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A CFA Institute Production

www.cfainstitute.org
Slides provided by speaker
The Journey Matters: Using Behavioral Finance in the
Management of Client Portfolios
Peter Brooks, Ph.D.
Behavioural Finance Specialist, Asia
May 2013
Securitizing a Cure for Cancer
Andrew W. Lo
Charles E. and Susan T. Harris Professor and
Director of the MIT Laboratory for Financial Engineering
MIT Sloan School of Management
17 October 2013
2
Conundrum
Genuine Breakthroughs In Biopharma:
2001: Gleevec, first of a new class of drugs based on molecular biology
(tyrosine kinase inhibitor)
2004: Avastin, angiogenesis inhibitor (VEGF)
2006: Sutent, approved for RCC and GIST simultaneously
2008: First cancer genome (leukemia) sequenced by Wash U. Genome
Institute, Nature 456 (2008):6672.
2012: Dr. Lukas Wartman, Wash U. cured of acute lymphoblastic leukemia
via RNA analysis and Sutent
2012: David Aponte cured of same type of leukemia using immunotherapy (T-
cells targeting CD19)
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Conundrum (2)
Weak Performance In Biopharma Investments
January 2002 to January 2012, NYSE/ARCA Pharma Index return:
1.2%
2001 to 2010 VentureXpert average biotech IRR: 1.0%
-10%
0%
10%
20%
30%
40%
-25%
5%
35%
65%
95%
125%
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1 yr IRR (LHS) 10 yr trailing IRR (RHS)
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Conundrum (3)
Why??
Conjecture: biopharma business model may be broken
As we get smarter, business risk increases (why?)
Additional uncertainty due to recent economic events
VC, private equity, and public equity are not ideal
Funding is declining despite/because of better science
Financial Engineering May Offer A Solution
Portfolio theory: multiple shots on goal
Securitization: long-term debt, tranches, guarantees,
5
Lessons from the Financial Crisis?
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U.S. Real Home Price Index, 18902012
Source: Robert J. Shiller
Home Prices
Population
How Did This Happen??
6
497
613
1,149
1,027
685
1,693
2,338
3,173
1,917
2,230
2,110
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1,660
2,056
0
500
1,000
1,500
2,000
2,500
3,000
3,500
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Lessons from the Financial Crisis? (2)
U.S. Mortgage-Related Debt Issuance ($Billions)
Source: SIFMA
What could possibly
go wrong?
7
How Could This Have Happened?
Who Benefited From This Trend?:
Commercial banks
Credit rating agencies (S&P, Moodys, Fitch)
Economists
Government sponsored enterprises
Homeowners
Insurance companies (multiline, monoline)
Investment banks and other issuers of MBSs, CDOs, and CDSs
Investors (hedge funds, pension funds, mutual funds, others)
Mortgage lenders, brokers, servicers, trustees
Politicians
Regulators (CFTC, Fed, FDIC, FHFA, OCC, OTS, SEC, etc.)
A Rising Tide Lifts All Boats
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How Could This Have Happened? (2)
Innovation Requires Financial Infrastructure!
Private investment
Accounting, legal, regulatory structures
Systemic stability
Well-functioning capital markets
Proper design of securities
Incentives Are Needed To Motivate Action
Fear Works Faster; Greed Is More Sustainable
Greed and altruism need not be incompatible
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The Power of Global Capital Markets
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U.S. Real Home Price Index, 18902012
Source: Robert J. Shiller
Population
E = mc
2
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Investment Problem
Consider The Following Investment Opportunity:
$200MM investment, 10-year horizon
Probability of positive payoff is 5%
If successful, annual profits of $2B for 10-year patent
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Investment Problem (2)
Consider The Following Investment Opportunity:
$200MM investment, 10-year horizon
Probability of positive payoff is 5%
If successful, annual profits of $2B for 10-year patent
$200MM
p = 5%
1 p = 95%
100.0%
+51.0%
E[R] = 11.9%
SD[R] = 423.5%
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What If We Invest In 150 Programs Simultaneously?:
Requires $30B of capital
Assume programs are IID (can be relaxed)
Diversification changes the economics of the business:
But can we raise $30B??
