Drugbaron Blog

December 17, 2011 no comments

Chocolate-flavoured Poison: Like red wine and debt, the company-building model of biotech investing tastes good but kills you eventually

The most dangerous imperatives are those that you actually like.  Hearing, and half believing, that red wine keeps the French safe from heart disease has no doubt led to many a hangover.  Hearing, and half understanding, John Maynard Keynes’ advice to spend your way out of recession is the root cause of the raging global economic crisis.

In the same way, the company-building model of biotech investing seems attractive to both investor and entrepreneur.  After all, drug development is a risky business, and having several assets to play with is surely essential for a successful outcome.  If one of the assets you are developing proves to be less valuable than everyone once hoped, then the back-ups offer you a lifeline – a chance to try again without being labeled as a failure.

But this illusion is as dangerous as believing that a bottle of red wine every day will help you live to the age of ninety, or that one more fiscal stimulus will allow Western economies to grow their way out of their debt-prison.   Just because life is more comfortable in a classic west-coast biotech company with several cash-hungry programmes, it doesn’t make it the best choice for either investor or founder.

Good news travels fast.  Almost everyone ‘knows’ that red wine is good for you, despite the lack of any real evidence to support such a claim.  The simple fact is, they want to believe it.

The source of this epic fantasy, for that is what it is, lies in epidemiological data that show markedly lower levels of heart disease in France than in the United Kingdom.  The French, with their love of cheese, eat as much saturated fat as their British neighbours, but they also drink much more red wine.  With the skill of an expert marketeer, this observation was labeled the French Paradox – how to eat a diet high in saturated fats and not succumb to heart disease.

The French Paradox and the concept of the Keynsian Stimulus are two examples of what DrugBaron calls “chocolate-flavoured poison”: they taste nice but eventually, if taken in excess, they will kill you

The obvious answer (obvious to the proponents of this hypothesis) is that the consumption of red wine, stuffed full of antioxidants and other goodies, prevents heart disease.

The right answer, sadly, is much more prosaic.  France allows its citizens to die gracefully from old age, while the UK (being a nation of shopkeepers and accountants) insists on designating a medical cause for every death.  Faced with the body of a centenarian, the doctor writing the death certificate must still offer a plausible cause of death – and more times the not, the choice is heart failure.  But such an insistence pollutes the statistics.  To put in the same bucket a man of fifty-five who died of congestive heart failure secondary to myocardial infarction and a man of ninety-five who died of congestive heart failure secondary to old age over-estimates the population burden of heart disease.

The proof that this is the cause of the French Paradox comes in many forms, but perhaps the easiest to understand are the studies that show a discontinuity in the rates of heart disease between towns only miles apart either side of the French borders with Holland, Switzerland, Italy and Spain.  National borders do not translate in sudden changes in diet or lifestyle, but they do reflect the changing statistical classifications imposed by governments (not to mention sudden changes in access to health care, or particular ways of treating certain diseases).

Once you account for the measurement artifact, there is no longer a Paradox to explain.

Definitively demolishing the French Paradox in high quality articles in top medical journals does little to disrupt the folk memory.  Its just too attractive as a justification for red wine consumption to let mere facts get in the way.

Asset-centric investing lacks the comforting chocolate flavour of company building.  But it lacks the poison too.

And so it is with the attraction of the fiscal stimulus.  For many an economist and for every politician the justification to spend money you don’t have on vote-winners of every kind, from gold-plated healthcare to early retirement on a generous pension, is simply too attractive to ignore.

As with the French Paradox, though, the devil lies in the detail.  The key point of the Keynsian stimulus is that the borrowed money is invested in assets that promote structural economic growth.  Structural economic growth.  Not short term gains in gross domestic product (GDP).  The flawed assumption that increasing GDP represents structural economic growth is the same as the assumption that the French and the British record heart disease the same way on death certificates.  Wrong.

As sure as night follows day, a fiscal stimulus will increase GDP as we currently measure it.  At least a fraction of the money injected into the economy will be spent, and will show in the GDP figures – no matter on what it was spent.  In the limit, since the economic activities of travel agencies appears in the GDP figures, if every last one of us went on holiday every week for a year, economic activity measured as GDP could increase.

But just spending the money, just raising parameters of economic activity such as GDP, is not enough.  What the money was spent on has to increase primary productivity (that is, the ability to make stuff we cant do without, like food and energy).   What Keynes envisaged all along was borrowing money to invest in infrastructure that boosts primary productivity.  As long as the gain in productivity over a reasonable period turns out to be greater than the full cost of the investment (taking into account interest), then the decision to borrow was a good one.  Put simply, it is investing ahead of the curve rather than behind it.

