De-risking drug development: Funding science with financial engineering

401k drug financing
A new proposal suggests spreading drug development risk among many small investors.
Ed Anderson, CCRP, is a clinical research specialist for the Clinical Research Center’s Development and Operations Core at Boston Children’s Hospital.

There’s no way around it. Obtaining approval to market a new drug is lengthy, complex, costly and fraught with uncertainty and risk. Financial engineers at MIT propose a strategy to minimize that risk—one that deserves a close look.

In the last 10 years, the aggregate cost of pharmaceutical research and development has doubled, but the number of approved products has remained the same. To compound the problem, a $1.6 billion reduction in NIH funding, caused by the 2013 sequester, has stalled research projects at more than 2,500 research institutions supported by grants. Pressure from investors and stakeholders is pushing pharmaceutical companies to focus on projects with a greater chance of financial success.

As a result, translational studies—those that bridge the gap between basic research and clinical trials—continue to be neglected and account for less than 12 percent of total research funding. Without funding, or a willingness to assume the financial risk inherent to these projects, novel candidate drugs cannot progress to clinical trials.

Concern about risk is legitimate. The vast majority of compounds don’t get past the hurdles of early phase clinical trials, and it is nearly impossible to know which are worth investing in. One potential solution could come from basic financial engineering: the creation of a biomedical “megafund.”

A pharmaceutical 401(k)?

Economists at MIT have proposed (PDF) the use of portfolio theory to take the risk out of investment in individual candidate drugs. The basic principle is to group candidate drugs into a portfolio. This would dilute the risk and increase the likelihood that the investment will be profitable, as there would be more possible chances for a successful candidate. The portfolio’s strength would increase with its size, and the more investment options that are added, the lower the risk that an individual product’s failure will hurt an investor.

Rather than a few venture capitalists, projects could be funded by many smaller investors.

Since each drug requires an investment of several million dollars, combining them requires an unprecedented capital investment, beyond what government, foundations and venture capitalists could provide. A biomedical megafund capable of arranging and managing these portfolios of drugs would instead need to rely on some form of crowdfunding. Rather than a few venture capitalists, projects would be funded through the participation of many smaller investors and would attract them with incentives comparable to what they already invest in.

Using securitization techniques, the economists, led by David Fagnan and Roger Stein, ran simulations for a theoretical cancer megafund, as Stein, chief analytics officer at State Street Global Exchange, described in a TED talk last November. They found that by combining the candidate drugs into a portfolio of 80 to 150 compounds, they could generate and issue bonds with a predictable rate of return—between 5 and 8 percent, with a 12 percent equity yield—similar to most 401(k) and pension plans. In addition, the models show that the megafund can be self-sustaining, earning revenue through the strategic buying and selling of new candidate products, which would each gain value as they progress through trial stages.

While the return rates are not appealing to venture capitalists, these “research-backed obligations” can be integrated into existing retirement plans and institutional investment portfolios. Investors could select a portfolio containing the type of research they support, tailored to their personal risk tolerance. Portfolios could include multiple treatments for one disease, for example, or a mixture of products targeting, say, orphan diseases.

Although this concept comes from outside the pharmaceutical industry, it serves as a reminder that we need to innovate our existing strategies and reduce the impact external financial circumstances have on work that needs to be done. Incorporating principles from other fields, such as financial engineering, can provide novel insight into familiar problems.

You can learn more about financial engineering and megafunds in this PDF or via Stein’s TED talk. And if you want to test out this idea and run your own simulations, the program is open source and available through MIT.

There will be significant costs and obstacles to any innovative idea, but in a field of study with the potential to save lives, we should always weigh the cost of action against the cost of doing nothing.

For more out-of-the-box ideas, attend Boston Children’s Global Innovation Summit + Awards 2014 this October 30-31.