Mr. Gapper as printed an interesting article in today’s FT which gives us Professor Andrew Lo’s idea of a Collateralized Drug Obligation – Wow!

This CDO is modelled off what we all know and love as a collateralized debt obligation, essentially a big pot full of mortgages that pays you a fixed coupon as mortgagees pay interest – your own personal share in a mortgage book if you will.

I will accept that I am no medical expert but the article does pose some interesting thoughts and questions for us laymen. Primarily, why do we need to add some crypto finance element to the medical profession?

According to Lo, the medical profession has been struggling for a myriad of reasons. Firstly, many blockbuster drugs will soon go ex-patent, meaning they can be replicated and produced by other generic companies that will make treatment more affordable for the consumer (good news!). This so called ‘patent cliff’ means that large drug companies will not have the reliable earnings streams they used to. They are therefore less able to engage in R&D and as a result less likely to produce treatments and cures (bad news!). Since the blockbuster drug days of the 90′s, medical companies have moved from resembling Apple to British American Tobacco, low growth, low innovation and low valuation multiples…… How do we stop the rot and make these companies successful while encouraging them to cure more illnesses?….The C.D.O (the drug one)!

Lo suggests that because there is no significant returns to investing in the equity, the medical world should entice the debt owners, who are happy with lower and capped returns for a less risky investment. In theory you could package the research of 100 drugs into a total cost of R&D, with the few blockbuster drugs used to repay the capital and a little interest on top. Using a flow chart as an example…

Unfortunately there are a few differences between mortgages and R&D that may mean that a CDO would not be the cure for, well, finding cures.

First, a mortgage CDO is a fixed pot of mortgages which are an easily understandable and fixed asset class. A mortgage costs X and it will generate a return of Y over a period of Z, with an insolvency probability of P%. Each letter is a known and fixed entity. Because of this, you can package this into a debt instrument receiving a speicifc coupon on a certain date and this allows you to pay a coupon on the overall package. R&D is a completely different animal. The success rate is a complete unknown – about as unknown as the timescale of research, the cost of research and the take-up of the drug.

The company could, for instance, start research on one hundred projects and after 1.5 years be no closer to producing a drug. How is the firm going to pay the coupon???? Furthermore, what if these one hundred projects fail to yield a blockbuster?? How are they going to pay the coupon in the first place, let alone return the capital!

Looking at the problem with an investor hat on, who is going to buy a C.Drug.O when it has the return profile of a bond with the risk profile of an equity? Why would an investor take on such risk if there is no reward at the end???? No 10x capital growth, simply a coupon that pays x% a year.

We must tread carefully here as this type of investment is not a typical investment. Because this research is for the benefit of mankind, it is difficult to class an investment of this nature as a simple bond. The payoff is not simply profit, but a huge positive externality along with the feeling that you personally have made a difference in peoples lives. As the Beatles sang

“Money Can’t Buy Me Love”

With this in mind, a CDO is definitely NOT an investable asset class, it would have more success as a charitable mechanism. Instead of your donations going to other worthwhile causes, you can donate to the drug fund with the knowledge you may help create a cure for a disease and maybe receive dividends back from your original donation.

Mr Lo of course will look at all these problems in an upcoming paper, which has yet to be published – I look forward to seeing how he tackles the many problems associated with his idea