E[R] = 11.9%
SD[R] = 423.5% / 150 = 34.6%
____
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What If We Invest In 150 Programs Simultaneously?:
Given the reduction in risk, debt-financing is possible!
$17B of high-quality 10-year debt can be issued
With securitization (RBOs) and third-party guarantees (CDS), debt
capacity is even larger
Event Probability
Minimum
Year-10
NPV
Maximum Year-0
Proceeds at
3.75% (10-Yr Aa
as of 9/13/13)
Maximum Year-0
Proceeds at
4.06% (10-Yr A
as of 9/13/13)
At least 1 hit: 99.95% $12,289 $8,504 $8,254
At least 2 hits: 99.59% $24,578 $17,009 $16,509
At least 3 hits: 98.18% $36,867 $25,513 $24,763
At least 4 hits: 94.52% $49,157 $34,017 $33,017
At least 5 hits: 87.44% $61,446 $42,522 $41,272
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Simulating A Cancer Megafund
Fernandez, Stein, Lo (Nature Biotech, Oct 2012)
Tufts Medical School CSDD + Deloitte/RECAP cancer compounds database from
19902011
2,000+ compounds 733 after cleaning data
Cost and revenue assumptions from historical data and literature (e.g., Bloomberg,
DiMasi et al. 2003, etc.)
Estimate transition probability matrix and valuations
Fagnan, Fernandez, Lo, Stein (AER, May 2013)
Pricing and impact of third-party guarantees on debt capacity and investment
performance
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Simulating A Cancer Megafund (2)
Simulation Results: Matlab and R Software Available
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What About Personalized/Precision Medicine?
Fagnan, Gromatzky, Fernandez, Stein, and Lo (2013)
Orphan Diseases: smaller population, urgent need, higher prices,
lower development costs, higher success rates (20%), faster time
to approval (37 years)
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What About Personalized/Precision Medicine?
Simulation results for funds of $135 million and $225 million are
even more attractive!
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Is This Realistic?
Is There Capacity From Investors? In 2012:
U.S. bond market: $38.1T
Mutual funds: $13.1T
Money-market funds: $2.7T
Norwegian sovereign wealth fund: $683B
CalPERS: $237B (as of June 30, 2012)
Target return of 126 public funds (2012): 8%
In 2012, the Size of the Entire VC Industry Was:
$199B
7.5%
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Is This Realistic? (2)
With Some Imagination, Megafunds Are Viable!
Imagine creating a $30B Cure For Cancer megafund
Imagine creating an advisory board of experts:
Imagine corporate pension funds, foundations, endowments,
insurance companies investing as well
Imagine 10MM households investing $3,000 each
Imagine government tax incentives, credit enhancement, etc. (think
Fannie Mae, Freddie Mac!)
George Demetri, Eric Lander, Bob Langer, Mark Levin, Frank McCormick, Larry
Norton, Phil Sharp; Warren Buffett, Bill Gates, Jacob Goldfield, Bob Merton, Jim
Simons, George Soros, Bill Sharpe
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There Are Many Potential Challenges
Size and Business Model: managing large portfolios of complex R&D projects
may require new management and governance structures (e.g., Manhattan
Project)
Centralization: must preserve the benefits of diversity as scale increases
Capacity: is the talent pool large enough to match the scale of this venture?
Complexity: can investors understand the risks and rewards of RBOs?
Excesses: if successful, the potential for abuse will also increase
Ethics: how to balance profit motive vs. social objectives for cures?
Is This Realistic? (3)
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Next Steps
Expose each stakeholder group to the tools, challenges, and
opportunities of other groups in the biomedical ecosystem
Clinicians, researchers, biopharma professionals, VCs, insurance
companies, regulators, investors, financial engineers, patients
Identify major obstacles to private-sector funding of translational
medical R&D
Propose some potential solutions to these obstacles (see
http://cancerx.mit.edu)
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Conclusion
Dont Declare War On
CancerPut A Price Tag
On Its Head Instead!
With Sufficient Scale, We Can Do Well By Doing Good
Finance does not always have to be a zero-sum game

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