIT Operations Research Center and Laboratory for Financial Engineering) proposed a new cure to cancer: financial engineering. The puzzle they identified was simple: remarkable scientific breakthroughs in biopharma on one hand; and mediocre financial performance and a flight of investment capital from on the other hand. Pre-clinical, early-stage drug development projects are risky, capital-intensive, and have a long pay-off timeline (10+ years). Public companies face pressure to manage quarterly earnings and are often deterred from such projects. The investment horizon of private equity projects is too short, and the projects are too expensive for venture capital funds to diversify. Andrew Lo and his colleagues advocate that the creation of a megafund can address the risks that come with single-project drug development. A megafund would use sufficient capital ($3 to $15bn) to securitize assets (equity, royalties) associated with multiple drug development projects (e.g. 150 trials). Diversification would allow this megafund to provide the high pay-offs of drug development investments but with much lower risk. Given its size, it would give the option to institutional and retail investors to invest in liquid instruments with equity and bond-like investment profiles.
Crowdfunding in biopharma has potential for huge value creation. To start with, crowdfunding can give capital access to an industry where funding is currently scare. The megafund Lo proposes uses a mix of debt and equity. The use of debt in an industry traditionally funded by equity will create value by lowering the cost of capital. By issuing “research-backed obligations”, institutional (e.g. pensions, endowments) and retail investors will be able to invest in a new asset class with a potential for double-digit returns. The performance of the underlying assets has a very low correlation to economic cycles, and the bond-like performance would be very attractive in today’s low interest rate environment. Economic and social value creation is also huge. Millions are affected by cancer and the total economic impact of premature death and disability from cancer worldwide in 2008 was $895bn, or 1.5% of GDP. The crowdsourcing model can also be applied to other areas, such as orphan diseases. In the U.S., 25mn people are affected by a total of 7,000 orphan diseases. Despite attractive financial returns associated with drug development, funding to cure orphan diseases has been scarce due to single-project risk.
Crowdfunding in biopharma can capture value by acquiring financial interest in a number of drug development projects. The megafund would invest in startups, public pharmaceuticals, private companies, royalty streams, intellectual property, and other assets. Royalties and the sale of assets to the secondary market would capture value. Investors would then realize this value through financial returns. Sample simulations indicate that megafunds could offer: a) 10-yr zero-coupon bonds with a yield of 3.8% and 0.4% default probability; b) equity with an expected return of 17.8% and standard deviation of 78.9%; c) multiple risk-return profiles in between (a) and (b) through the use of tranches.
Naturally a number of conditions need to be met for the model to succeed. Project results need to be independent to achieve diversification. Although this seems to be the case, regulation of intellectual property and healthcare reimbursement costs could impact all projects simultaneously. The sheer size of this megafund makes implementation difficult and the process of capital allocation would have to be carefully executed. Lastly, investors would need to become comfortable with the complexity of the model and liquidity terms would need to ensure a steady supply of capital.
Healthcare drug development and climate change are examples of failure of the capitalist system as it stands today. Government action and funding have not really addressed these problems. Capital markets do not reward investors sufficiently in these areas and as a result scientific research does not reach its potential. Lastly, investors are not compensated for the externalities associated with these big problems. There is no doubt that implementing the crowdfunding model Lo and his colleagues created will be difficult. But there is also no doubt that their approach is very noble and that there is huge value to be created and captured by investors and society.