Andrew Lo

Canfinancialengineeringcure
cancer?
Anewapproachtofundinglargescalebiomedicalinnovation
AndrewW.Lo
(jointworkwithJoseMariaFernandezandRogerM.Stein)
SloanReunion2012
Sloan
Reunion 2012
June8,2012
The contents of this presentation are based on the research carried out at the MIT Laboratory for Financial Engineering by Jose
Maria Fernandez,, Roger
g
M. Stein and Andrew W. Lo. For total or p
partial reproduction
p
please contact jjose
p
maria.fernandez@sloan.mit.edu
2012byJoseMariaFernandez,RogerM.Stein,AndrewW.Lo
AllRightsReserved
Summary
Biomedicalinnovationhasthreeimportantcharacteristics:
Expensive,risky,andlengthy
Traditionalfundingvehiclesarenotideal(private/publicequity)
Riskisoneofthemainissues(complexity,FDA,patentcliff)
Ri ki
fth i i
(
l it FDA t t liff)
Diversificationisthesolution:largepooledvehicleslowerrisk
Withsufficientdiversification,longtermdebtispossible
Morepatientcapital,butstillimposesdiscipline(interestpayments)
Muchlargerpoolofcapital,allowinggreaterparticipation
Thefinancialtechnologyandinstitutionsalreadyexist
Thenaturalscalerequiredis$5to$30billion
Thenat ralscalereq iredis$ to$30billion
Usingfinancialengineering,thisisachievabletoday
MITLFE
2012byFernandez,Stein,andLo
AllRightsReserved
Slide2
Lessonsfromthefinancialcrisis?
Pension
Funds
Foundations,
Endowments
In
nsurance &
CDS Market
Sovereign
Wealth Funds
Ra
ating
Age
encies
Mutual
F d
Funds
Commercial Banks
$$$$$$
Investment Banks
Mortgage Companies
Fannie Mae
$$$$$$
Freddie Mac
Politicians
$$$$$$
Hedge
Funds
MITLFE
AllRightsReserved
Slide3
Real Home Price Index (1890-2006)
200
Index o
or Interest R
Rate
180
160
140
120
100
80
60
1880
1900
1920
1940
1960
Year
Source: Robert J. Shiller, Irrational Exuberance, 2nd. Edition.
MITLFE
AllRightsReserved
1980
2000
2020
To get back to longrun average, we need

45% real drop
( 35% nominal
(=
i ld
drop))
Slide4
Considersimplesecuritizationexample
90%
$1,000
$1,000
I.O.U.
10%
Price = 90% $1,000 + 10% $0

= $900
$0 (Default)
90%
$1,000
$1,000
I.O.U.
10%
9/21/2010
Price = 90% $1,000 + 10% $0

= $900
$0 (Default)
2010 by Andrew W. Lo All

Rights Reserved
Slide 5
$1,000
$1,000
I.O.U.
MBS
Senior Tranche
Portfolio
$1,000
$1,000
MBS
I.O.U.
Junior Tranche
9/21/2010

Rights Reserved
Slide 6
AssumingIndependent
Defaults
$1,000
I.O.U.
Portfolio
Portfolio
Value
Prob.
$2,000
81%
$1,000
18%
$0
1%
$1,000
I.O.U.
9/21/2010

Rights Reserved
Slide 7
AssumingIndependentDefaults
$1,000
MBS
Senior Tranche
$1,000
MBS
Portfolio
Value
Prob.
Senior
Tranche
Junior
Tranche
$2,000
81%
$1,000
$1,000
$1,000
$
,
18%
$1,000
$
,
$0
$
$0
1%
$0
$0
Bad State
For Senior
Tranche (1%)
Bad State
For Junior
Tranche (19%)
Junior Tranche
9/21/2010

Rights Reserved
Slide 8
$1,000
MBS
Senior Tranche
$1,000
Portfolio
Value
Prob.
Senior
Tranche
Junior
Tranche
$2,000
81%
$1,000
$1,000
$1,000
18%
$1,000
$0
$0
1%
$0
$0
Price for Senior Tranche
= 99% $1,000 + 1% $0
= $990
Price for Junior Tranche
= 81% $1,000
$1 000 + 19% $0
= $810
MBS
Junior Tranche
9/21/2010

