David Bowie and Pharmaceutical Finance

Home ownership was a pipe dream for many until Lewis Ranieri came along, started securitizing mortgages and created the Mortgaged Backed Security in the 1970’s popularly referred to as the MBS .

Securitization, loosely speaking is the process of pooling together financial assets and subsequently issuing claims - bonds - against their cash flows, in this case mortgage payments (MP), to investors through a special purpose vehicle A.K.A the SPV as illustrated in Figure 1.

Now MBS’s generated healthy returns for investors, and put a roof over many people’s heads who previously couldn’t afford one. (Excesses in the MBS markets were also found culpable for the recent financial crisis, but more on that later)

After securitizing home loans, Wall Street turned its attention towards other products: Jumbo Loans, Commercial Loans, Student Loans, Royalties from catalogue of David Bowie Songs.

Thanks to the ingenuity of Securitized Products like the MBS, poor students were able to pursue higher education (The SLABS) , Skylines started to sprout across the US (The CMBS) and David Bowie was able to lead the jet setting extravagant life of a rockstar (The ABS).

The RBS

It's time we applied the same financial ingenuity for Bio-Pharmaceutical R&D and created the Research Backed Security market (RBS) which will hopefully finance the radical ideas of the industry’s researchers for diagnostics, drugs and medical devices . 

RBS Mechanics

RBS is a securitized product conceived by Andrew lo of MIT where instead of using Real Estate as collateral like in an MBS and disbursing Mortgage Payments to the owners of the security, RBS dealmakers pledge IP as collateral and disburse cash flows from sale of the drugs or the sale of In Process Research and Development (IPRD).

The Burden of Disease

To understand the benefits the RBS market will bring to investors and industry, let us run some back of the envelope calculations

Medically, there are three diseases that have scourged the American people for far too long like no other.

• Cancer: There are roughly 30,000 variant of cancer. If indeed it takes 2 billion dollars to bring a drug to market and assuming some treatments can be administered across indications, it would still take trillions of dollars to cure all cancers. 
• Alzheimer: In the Summer of 2016, Congress earmarked $940 mn for Alzheimer’s research. As a point of comparison, Alz.org estimated that cost of care for the Alzheimer’s patients for 2017 will be to the tune of $260 bn.
• Diabetes: In 2012, The American Diabetes Association (Association) estimated that diagnosed diabetes bled the American economy dry of $245 bn in explicit and opportunity costs.

Compare all of the aforementioned costs of treating and curing disease with the money raised by Biotech IPO’s and Venture Capital funds in 2015.

Clearly healthcare funding has been on a healthy upward trend but what is also apparent that its levels still do not reflect the fiscal toll disease takes on the US economy. 

The Problem

We must spend more on new therapeutics. But how do we incentivize Investors and broaden our base thereof. Currently they have been averse to investing in drug discovery and development (DD&D) as the realities of the endeavor are out of sync with their expectations . Figures! Takes around 10 to 15 years and several billion dollars to develop a drug as mentioned earlier. Furthermore, 9999 out of 10,000 molecules fail to make it to human trials from the discovery Stage! Can you blame the Investor? DD&D is a risky proposition. 

Furthermore, VC funds have a very short term time horizons (5-8 years) compared to the DD&D lifecycle. Investing in single compounds is fraught with risk. VC’s occasionally assume such risks but it’s not enough to level the scales between costs of and funding for disease.

Incidentally, Public Bio-pharmaceutical equity investors like every other type of investor are obsessed with earnings, and seek growth therein every quarter. Consequently, I can empathize with Pharma executives when they abandon promising long term molecular prospects to fulfill their fiduciary responsibilities.

The Solution

Traditionally, the preponderance of Biopharmaceutical innovation has been funded with Equity issuance/VC. But as I argue above there is misalignment between the two. Debt Capital Markets on the other hand have been neglected as a source for Healthcare capital. This is where RBS’s come in. A diverse, liquid and well-regulated RBS market can increase private sector contributions to DD&D by many orders of magnitude

To make DD&D more appealing to the traditional investor, RBS leverages the principles of portfolio management and securitization to increase returns and reduce risk. To reiterate the basic principles are as follows: 

1.      Take a DD&D project and pool it’s IP/CF with that of other projects. More novel the mechanisms for each project greater the diversification of the pool.

2.      Secure the rights to the intellectual property and cash flows from these projects under an SPV

3.      SPV can then issue RBS bonds against them as illustrated in Figure 1.  

An RBS bond issuance can be focused on a single therapeutic area - Cancer Megafunds have been proposed - or several, namely oncology, neurology nephrology etc. Bonds issued against research being pursued in multiple areas will achieve greater diversification. 

On another note, as the public interest is being served by the RBS market, to give it depth and render it liquid, Governments and Philanthropies can be lobbied to become Guarantors that assure payments to the owners of various tranches of RBS bonds.

The Problem with the Solution

It is not however all sunshine and rainbows.

Just like with the real estate market, an RBS market especially one without proper regulatory oversight will incentivize research pursued not to find cures but to line the pockets of intermediary financial institutions and laboratories. To mitigate this Moral Hazard, the SPV’s securitizing research projects must by regulatory requirement retain a part of the RBS issuance, preferably the riskiest. This will alleviate concerns about the information asymmetry between potential RBS investors and the sponsors of Research.

Secondly, due diligence for securitized products is complex even when pooling together home loans relatively simpler products vis-a-vis complex scientific endeavors to understand the mysteries of human mind and body whose IP will collateralize the RBS. It is reasonable to assume the relative inscrutability of scientific research will keep some investors away.

Thirdly, the father of the RBS Andrew Lo cautions practitioners in his many publications on the assets class that achieving diversification with RBS w.r.t mechanisms of action, therapeutic area of focus, stage of trial will be far more difficult. Large deal sizes in the billions of dollars will be needed to pare risk insofar that it appeals to a large enough investor base. 

Conclusion

Notwithstanding, these obstacles to fostering RBS market are not insuperable. And even if they were.... patients are suffering…..people are dying. We must find a way. Life Science investments although rising still remain insufficient to meet neglected medical needs. Stakeholders in society: The Markets, The Taxpayers, Government, Academia, Charitable Organizations, Transnational bodies must band together to build the financial infrastructure that will support the efforts to improve Human Health for decades to come.