Sunday, December 15, 2013

"Can Financial Engineering Cure Cancer?"

From Enterprising Investor:
This may seem an odd question, but can financial engineering cure cancer? No less of an intellectual light than Andrew W. Lo of the Massachusetts Institute of Technology and member of the Future of Finance Advisory Council believes financial engineering may be a potent weapon in the quest to find a cure. In fact, this was the topic of Lo’s presentation at the recent Fixed-Income Management Conference in Boston.
Lo’s thesis rests on several key points:
  • Applying portfolio theory to finding a cure for cancer helps increase expected returns and lower expected risks for the capital deployed.
  • Applying financial engineering through securitization allows for financing a cure for cancer in a smarter way that ensures greater participation from prospective investors.
  • Recent anecdotal evidence suggests that human genome mapping allows for the identification of problematic genes that may be targeted by customized medicines to fight specific cancers.
Notorious capital destroyers, biotech investments of more than $400 billion have never generated returns in the aggregate covering their costs of capital. In fact, venture capital firms are so discouraged by their returns that the number and size of biotech investments has steadily declined from their peaks in 2007–2008.
Lo thinks he knows why biotech investments have generated such poor returns: the industry is financed incorrectly. Specifically, he thinks the business models are bad because as biotech gets more knowledgeable, the business gets riskier. Lo believes that cures for cancers are unique to each patient and therefore require unique drug treatments as opposed to massively scalable compounds. Yet, the pharmaceutical industry cannot recoup its massive investment in research unless it has blockbuster drugs that can generate returns to compensate for massive upfront costs.

This is where portfolio management comes in. To find cures for cancer, investors must fund about 150 projects in order to lower the standard deviation of possible returns from cancer cure projects. With such a high number of viable projects, it becomes possible to issue debt. Once it is possible to issue debt, securitization concepts may be layered on top of portfolio theory to find viable cancer cures.

As with traditional securitization, various tranches would be created for different risk appetites and with different guarantees for creditors buying those differently segmented risky tranches. Equity portions of the return stream could then be financed by the traditional risk preference buyers, such as private equity and venture capital. Now the combination of portfolio management and securitization makes for a viable business, according to Lo....MORE