Rights Reserved
Slide 9
NonInvestmentGrade
Similar to
Junior
Tranche?
Similar to
S i
Senior
Tranche?
MITLFE
AllRightsReserved
Source:Moodys.
Slide10
U.S.BondMarketDebtIssuance($Billions)
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Municipal
185.2
220.7
286.8
227.5
200.8
287.7
357.5
357.5
382.7
359.8
408.2
386.5
429 3
429.3
389.5
409.8
433.1
Treasury1
612.4
540.0
438.4
364.6
312.4
380.7
571.6
571.6
745.2
853.3
746.2
788.5
752 3
752.3
1,037.3
2,185.5
2,303.9
MortgageRelated2
479.7
577.6
1,118.1
985.4
660.0
1,663.9
2,283.0
3,084.3
1,879.0
2,182.4
2,088.8
2 186 2
2,186.2
1,362.2
2,041.4
1,742.7
Corporate
Debt3
343.7
466.0
610.7
629.2
587.5
776.1
636.7
775.8
780.7
752.8
1,058.9
1 127 5
1,127.5
707.2
901.8
1,062.7
FederalAgency
Securities
277.9
323.1
596.4
548.0
446.6
941.0
1,041.5
1,267.5
881.8(4)
669.0
747.3
941 8
941.8
984.5
1,117.0
1,032.6
AssetBacked
168.4
223.1
286.6
287.1
281.5
326.2
373.9
461.5
651.5
753.5
753.9
509 7
509.7
139.5
150.9
109.4
Total
2,067.2
2,350.5
3,336.9
3,041.8
2,488.8
4,375.6
5,264.2
6,717.0
4,524.3
5,512.1
5,823.9
5 946 8
5,946.8
4,620.2
6,806.4
6,684.5
Interestbearingmarketablecouponpublicdebt.
IncludesGNMA,FNMA,andFHLMCmortgagebackedsecuritiesandCMOsandprivatelabelMBS/CMOs.
3 Includesallnonconvertibledebt,MTNsandYankeebonds,butexcludesCDsandfederalagencydebt.
4 Beginningwith2004,SallieMaehasbeenexcludedduetoprivatization.
Beginning with 2004 Sallie Mae has been excluded due to privatization
2
MITLFE
AllRightsReserved
Source: SIFMA
Source:SIFMA
Slide11
$1,000
MBS
Senior Tranche
Portfolio
Value
Prob.
Senior
Tranche
Junior
Tranche
$2,000
81%
$1,000
$1,000
$1,000
18%
$1,000
$0
$0
1%
$0
$0
$1,000
MBS
ButWhatIfDefaultsBecome
Hi hl C
HighlyCorrelated?
l t d?
Junior Tranche
9/21/2010

Rights Reserved
Slide 12
S&PCaseShillerComposite10Index(nominal)
250
20
June 2006: 226.29
Effective Fed Funds Rate
S&P/CaseShiller Composite 10
200
33.5%
16
12
Index Le
evel
150
July 1996: 78.10

April 2009: 150.44
MITLFE
AllRightsReserved
Jan-13
J
Jan-12
J
Jan-11
J
Jan-10
J
Jan-09
J
Jan-08
J
Jan-07
J
Jan-06
J
Jan-05
J
Jan-04
J
Jan-03
J
Jan-02
J
Jan-01
J
Jan-00
J
Jan-99
J
Jan-98
J
Jan-97
J
Jan-96
J
Jan-95
J
Jan-94
J
Jan-93
J
Jan-92
J
0
Jan-91
J
0
Jan-90
J
Jan-89
J
50
Jan-88
J
Jan-87
J
100
Effective Fed Funds

s Rate (%)
Updated June 1, 2012
Slide13
AssumingPerfectlyCorrelatedDefaults
$1,000
MBS
Senior Tranche
$1,000
Portfolio
Value
Prob.
Senior
Tranche
Junior
Tranche
$2,000
90%
$1,000
$1,000
$0
10%
$0
$0
Bad State
For Senior
Tranche (10%)
MBS
Bad State
For Junior
Tranche (10%)
Junior Tranche
9/21/2010

Rights Reserved
Slide 14
AssumingPerfectlyCorrelatedDefaults
$1,000
MBS
Senior Tranche
Portfolio
Value
Prob.
Senior
Tranche
Junior
Tranche
$2,000
90%
$1,000
$1,000
$0
10%
$0
$0
Price for Senior Tranche
= 90% $1,000 + 10% $0

