Moonshot: Financial Engineering to Save the World

Hub & Company
Feb 24, 2020 · 4 min read

The costs associated with the development of drugs from the lab to the market have increased to $2.5 billion in the past decade. (DiMasi et al, 2016). This is definitely part of the reason for the decline in the number of new drugs approved by the FDA per billion dollars (USD) spent on research and development has halved nearly every 9 years since 1950. Eroom’s law depicts the challenges that a growing number of small to medium biotech and pharmaceutical companies are having. Often, their ability to investigate potentially world-changing ideas is diminished. Companies shooting for the moon do not match the risk parameters of retail, and institutional investors halting their research, rendering their approach and progress useless. Aside from the high failure probability, these “Moonshot” projects require massive amounts of funding, that few investors even have access to. However, packaging them in Collateralized Debt Obligations could be a way to redistribute the risk that investors face, giving them a favourable risk/reward profile, while also providing these potentially world-changing companies with the funding they need to continue their research.

The hypothetical given in paper written by John Hull, Andrew Lo, and Roger Stein, is one where there is a simple upfront capital investment, a known duration, and a known payoff at the end of the project. This hypothetical project requires an initial investment of $200 million, lasts 10 years, and has a 5% probability of a payoff of $10 billion. Even though there is an expected value of $500 million (5% of 10 billion). However, due to human’s inherent nature when assessing situational risk we tend to be more wary of our losses than our potential earnings. This is the driving principle of a behavioural economics paper by Erik Snowberg and Justin Wolfers. However, by forming a portfolio of many such projects, one can alter the risk/reward profile to be in the interest of the investor. A fund of 150 statistically independent projects- each identical to the aforementioned example the statistical odds of at least one success skyrocket to an astounding 99.95% and the probability of at least four successes would be about 95%. Now both institutional and retail investors would find such an investment more viable. Such a portfolio would be a viable alternative investment for large institutional investors. Specifically, insurance companies would find this product valuable because they could hedge against cures found for diseases they cover.

By packaging several of these projects together, Hull coined the term “RBO”, Research-Backed Obligation. The product described in his paper is a CDO consisting of bonds issued by Moonshot projects. It would function like any other CDO, with various tranches of the product accessible to investors based on their required risk profile. The one issue with creating CDOs out of these incredibly high default-risk bonds is the lowest tranche of the CDO will almost surely get wiped out, as the expectation is a significant number of these bonds will default. We believe in order for an RBO to work, a government organization or charity group would need to fund the equity tranches of the RBO, and write it off as a donation to research. By funding the equity tranche charities and governments would allow the more stable tranches of the RBO to become accessible for institutional investors, significantly lower the risk the investors in the upper tranche take on and be the first step in funding world-changing projects.

The fact that the RBO would still be backed entirely by Biotech startup companies poses a problem in that the whole RBO is exposed to the risk of the biotech industry. We propose combining various startups doing research for the betterment of society into a single RBO. This would expand the RBO past biotech and into other emerging fields including alternative energy, quantum computing, etc. and thereby decreasing our exposure to any specific industry.

Due to the high-risk nature of the companies going into the RBO, high levels of due diligence would need to be conducted on each company to determine their probabilities of success for the pricing of the product. Because these companies would all be conducting cutting-edge research, it is reasonable to assume we would run into a lack of qualified professionals to conduct this due diligence.

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