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A hedge fund manager aims to solve the funding problems facing early-stage biomedical research.

By Jessica Leber on November 19, 2012

Hedge fund manager and prominent economist Andrew Lo is recognized for developing theories about how markets function and why they failed during the financial crisis. Now Lo, who is also the director of the MIT Sloan School of Management’s Laboratory for Financial Engineering, thinks he can also help create a better market for investing in promising treatments for cancer.

His proposal is to structure a new kind of financial tool, a “megafund,” for funneling up to $30 billion into the discovery of cancer drugs. The project would be unprecedented in scale at a time when the biomedical sector is searching for fresh funding ideas. As Lo says, the community is “ripe for something new.”

In a paper published in Nature Biotechnology earlier this fall, Lo and his coauthors note that large pharmaceutical companies are no longer nurturing early-stage drug development. Venture capitalists, too, are deserting life science startups, which averaged them negative 1 percent returns over the last decade. The result is a growing funding gap between basic lab research and commercial drug development. And fewer drugs are surviving the costly gauntlet of clinical trials to eventually reach FDA approval.

Lo’s proposal would expand the pool of capital available for life science investment by bringing together investors who would not normally fund research at top biomedical universities in exchange for a small percentage of all royalties from successful drugs or licensing revenues that result.

About five drug royalty investment companies already exist, Lo says, but they only invest in drugs that are already approved. His plan would do this at an earlier and riskier stage, and spread the risk using techniques found elsewhere in finance—and familiar from the mortgage crisis—securitizing future revenues, in this case from drug compound licenses, into debts called “research-backed obligations.”

Boosting funding this way could have a big payoff, Lo says. The sheer size of the megafund would reduce risk by diversifying investments across many more projects, and therefore could provide investors stronger guarantees of returns than any smaller fund. Just one blockbuster drug, the paper notes, can net $2 billion in income a year over a decade.

Lo’s computer models, based on historical data, indicate a $5 to $15 billion megafund would yield 9 to 12 percent returns for equity investors, and 5 to 8 percent returns for “research-backed obligation” holders—rates that could be attractive to pension funds, for example. Careful and realistic planning could avoid the “pitfalls” that sank the mortgage companies during the financial crisis, the Nature paper says.

So far, all of this is just words on paper and code in a software model (which Lo has released for others to tinker with).

Melissa Stevens, deputy executive director of Faster Cures, a nonprofit think tank, sees promise in the idea, but says there would also be lots of details to get right—cataloging the assets that exist, and deciding how to choose them, and assessing the levels of risk and time until reward. Hammering out workable agreements between researchers and investors would be a challenge, but not “insurmountable,” she says.

Nor will the concept solve all of the problems involved with life science investing. More money won’t fix, for example, the scientific and regulatory slowdowns that contribute to decreased productivity of each research dollar. “The question is not only how we can attract more capital into R&D, but how we can decrease the amount of capital that we need,” Stevens says. (Lo imagines a megafund could actually help this too, providing shared resources like basic legal support or lab resources among portfolio projects.)

The megafund idea is a relatively radical example of a growing number of new drug research funding models being tried in the face of the industry’s recent challenges.

Meanwhile, to attract more funding, “hybrid” funds are emerging that bring in nontraditional venture capital investors, like governments and philanthropies, willing to absorb more risk or wait longer for a reward, says Stevens.

Lo is organizing a conference for next year to bring together investors, researchers, executives, and the National Cancer Institute to hammer out more details. He thinks it should all be an easier sell in the post-financial crisis, post-bailout world: “We spent billions on General Motors, which sells cars people don’t want to buy. So $30 billion for cancer research should not be a big deal. These numbers don’t look that big to me now.”