= $900 ((was $990)
Price for Junior Tranche
= 90% $1,000 + 10% $0

= $
$900 ((was $
$810))
$1,000
MBS
Junior Tranche
9/21/2010

Rights Reserved
Slide 15
Wheredidallthemoneygo??
MortgagesOutstandingandEquityExtractions
9/10/2009
2009 byKhandani,Lo,and
Merton
AllRightsReserved
Slide16
Howcouldthishavehappenedtous?
HallofShame?:
Homeowners
Commercialbanks
InvestmentbanksandotherissuersofMBSs,CDOs,andCDSs
Mortgagelenders,brokers,servicers,trustees
Creditratingagencies(S&P,Moodys,Fitch)
Insurancecompanies(multiline,monoline)
I
i ( ltili
li )
Investors(hedgefunds,pensionfunds,mutualfunds,others)
Regulators(SEC OCC CFTC Fed etc )
Regulators(SEC,OCC,CFTC,Fed,etc.)
Governmentsponsoredenterprises
Politicians
Isthefinancialsectorbecomingtoobig?
MIT LFE
2012 by Fernandez, Stein, and

Lo All Rights Reserved
Slide 17
Isthefinancialsectorbecomingbigger? Yes!
MIT LFE
2012 by Fernandez, Stein, and

Lo All Rights Reserved
Slide 18
Why?
WorldPopulation,10,000BCto2011AD
Source: U S Census
Source:U.S.Census.
MITLFE
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Slide19
Innovationrequirescollaboration
Collaborationrequiresfinancialinfrastructure
Privateinvestment
P
i t i
t
t
Wellfunctioningcapitalmarkets
P
Properdesignofsecurities
d i f
ii
Accounting,legal,regulatorystructures
Systemicstability
bl
andalignedincentives(human
andalignedincentives(human behavior)
MITLFE
Fearworksfaster
Greedlastslonger
AllRightsReserved
Slide20
Anexample
TheDARPAnetworkchallenge
Find10redballoonsinfixedlocationsinU.S.
Find10redballoonsinfixedlocationsinU S
$40Kprizetofirstteamtofindall10locations
MITteamwon
8:52:41!
How??
Financialengineering!
$4,000perballooniftheywon
= $2,000tolocator+
$1,000topersonwhoaskedlocator+

h k dl
$500topersonwhoaskedperson+
+remaindertocharity
MITLFE
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Slide21
Anexample
E=mc2
Real Home Price Index (1890-2006)

