Note: finance topics are slightly sensitive, so, while nothing in this article contains proprietary information, I will not include the names of people I talked with for this piece. I appreciate everyone who reached out to help me put this together!
For $250 million and ten years of your life, you may purchase a lottery ticket. The ticket has a 5% chance of paying out. When it does pay out, it pays roughly $5 billion. A quick calculation will show you that the expected value of the ticket is $250 million. This is essentially what drug development is. Or rather, it’s what drug development was, twenty years ago. The upfront payments have been climbing, the hit rates falling, and expected values have, at best, held flat. Should you buy a ticket?
Perhaps not. In fact, any reasonable player should have long since stopped playing this stupid game. Unfortunately, we still need drugs. People have cancer, and heart failure, and Alzheimer’s, and a thousand genetic diseases that nobody has ever heard of, and the only industry on Earth currently set up to do anything about any of this is the same industry running the lottery-ticket business described above. The game is dumb and we need it played anyway.
So the real question is not whether to play, but how to make playing less awful for those involved. And the answer, increasingly, is ‘financial engineering’: a set of structural tricks that let people hold more tickets than they otherwise could, or buy a fraction of the winning tickets after they’ve been drawn, or some other strange, clever thing that all financiers find obvious and everyone else has never heard of. All this, done to trade and barter over the risk inherent to the whole enterprise, slicing it into pieces small enough that someone, somewhere, is willing to hold each one in exchange for something.
I’ll walk through a handful of these, the people who invented them, and case studies involving the tactic. And at the end, we’ll ask the question of whether all these tricks are, in aggregate, altering what the pharmaceutical industry decides to value.
The first such trick, and the one that perhaps kicked off the start of the whole effort, was dreamed up by a man named Andrew Lo.
Andrew Lo is a finance professor at MIT's Sloan School of Management. Among all TED talks that have ever been produced, there are few worth watching. Andrew’s talk, which has the wonderful title ‘Can Financial Engineering Cure Cancer?’, is one of them:
https://www.youtube-nocookie.com/embed/xu86bYKVmRE?rel=0&autoplay=0&showinfo=0&enablejsapi=0
I recommend you listen to the full thing, because it really is quite good. If you’re strapped for time, the core thesis is as follows:
Individual drug programs fail about 95% of the time. But this doesn’t mean the expected value of a single program is necessarily bad. As I said at the start: a 5% shot at a $5 billion blockbuster against a $200 million development cost is technically positive EV on paper. But this implies that you need to be able to survive the 95% of outcomes in which you lose everything, and most investors, reasonably, will not.
Lo's insight, published in a 2012 Nature paper, was simple. Just bundle 50 or so drug programs into a single entity, one with a war chest of $5 to $15 billion, and roll the dice. The individual drug programs are still terrible standalone bets, but if they're sufficiently uncorrelated, at least one is almost guaranteed to hit, and it will hit big enough to pay off all the programs that failed. Which means you can keep playing, forever. Of course, the ‘uncorrelated’ bit is the ‘spherical cow’ part of all this. It’s impossible to do it perfectly, but it can be done well enough for risk to fall dramatically.
There’s an extra layer of complexity here about how if you can get the portfolio risk to be low enough, you can issue debt against the portfolio to sell as bonds, which unlocks a much larger pool of non-venture capital who want more stable returns. This is arguably the most interesting thing that Andrew believed in, but this particular bit never really went anywhere. We’ll discuss the obvious ‘why not?’ question at the end of this section.
The direct descendant of this whole thesis—at least the ‘drug portfolio’ part—is [BridgeBio Pharma](https://bridgebio.com/?), founded in 2015 by Neil Kumar, who was Andrew’s student at MIT. It is structured almost identically to Andrew’s original thesis: a central holding company that creates subsidiary companies, each focused on a single rare disease. Each subsidiary has its own equity structure, its own management team, and 1-2 drug programs. If a subsidiary's drug fails, it dies, but BridgeBio survives. If it succeeds, the parent holds enough equity to capture massive upside. The company IPO’d in 2019, is now worth billions, and has a pretty good stock trend for a biotech.