A sure way to end a conversation at a cocktail party is to mention that your job entails financial engineering. Securitization and the collateralized obligations it produced led to the financial crisis and the near-collapse of the financial markets. But financial engineering’s bad reputation could turn around: A highly respected academic has devised a way to apply the core principles of financial engineering to one of the most daunting challenges facing mankind.
Andrew Lo thinks financial engineering can cure cancer.
The biggest problems confronting cancer research are the enormous cost of developing drugs, the long research and development cycles and the high likelihood that a drug will fail. The rewards for a successful drug, however, are enormous – not just medically, but financially as well.
Lo has proposed a way that drug companies can use financial engineering to spread risks among investors and provide incentives to develop successful cancer treatments. He claims that a securitized-debt offering – a “cancer mega-fund” – would offer investors attractive risk-adjusted returns.
Lo is a professor at the MIT Sloan School of Management and director of its Laboratory for Financial Engineering. He spoke at the CFA Institute’s fixed-income conference in Boston on October 17.
“You can actually make money – good money – by curing cancer,” according to Lo.
Each year, 230,000 women get breast cancer and 30,000 die of the disease. The annual cost of breast-cancer treatment is $100,000. But a drug that cost $50,000 a year and transformed breast cancer into a chronic manageable disease would be a very compelling business proposition, according to Lo.
“There has got to be a way to make money for everybody if you can finance that kind of drug discovery,” he said. “We just need to find a better way to do it.”
I’ll look first at a conundrum that Lo identified – why pharmaceuticals have had poor returns, despite a “golden decade” of advances in cancer treatment – and then discuss how a cancer mega-fund would work.
The conundrum
Over the last decade, Lo said there have been tremendous breakthroughs in our understanding of the molecular basis of cancer. He cited the development of drugs such as Gleevec in 2001, which offered a first-of-its-kind cure for leukemia because of the way it exploited the molecular basis of the disease, followed by another so-called designer drug, Avastin, in 2004.
Sutent, which was released in 2006, was even more remarkable. It treats kidney cancer, and its developers went on to become the first to sequence a cancer gene, for leukemia.
Last year, one of its developers, Dr. Lukas Wartman, had a recurrence of a particularly nasty kind of leukemia called acute lymphoblastic leukemia, which kills in weeks, not years. Wartman’s co-researchers sequenced his DNA and RNA and that of his leukemia gene. The RNA sequencing, which was not normally done, led them to discover a genetic mutation that indicated there was a drug that could suppress the leukemia gene.
That drug was Sutent.
Within a few months of beginning treatment, all trace of Wartman’s leukemia had disappeared. He was cured, though that’s a term oncologists don’t like to use given cancer’s unpredictability.
A similar breakthrough occurred the day before Lo spoke, when scientists at the Washington University Genome Institute identified a very small number of genes responsible for tumor growth in 12 different kinds of cancer.
Here’s the conundrum. Despite this progress in medical science, the investment performance of biotech and pharmaceutical companies over the last decade has been dismal, according to Lo. The NYSE Arca index of pharmaceutical companies has returned -1% over that period. Last year saw the smallest number of biotech startups, and there are now about half as many of those companies as there were a decade ago.
The reason for this, according to Lo, is that the bio-pharma business model is broken. The risks in the industry are growing – precisely because the science behind it is getting smarter.
In the “old days,” Lo said drug developers were able to test a drug by giving it to a large population of those with the disease. It might help 10% of them, and 1% might die. Now, however, because of the ability to sequence genes, scientists can pre-determine which 10% of the population should receive the treatment. That’s great for those lucky enough to receive the drug, who can get positive outcomes with few side effects.
But 90% of the market for the pharmaceutical industry can be eliminated, since they are not appropriate for treatment.
“All of these advances that these scientists are pioneering are leading us to better outcomes in terms of patients,” Lo said, “but the economic risks are actually going up, the complexity is going up, and as a result, not surprisingly, the investors are leaving the space.”