200
Index o
or Interest R
Rate
180
160
140
120
100
80
60
1880
1900
1920
1940
1960
1980
2000
2020
Year
Source: Robert J. Shiller, Irrational Exuberance, 2nd. Edition.
MITLFE
AllRightsReserved
Slide22
Thepowerofglobalcapitalmarkets
Whatifwecouldfocusthispowerforgood?
Financialengineeringwitha
Financialengineeringwithaconscience
conscience
Applyexpertisetotacklingsocietysbiggestchallenges
Facilitatecollaboration,collectiveintelligence
Facilitatecollaboration collectiveintelligence
Withtheproperfinancialengineering,webelievewecan
solve thefollowingproblemswithinthenext20years:
1. Cancer
2. Energycrisis
3. Globalwarming
How?
MITLFE
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Slide23
Curingcancer
Cancerisacomplexandgrowingconjointofover200diseases
Manypossiblemechanismsforfightingcancer:
over900drugsandvaccinesbeingdeveloped
Inventoryof20+yearsoflatestagedrugstobefinanced(StewartandNaeymiRad,2010)
Pharma cannotpursuemorethanafew;VCresourcesarelimited
p
R&Dproductivityhasfallenoverthepastfewyears
FDANewDrugApprovals
60
53
Newmolecularentities
totalapprovals
50
Biologicslicenseapplication
39
40
30
35
31
30
29
27
25
24
21
21
18
17
20
10
3
7
3
18
24
21
19
16
15
0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
MITLFE
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Slide24
Curingcancer:wouldyouinvest?
Wouldyouinvestinasingledrugdiscoveryproject?
Considerthefollowingstylizedexample:
Investmentpernewcompound$200MM
5%successrate,10 yeardevelopmentcycle
5%successrate,10yeardevelopmentcycle
Netincomeofapprovedblockbusterdrug=$2b/yearfor10years
PV10 (y1120@10%costofcapital)=$12.3b
MITLFE
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Slide25
Wouldyouinvestinasingledrugdiscoveryproject?
Considerthefollowingstylizedexample:
Investmentpernewcompound$200MM
5%successrate,10 yeardevelopmentcycle
5%successrate,10yeardevelopmentcycle
Netincomeofapprovedblockbusterdrug=$2b/yearfor10years
PV10 (y1120@10%costofcapital)=$12.3b
SUCCESS:51%=(12.3/0.2)1/10 1
Return:
E[R]=11.9%
FAILURE:100%
Ri k S d dd i i f
Risk:StandarddeviationofannualizedROI:
li dROI 423.5%
%
MITLFE
AllRightsReserved
Slide26
Whatifyouhadtheoptionofinvestingin150newdrug
programsatthesametime?
ROIandProbabilities
Probabilityofatleast5successesis87.4%
ROI(exactly5success)=(5*12.3/30)^0.11=7.4%
MITLFE
Risk
StandarddeviationofannualizedROI
StandarddeviationofannualizedROI=
=423%150)=34.6%
AllRightsReserved
Slide27
Approved
PhaseIII
Phase II
PhaseII
PhaseI
WD/Sold
WD/Sold
WD/Sold
WD/Sold
/ ld
Approved
PhaseIII
PhaseII
PhaseI
WD/Sold
WD/Sold
WD/Sold
WD/Sold
Approved
Ph
PhaseIII
III
PhaseII
PhaseI
150
WD/Sold
WD/Sold
WD/Sold
WD/Sold
Year 1
Year1
MITLFE
Year 2
Year2
Year 3
Year3
Year 4
Year4
AllRightsReserved
Year 10
Year10
Slide28
E i
Equity
ABonds
Residual
R id l
InterestPayments
I t
tP
t
A Bonds
Aa
B d InterestPayments
Aaa Bonds InterestPayments
Year1
Year 1
MITLFE
Year2
Year 2
Year3
Year 3
Year4
Year 4
AllRightsReserved
Year10
Year 10
Slide29
Giventhereductioninrisk,debtfinancingisnowpossible!
Defaultprobabilityisdeterminedbytheprobabilityofhits:
Defaultprobabilityisdeterminedbytheprobabilityofhits
$16.8BofAaa debtcanbeissued
Withsecuritization,debtcapacitymaybeevenlarger
MITLFE
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Slide30
ResearchBasedObligations(RBOs)
Business structure of a biomedical megafund SPV

