Spin-outs and venture capital won’t fill the pharma R&D gap

Now that Pfizer has, for the moment, been rebuffed in its attempt to take over AstraZeneca, it’s worth reflecting on the broader issues this story raised about the pharmaceutical industry in particular and technological innovation more generally. The political attention focused on the question of industrial R&D capacity was very welcome; this was the subject of my last post – Why R&D matters. Less has been said about the broader problems of innovation in the pharmaceutical industry, which I discussed in an earlier post – Decelerating change in the pharmaceutical industry. One of the responses I had to my last post argued that we shouldn’t worry about declining R&D in the pharmaceutical industry, because that represented an old model of innovation that was being rapidly superseded. In the new world, nimble start-ups, funded by far-seeing venture capitalists, are able to translate the latest results from academic life sciences into new clinical treatments in a much more cost-effective way than the old industry behemoths. It’s an appealing prospect that fits in with much currently fashionable thinking about innovation, and one can certainly find a few stories about companies founded that way that have brought useful treatments to market. The trouble is, though, if we look at the big picture, there is no evidence at all that this new approach is working.

A recent article by Matthew Herper in Forbes – The Cost Of Creating A New Drug Now $5 Billion, Pushing Big Pharma To Change – sets out pharma’s problems very starkly. The exponentially increasing costs of developing new medicines now means that, on Herper’s analysis, the cost to big pharma of developing a single new medicine is now approaching $5 billion. This reflects the fact that 95% of drug candidates don’t make it to market, because they fail, in clinical trials, to demonstrate that they are both safe and effective; the costs of these failures have to be borne from the revenues of the 5% that are successful. With the cost of drug development this high, some are wondering whether the returns can ever justify the outlays. It’s arguable that, purely from the point of view of maximising shareholder value, it’s rational to to stop R&D altogether and squeeze the returns on existing products for as long as possible. This is precisely the approach taken by Michael Pearson, CEO of Valeant Pharmaceuticals, currently involved in a hostile take-over bid for Allergan.

But if big pharma did stop doing R&D, where would the new products come from? The fashionable answer is that the risky business of discovering new drugs would be handed over to spin-outs and start-ups backed by venture capital. That this is implausible as a global solution is shown just by looking at the scale of activity. To calibrate this, note that Herper’s analysis estimates that on average a company that produces a single new drug takes $350 million to do it. The reason this is much less than the cost per drug to big pharma is because it doesn’t include the costs of failure; if (as usually happens) the new drug that the company is based around fails to make it to market the investors just lose their money. But the total amount of venture capital money that went into the biotech and pharma sectors in 2012 was, according to the British Venture Capital Assocation, just £46 million. For comparison, the total R&D spend in the pharmaceutical industry in 2012 was £4.2 billion, according to the ONS. The 15% decrease in pharma R&D spend between 2011 and 2012 – £727 million – by itself was 15 times more than the VC money that went in.

There is no mystery as to why so little money goes in to support early stage pharma and biotech companies – not only are the investments very risky, but on average the returns are poor. According to the BVCA Performance Measurement Survey, Venture Capital funds in the UK generated, between 1996 and 2008, an internal rate of return of just 0.4% a year. The report doesn’t break down the performance between different sectors, but taking into account all private equity and VC funds, the return on technology investments was 1.1% compared to that from non-technology investments of 14.9%. There’s no reason to believe that pharma and biotech investments were better performing than the average VC or technology investment – on the contrary, it seems much more likely that those averages were pulled up by internet and software investments and that the picture for pharma and biotech is even worse than these figures suggest.

So if the returns on early-stage investments in the pharma and biotech sectors are so poor, why do they attract any private sector money at all? Another interesting figure in the BVCA statistics is that the total investment in VC and private equity included £424 million from UK government agencies – this sum actually exceeds the total sum invested in the technology sector as a whole both at the VC and expansion stage (this was £420 million). In addition to these investments, such companies increasingly rely for their operating cash on grants from government agencies like the TSB and MRC – through schemes like the £180 million Biomedical Catalyst Fund – and the EU. The reality, then, is that the early stage, VC supported spin-out companies are largely the result of state action, rather being the products of capitalism in the raw. This is not necessarily a bad thing, given the need for the innovation that they promise, but we should be clear-eyed about what is going on, and ask whether the scale and organisation is right for this kind of state investment.

If I take a personal view, I certainly wouldn’t be demanding that my pension money was put into early stage pharma and biotech companies – I’d like some money to live on in my old age, and from an investment point of view it’s far from clear that pharma and biotech are good bets. But also, when I’m old, I’d like medicine to have advanced – I’d like there to be some new antibiotics to replace the ones that pathogenic bacteria will have become resistant to, and maybe even some useful therapies for the dementias that are growing so much more prevalent in our ageing populations. And there is the dilemma that we need to face – in pharmaceuticals, and perhaps in other areas too, our version of finance capitalism seems to be structurally incapable of delivering the innovation we need.