By contrast, extending my deliberately ridiculous example, borrowing money to send everyone on holiday for a week, while raising economic activity (and GDP) in the short term, while the money is spent, produces no leverage (of course, in my example, by taking people away from their normal jobs, it actually decreases primary productivity).

While no government, to my knowledge, has ever borrowed money to send its citizens on a week’s holiday, they are doing something very similar: they are borrowing money to fund growing pension deficits caused by allowing citizens to retire from primary production too early.

Don’t get me wrong – DrugBaron looks forward with anticipation to a well-earned rest in retirement.  But that does not disguise the fact that borrowing money to pay for pensions does not count as a fiscal stimulus.

And it isn’t just pensions.  Raising the wages of public sector workers has a similar effect of growing economic activity without affecting primary productivity.  Paying benefits to the unemployed or disabled is exactly the same.   National defense spending?  Same again.  And because pensions, benefits and public sector payroll (before we get to defense) are such a massive fraction of total spending, it is nothing more than window dressing to claim the “new borrowing” associated with each new fiscal stimulus is being directed to economically productive infrastructure.

“By all means cure me of my addition to debt and company building – but please don’t try and cure my addition to red wine.  After all, its good for my heart”

The point of this article is not discuss how politicians should be spending national budgets (be it on health, pensions or public services).  The point is that they should not be borrowing to do it because, compared to when Keynes first came up with his prescient advice, the modern government budget is weighed down with economically unproductive spending.  That simply wasn’t true in the 1930s.  Yet they borrow, borrow, borrow.  Always with the palatable justification that it is stimulus.

The parallels with the French Paradox are very good: debt-funded stimulus, like the red wine, is made to look good for you by the way we collect the statistics.  The untenable hypothesis is then the justification to drink more and more.  And like the red wine, the consequences are first a hangover, and then cirrhosis of the liver.  The worrying possibility, though, is that the current debt crisis is the terminal alcoholic liver disease.  And like the alcoholic, a significant fraction of the population cannot let go of their addition to debt, no matter how bad the situation has become.

The French Paradox and the concept of the Keynsian Stimulus, are, then, two obvious example of what DrugBaron calls “chocolate-flavoured poison”.   They taste nice, but eventually, if taken in excess, they will kill you.

Building companies with multiple assets to diversify the risk is biotech’s chocolate-flavoured poison.   And the chocolate taste has won over investors and entrepreneurs alike.

In a typical company-building model, the attraction is to have more than one asset per company.  The chocolate flavor is the reduced risk of complete failure – if the lead asset doesn’t make it, with hardly a loss of a heartbeat you can divert the resources and infrastructure to the second asset.  No-one has to lose their job, no-one has to be labeled a failure.

But the poison lies in the reduced stringency for selecting the assets.  The due diligence was focused on the lead asset, the one generating the excitement, the one driving the valuation.  The second and third assets are just coming along for the ride.  But when the lead programme fails, how good, really, are they?  Would you have invested in them had they not been packaged skillfully with the now-defunct lead programme?  Oftentimes, not.

Worse still, is the reduced stringency in qualifying the lead programme.  It is hard not to be comforted, just a little bit, by the presence of the second and third programmes, even if you attached little or no actual value to them.   Do you trust the lead programme enough to invest in it stark naked (the asset, that is, not the investor)?

For many an economist and for every politician the justification to spend money you don’t have on vote-winners of every kind is simply too attractive to ignore

The alternative of course is the asset-centric model – strictly one asset per company.  Now the risk profile of the asset is simple to judge and the stringency of the filter is maximal.  With the need for the entrepreneur to lock themselves into the development of a single asset for the duration of the task, they have a huge opportunity cost in selecting the asset they bring to the table.  Assets selected in this way by investor and entrepreneur alike are, on average, more likely to be successful than the second and third assets in a larger biotech.

So great is the advantage of this approach, that the benefit of increased stringency in asset selection outweighs the disadvantages that come from isolating individual projects (such as the need for a high quality development team for each asset – hard as such teams are to come by).  In any case, with a little care it should be possible to extract some if not all of the benefits of synergy will still operating with all the benefits of isolation in the asset-centric model, as DrugBaron recently considered.

The asset-centric approach, then, lacks the chocolate-flavour of the company-building model for both investor and entrepreneur.  But crucially it lacks the poison too.  If the biotech world can cure itself of its comforting addiction to costly company building, then returns on the asset class will surely rise.  If Western politicians can cure themselves (and their populations) of their addiction to debt dressed up in the clothes of fiscal stimulus, then maybe our economy can finally exit crisis mode.   But please don’t try to cure me of my addiction to red wine – its good for my heart.

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