Funds are raised from retail or institutional investors (1) through the capital markets issuance (2) of various types
of debt and equity. These funds are invested in molecules being developed to cure cancer (3). Some funds are
reserved to pay for later clinical development costs and, if required, to cover the first few periods of coupon
payments. The portfolio of drugs is developed over time (4). At any time a compound can be discontinued, move
to the next phase or even two phases ahead based on the results of the trials done. It is also possible that
compounds are sold prior to their FDA approval for marketing if it is necessary to monetize them to cover some
of the fund interest or principal payments. Any com pound that is approved for marketing as a new drug is sold
to a biopharma company. At the end of the life of the fund, all remaining compounds in the portfolio are sold (5).
After bondholders are paid back (6), the residual cash is used to pay back the equity holders (7).
MITLFE
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Slide31
Istherecapacity/appetitefrominvestors?In2010:
U.S.bondmarket:$35T
U S b d
k t $ T
Mutualfunds:$12T
Moneymarketfunds:$1T
Norwegiansovereignwealthfund:$537B
CalPERS:$226B
Targetreturnof126publicfunds(2010):8%
T
t t f 6 bli f d (
) 8%
I
In2010,thesizeoftheentireVCindustrywas$176B
th i fth ti VCi d t
6B
MITLFE
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Slide32
Howdoesthismodeldifferfromexistingsolutions?
Debtfinancingthroughriskmitigation(comparedto
Debt financingthro ghriskmitigation(comparedto 150companies!)
0companies!)
Industryriskinsteadofsinglecompany risk
Investinginintellectualproperty,notexistingcompanies
Investinginintellectualproperty notexistingcompanies
Investinginearlystageprojects(valleyofdeath),notjustmatureproducts
Capitalstructureofthefundbettermatchesinvestorpreferences
Accesstovastlylargerpoolsofpotentialinvestors
Longtermdebtfacilitatespotentiallylongerinvestmenthorizons
Long termdebtfacilitatespotentiallylongerinvestmenthorizons
Allstakeholdersbenefit(investors,managers,researchers,insurers,
regulators patients)
regulators,patients)
Fundingmechanismcreatesanew,morepowerful,andsustainablebridge
p
betweencapitalmarketsandscience
MITLFE
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Slide33
Howwouldvariousstakeholdersbeaffected?
VCs:reducesfuturefinanceriskstotakeonprojectscurrentlyunfunded
VCs reducesfuture financeriskstotakeonprojectscurrentlyunfunded
Biopharma:largersupplyofdrugstodistribute,lowerrisk,greaterliquidity
Drugdevelopmentcompanies:morebusiness,resources,andliquidity
Drugdevelopmentcompanies morebusiness resources andliquidity
Investors:newsupplyofinvestableassetswithlesscorrelatedreturns
Healthinsurancecompanies:newwaystohedgetheirbalancesheets
Healthinsurancecompanies newwaystohedgetheirbalancesheets
Investmentbankers:newbusinessusingexistinginfrastructure,PR
Government
Government,regulators:newopportunitiestoincreaseprivatesector
regulators newopportunitiestoincreaseprivate sector
involvementinthefundingofinnovation;jobs;politicallypopularissue
Foundations:newchannelthroughwhichtosupporttheirgoals
Society: New,faster,cheapercures!
MITLFE
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Slide34
Whataresomeofthepotentialchallenges?
Size:managinglargeportfoliosofcomplexR&Dprojectsmayrequirenew
managementandgovernancestructures(e.g.,ManhattanProject)
Centralization:mustpreservethebenefitsofdiversityasscaleincreases
p
y
Capacity:isthetalentpoollargeenoughtomatchthescaleofthisventure?
Complexity:caninvestorsunderstandtherisksandrewardsofRBOs?
p
y
Excesses:ifsuccessful,thepotentialforabusewillalsoincrease
Ethics:howtobalanceprofitmotivevs.socialobjectivesforcures?
MITLFE
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Slide35
WithSomeImagination,ThisCanBeAchieved!
Imaginecreatinga$30B
Imaginecreatinga$30BCureForCancermegafund
CureForCancer megafund
Imaginecreatinganadvisoryboardofexperts:
FrancisCollins
FrancisCollins,EricLander,BobLanger,PhilSharp,HaroldVarmus,
EricLander BobLanger PhilSharp HaroldVarmus
CraigVenter;WarrenBuffett,BillGates,JacobGoldfield,BobMerton,
JimSimons,GeorgeSoros,BillSharpe
IImagine10MMhouseholdsinvesting$3,000each
i MMh
h ld i
ti
h
Imaginecorporatepensionfunds,foundations,
endowments,insurancecompaniesinvestingaswell
d
t i
i i
ti ll
Imaginegovernmenttaxincentives,credit
enhancement,etc.(thinkFannieMae,FreddieMac!)
h
t t (thi kF
i M F ddi M !)
MITLFE
AllRightsReserved
Slide36
Conclusion
Don tDeclareWarOn
Dont
Declare War On
Cancer
PutAPriceTagOnIts
Put
A Price Tag On Its
HeadInstead!
WithSufficientScale,WeCanDoWellByDoingGood
MITLFE
AllRightsReserved
Slide37
Conclusion
NotToTry?
CanWeAffordIt?
heartdisease,Alzheimers,dementia,
diabetes,obesity,H1N1,energycrisis,
cclimatechange,solarflares
ate c a ge, so a a es
WiththeProper
With
the Proper
Financial Structure,
FinancialStructure,
Anything IsPossible!
MITLFE
AllRightsReserved
Slide38
ThankYou!

Andrew Lo

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Canfinancialengineeringcure

Source: Robert J. Shiller, Irrational Exuberance, 2nd. Edition.

To get back to longrun average, we need

Price = 90% $1,000 + 10% $0

Price = 90% $1,000 + 10% $0

2010 by Andrew W. Lo All

2010 by Andrew W. Lo All

2010 by Andrew W. Lo All

2010 by Andrew W. Lo All

Price for Senior Tranche

Price for Junior Tranche

2010 by Andrew W. Lo All

2010 by Andrew W. Lo All

July 1996: 78.10

Effective Fed Funds

Updated June 1, 2012

2010 by Andrew W. Lo All

Price for Senior Tranche

= 90% $1,000 + 10% $0

Price for Junior Tranche

= 90% $1,000 + 10% $0

2010 by Andrew W. Lo All

2012 by Fernandez, Stein, and

2012 by Fernandez, Stein, and

Real Home Price Index (1890-2006)

Aaa Bonds InterestPayments

Business structure of a biomedical megafund SPV

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