Despite biotech's incredible potential to cure debilitating diseases and improve the quality of life for people around the world, public and private funding for early-stage biomedical research and design is declining-a trend that could jeopardize efforts to find improved treatments for people with life-threatening illnesses.
Public financing is largely dependent on funding by the National Institutes of Health (NIH). For the period 1993 through 2003, research funding by the NIH, and research and development (R&D) spending by large pharmaceutical companies, rose dramatically. The annual rate of patenting for medical discoveries rose even faster. But during the same period, applications to the FDA to initiate clinical trials plunged, as did the number of applications for FDA marketing approval.
However, we at the Milken Institute have studied this question and have recently released a report illustrating how this funding shortfall can be fixed using innovative financial tools to lower the risk to investors and increase the flow of capital to research for promising new drugs.
We found that the current shortage of capital in new drug development can be resolved through public-private partnerships. By creating new financial tools and incentives, we can increase the funding for this research and help improve global health. In our report, "Financial Innovations for Accelerating Medical Solutions," we identify market vehicles that could leverage private foundation resources and donations to reduce credit risk, attract investors, and accelerate commercialization in a broad range of disease areas.
The funding challenge
Since 2004, NIH research funding has remained static or decreased, based on adjusted dollars. In fact, the most recent budget cut of 2006 is steep enough to bring NIH research and development spending below the 2003 funding level in real terms, erasing the increases of previous years. And our most productive engines of innovation to date, the large pharmaceutical companies-now under increasing competitive and financial pressures-have pulled back from early-stage discovery and development.
Promising discoveries in cancer and other human disease areas languish for lack of capital resources and development expertise, and developed products fail as a result of inadequate access to marketing platforms. Industry trends, however, may not favor easy solutions. The average cost of bringing a new drug through development, clinical trials, and market launch has risen sharply. And market launch is no guarantee of success: of products that reach the market, 70% fail to recoup their R&D investments.
It is no surprise that a solution that accelerates medical innovation has not emerged from the industry. Instead, financing for the biotech industry in general has diminished for early, innovative projects. There is nearly no venture capital available for new ideas that lack significant clinical data.
Finally, looking more broadly across the negative trend, we find that within the current allocations of health care investment, less than 10% of global investment in pharmaceutical R&D is devoted to diseases of poverty, such as malaria, AIDS, and tuberculosis, which may affect up to 90% of the world. Instead, pressure to turn a profit means that pharmaceutical companies turn to drug development for "lifestyle" and "Western" diseases.
The report's six recommendations incorporate lessons learned from previous experiments with early-stage drug research, as well as tools from other industries.
1. Reduce risk by pooling intellectual property
Diversification sounds like an obvious solution, but its implementation in the financial markets requires new investment vehicles. Precedent exists in the film industry, where investor syndicates finance pools of films (intellectual property). Similar vehicles could be used in the biotech industry.
Film production and drug development are both expensive, high-risk endeavors that rely on innovation. One of us (Martha Amram) and Laura Martin, a media analyst with Soleil/Media Metrics, presented participants of a workshop hosted by the Milken Institute with a breakdown of a film's value as it passes through various stages of production. The film industry, they said, has had to address similar questions: How and why did large film studios, once full-service providers, come to focus on the value-chain terminus? And what financial structures have evolved to finance risky early-stage projects?
Both drug development and film production use the same "stage-gate" (expected value) valuation model, in which value increases as risk is resolved and the film is closer to returning revenues. In addition, both industries have a skewed value distribution, with a few immensely valuable outcomes and many outcomes of small or no value. More than 40% of films did not recover their costs at the box office in 2004, a success rate that is similar to that of biotechnology.
2. Use foundation funds to enhance credit quality and attract potential investors
Foundations tend to limit their financial participation in drug development either to providing some funding (though small amounts) to initial research or to giving reimbursable grants with the expectation of a return from royalties on potential sales.
There are also two alternative roles for foundations: playing the role of credit enhancers, so that debt and equity capital are raised more cheaply; and facilitating the sharing of research for a specific disease. In a discussion of credit enhancement, Nir Kossovsky, founder and CEO of Technology Option Capital, said it is not enough for two parties-intellectual property (IP) holders and capital providers-to simply join forces. They need a legal structure to capture the governance, obligations, and payouts of their collaboration.
3. Use liability insurance to enhance credit quality
Directors and officers (D&O) insurance covers the actions of senior corporate management and board members, and includes actions pertaining to intellectual property and product development. For a premium increase, suggested Robert Block, the managing director of Technology Option Capital, this coverage could be expanded to the scientific and commercial risks of biotech product development.
As a commercial entity, a private company could carry D&O insurance, which would serve as an additional credit enhancement. Thus, Block argued, the D&O policy already insures against actions the board may take that could harm the value of the firm, including technology management, in general, and drug development failure, in particular. Insurers, he said, are already exposed to technology risk, and because the proposed private company governance structure increases transparency, they should be willing to provide extra coverage for extra premium.
While some workshop participants found Blocks' proposal intriguing, others argued that D&O insurers could find the increased exposure too risky, due to the intrinsically uncertain nature of drug development.
