Doing well by doing good

Drug approval swaps and megafunds can channel capital towards world’s greatest problems, writes MIT’s Lo

Medicine bottles
Financial innovation could provide much-needed funding for biomedical research
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In the past decade, financial industry excesses have been cited as the source of many ills afflicting economies and political systems in the West. But, if used responsibly, finance could help provide the cure for some of humanity’s most pressing problems – from cancer to fossil fuel depletion and climate change.

Let’s take an area encompassing the first of those: the development of new medical treatments. The world’s unsolved health puzzles, such as cancer and Alzheimer’s disease, require increasingly complex biomedical approaches, and greater complexity means greater risk of failure for a particular new drug or device. That translates into less funding.

Despite a banner year for biotechnology venture capital in funds raised, funds deployed and new companies launched, funding for preclinical research and development, and early-stage drug discovery is still scant, and certain areas – including paediatric cancer, Alzheimer’s, infectious diseases and new antibiotics – are suffering a decline in funding. This lack of investment isn’t necessarily irrational from the individual investor’s perspective, as low probabilities of success and downward pressure on drug prices imply lower expected financial returns. But it’s incredibly short-sighted from a societal perspective.

Enter financial innovation. One example is a ‘drug approval swap’ – a bilateral agreement between two counterparties in which one party pays a fixed notional amount to the other party if a specific drug fails to achieve regulatory approval. Like the more traditional credit default swap, drug approval swaps would allow healthcare stakeholders to transfer risk more efficiently. A 2017 research paper I co-authored with Adam Jørring, Tomas Philipson, Manita Singh and Richard Thakor shows that these securities can be easily priced as digital options and, if used properly, can greatly reduce the financial risks of drug development, drawing more investment capital into the industry.

Another idea would be to apply portfolio theory to drug development in order to improve the activity’s risk/reward profile. Instead of funding projects one at a time, each with a high probability of failure, why not fund a large portfolio of projects simultaneously – a megafund – with enough diversification so as to lower the risk of failure and increase the likelihood of attractive returns to investors?

Megafunds of $5–15 billion may yield average investment returns of 8.9–11.4% for equity holders and 5–8% for holders of ‘research-backed obligations’, as shown in a 2012 article I wrote with Jose-Maria Fernandez and Roger Stein. These are lower than typical venture capital hurdle rates but attractive to pension funds, insurance companies and other large institutional investors.

Variations of the megafund structure and drug approval swaps can be used for many different types of ‘long shots’ … such as fusion energy, space colonisation, and geo-engineering solutions to slow or reverse the effects of climate change

The megafund method isn’t a panacea for all economic problems in biomedical research. It doesn’t address product pricing or cost effectiveness, and in some cases – such as the development and stockpiling of certain vaccines – there is simply no positive expected return to the investor under realistic assumptions.

In those cases, the public sector needs to step in and step up. A medical megafund isn’t supposed to replace the role of public institutions; it’s meant to assist them by channelling private energies to the public good. For example, in the critically important and underfunded area of paediatric cancer, either philanthropic investment, also known as venture philanthropy, or low-cost public sector guarantees can reduce the risk and increase the expected return for more traditional sources of private-sector capital, according to recent financial analysis I carried out with Peter Adamson, Sonya Das and Raphael Rousseau.

These are just a few examples of how finance can be refocused to de-risk some of today’s biggest endeavours. Variations of the megafund structure and drug approval swaps can be used for many different types of ‘long shots’ – investment opportunities that are low-probability but huge-payoff bets such as fusion energy, space colonisation, and geo-engineering solutions to slow or reverse the effects of climate change. These opportunities will require financing and risk transfer on a massive scale, but at such scales they actually become less risky and more attractive to investors, moving into the realm of the feasible.

Back in 2003, Warren Buffett called derivatives “financial weapons of mass destruction”, a prescient observation given their role in the subsequent global financial crisis. But his analogy cuts both ways. If used responsibly and carefully, financial innovation can become one of the greatest inventions of all time, fuelling virtually unlimited economic growth and welfare for all rather than just the privileged few.

The financial industry can do well by doing good and it can do it now.

Andrew W. Lo is a professor at the MIT Sloan School of Management, director of the MIT Laboratory for Financial Engineering, a principal investigator at the MIT Computer Science and Artificial Intelligence Laboratory, an affiliated faculty member of the MIT Department of Electrical Engineering and Computer Science, an external faculty member of the Santa Fe Institute and a research associate of the US National Bureau of Economic Research.

Editing by Olesya Dmitracova

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