The traditional funding sources – venture capital, private and public equity – for biomedical research are no longer ideal. Lo said there are three reasons for this: Drug development is extremely expensive, it takes a long time and its complexity leads to high failure rates. It is not a surprise, he said, that investors don’t get the best outcomes.
“The funding in biomedicine is declining at the worst possible time, at the time that we are just at the point of making a significant set of transformative breakthroughs,” Lo said.
Enter the cancer mega-fund
Lo walked the audience through an exercise to illustrate the investment potential of a cancer mega-fund.
He began by defending the virtues of securitization, while admitting that it was a catalyst for the housing bubble and the ensuing financial crisis. The reason why real estate prices grew so rapidly prior to 2008, according to Lo, was that securitization enabled everyone – bankers, mortgage brokers, homeowners and investors – to benefit. Greed motivated the upward climb in housing prices. Everyone had a strong financial incentive to facilitate the flow of capital into the housing market and to ensure the success of the financial engineering that made it possible.
Unlike fear, which incents only in the short term, Lo said greed is a much more powerful motivator. Lo’s cancer mega-fund is designed to appeal to investors’ greed.
Lo asked the audience whether they would make a $200 million, one-time investment in something that had a 5% chance of success in 10 years, but with an uncertain payoff. Nobody took him up on this proposal. That is essentially what companies now face when developing a cancer drug.
If those companies are lucky enough to succeed, the typical cancer drug generates about $2 billion a year in profits over the 10-year lifetime that it is protected under patents. Discounting those cash flows at 10%, which Lo said is the cost of capital for the pharmaceutical industry, investors can see a present value of $12.3 billion 5% of the time. The other 95% of the time, investors get nothing.
That’s equivalent to an investment with a 12% annual return and a standard deviation of 423.5%, which nobody in the audience would accept.
Now, suppose that one had $30 billion and could invest in 150 of those companies, Lo posited. In that case, assuming the returns are independently and identically distributed (IID), investors get the same 12% rate of return, but with a standard deviation of approximately 35%.
Many in the audience indicated they would invest on those terms, especially after Lo explained that the returns would be completely uncorrelated to the equity markets.
In such a structure, the probability of at least two successes among the 150 companies is 99.59%. With those characteristics, the money could be raised in the bond market with a AA rating.
Securitization and tranching would broaden the appeal of such an offering. Lo said he has constructed a model based on historical data for cancer compounds from 1990 to 2011, with a 5% senior tranche, an 8% junior tranche and the remainder in an equity tranche. The returns for the equity tranche would be 9% to 11%, with default rates within the industry standard for A- and AA-rated debt.
“If we do not talk about a decent rate of return, if we do not let investors benefit from it, then we are left to the generosity of the nonprofit sector,” Lo said.
Based on his conversations with financial and medical “insiders,” Lo is convinced his idea is worth trying. The venture capital industry had only $199 billion in assets last year, of which only $4.1 billion was invested in biotech. But the $38.1 trillion U.S. bond market has ample liquidity, and the characteristics of a cancer mega-fund should appeal to institutional investors like public pensions, endowments, insurance companies and sovereign wealth funds.
Insurance companies would find the investment attractive, because it would hedge against the longevity risk in the life insurance policies they write. Life insurers face the risk of early death of the policyholder, and a cancer bond would offset that risk, by extending lifespans.
Even individual investors might find these bonds attractive. Lo said a $30 billion mega-fund would only require 10% of the 130,000 million U.S. households to invest $3,000 each, perhaps through 401(k) plans.
Lo recalled that in 1971, President Nixon declared war on cancer. Lo said he isn’t sure whether we are winning, but “war” is the wrong metaphor, because it is based on fear. Lo wants to focus squarely on greed.
“Instead of declaring war on cancer,” he said, “what we really ought to be doing is putting a price tag on its head.”
Read more articles by Robert Huebscher