4. Tap into the emerging market for IP-backed securities
Several workshop presenters were active participants in the emerging market for IP-based lending. This is a growing segment of the asset-backed securitization market. Although the IP in drug development is protected by patents, IP protected by copyrights and trademarks has dominated the market to date.
Many companies are eager to monetize their IP, said Keith Bergelt, president and CEO of IP Innovations, based in Charlotte, N.C. Recent data from Ocean Tomo, a merchant bank specializing in IP, shows that, on average, 87% of corporate value comes from intangible assets.
While IP Innovations and another workshop participant, UCC Capital, were hesitant about lending to firms in the pre-revenue drug discovery market, IP Innovations' Bergelt said his company was evaluating a loan transaction for a company with a set of medical device patents and a history of obtaining significant licensing revenues from large industry players.
5. Use advanced purchases to underwrite medical research and drug delivery
Workshop participants reviewed two recent public-private partnerships for drug development to explore the economics and conflicting incentives that arise when serving under-funded patient groups. The partnership between Bayer Healthcare AG and the Global Alliance for TB Drug Development (the TB Alliance) helps to illustrate financial innovation in the fight against tuberculosis. The TB Alliance estimates that the tuberculosis drug market is currently about $600 million per year and expected to increase to $700 million by 2010. The cost of developing a single anti-TB drug is estimated to be near $100 million, according to the TB Alliance. The relatively small size of the market, plus the economic and geographic considerations of this disease, have made this effort unattractive for any single drug company.
The TB Alliance will coordinate and help cover the cost of the trials, leveraging substantial support from several US and European government agencies. The partnership's goal is to make moxifloxacin, an anti-TB drug, available at a not-for-profit price. With its costs covered, Bayer could sustain supply. Furthermore, if the drug development process is successful, Bayer will receive approval from the FDA for an additional prescriptive use for moxifloxacin.
The second public-private partnership was between GlaxoSmithKline Biologicals (GSK) and the International AIDS Vaccine Initiative (IAVI). Similar to the partnership described above, GSK and IAVI will collaborate to try to develop an AIDS vaccine. IAVI, which will contribute funding, is in turn funded by donations from countries (primarily Europe and the United States), as well as the Gates and Rockefeller foundations. And again, the goal is to make a sustained supply of an AIDS vaccine available at a not-for-profit price by GSK.
This innovative financing could change the economics of the public-private partnership by creating a market that will pay fair-market price for the therapy. The advanced purchase can create a privatization effect, eliminating the need for complex coordination between multiple government agencies, foundations, and the nonprofit catalyst.
A critic of the advanced purchase commitment, Andrew Farlow of Oxford University, has argued that the program design will not lead to the most effective cure for some conditions, because it rewards the first pharmaceutical solution to market. What if the second vaccine to market is the better cure? Program supporters say that not all funds will be spent at once, so there will be purchasing power left for the second to market. Farlow also argues that the program design is rife with potential corruption, as the host government is asked to contribute $1 per vaccine, while the foundations pay $14. An unscrupulous firm could potentially bribe government officials to allocate millions of dollars in revenue.
6. Use donor bonds to underwrite medical research and drug delivery to under-funded patient groups
In March 2005, six European governments announced a financial innovation, donor bonds, designed to accelerate the delivery of medicines to Africa. The bond offerings, expected to total $4 billion over several years, will provide governments with more to spend on immunization in Africa than is now the case. The structure of donor bonds imitates the practice of credit card companies: using future customer repayments as the collateral for borrowing. With donor bonds, future gifts are the collateral for borrowing. The future stream of payments is transformed into an immediate lump sum.
These donor bonds can, therefore, enlarge the existing supply of medicines to developing countries. The drug company has already developed the drug and is now marketing it in the developed world at a profit and selling it in the developing world at cost. The donor bonds infuse the developing market with demand in the near-term. As the drug company is already in production, the mechanics of challenge are simple ones of production and supply-chain expansion.
Moving forward
The experts and stakeholders who gathered at the Milken Institute's workshop in late 2005 provided several innovative strategies to "cure" the financing gap and offer new supplies of capital to drug development.
Proposal No. 1
Develop a case study around one or more of the recommendations. Participants would identify specific incentives and problems, and design an implementation plan. The case study would conclude with a one-day session for potential "transaction partners," who would determine funding feasibility.
Proposal No. 2
Create a simulated diversified pool of patents and/or early-stage drugs under development for a single disease area. Analysts and experts from ratings agencies, as well as representatives from interested foundations, would provide a detailed review of risks and opportunities.
Proposal No. 3
Use a real, rather than simulated, pool of patents and/or early-stage drugs for which there exist both market need and philanthropic foundation support. Workshop participants representing pharmaceutical and biotechnology companies, institutional investors, medical foundations, rating agencies, and government health agencies would then use one or more of the recommended financing solutions to earn the patent portfolio an investment-grade rating through the mitigation of credit, basis, and performance risk.
Whether the solution is diversification and pooling, the use of foundations, enhanced D&O insurance, advanced purchases, donor bonds, or a combination of strategies summarized here, one thing remains clear: The current shortage of capital in the development of drug, medical device, and health care technology can be resolved through public-private partnerships. Financial technologies, innovative securitization, and structured finance can address capital needs in the realm of global health, human capital development, and broader economic growth.