Of private equity, research, and drug development

Yesterday it was announced that First Data, one the nation's major credit-card processing companies, agreed to be bought out by the huge private equity firm, Kohlberg Kravis Roberts & Co., for $29 billion. The New York Times reported:

“The deal ranks among the 10 largest buyouts ever and signals the continued might of private-equity firms, aided by a flood of cheap debt and eager institutional investors like pension funds.”

What does this mega deal have to do with pharmaceutical drug pipelines?

As many know, we are currently “basking” in an era of low interest rates. Many would regard this as a good thing. Indeed, I don't mind the relatively low mortgage rates now; certainly as compared to the 1970s and 1980s. But, as with everything, there is no free lunch and there is a price to low interest rates.

Of course, there are the macroeconomic arguments that point to overheated economies leading to higher inflation. Some would also say that the current housing meltdown is related to easier money policies. And while not necessarily a "price to be paid," one implication of the low cost of debt financing is the current boom in private equity, as evidenced by today's KKR-First Data deal. But there is also another price to be paid for an economy that is tilted in favor of debt rather than equity. Roughly speaking, debt is a conservative financing instrument. While not inimical to innovation, it is not the currency that lubricates revolutions. Private equity firms can provide great value to the economy but they, too, will acknowledge that this value involves incremental improvements to an existing company's operations. To be sure, this can sometimes create stupendous value (why else would pension funds risk their capital?) but private equity (and by extension activist hedge funds) exact their value through mechanisms such as management changes, business process improvements, new market developments, etc. This adds value but it is not innovation in any substantial sense.

Well, one might answer: innovation is the job of universities and venture capital, and indeed that is the case. However, despite our high levels of liquidity, the world does not have unlimited money. The $29 billion for First Data means that much money doesn't go to venture capital or other forms of equity-based innovation financing.

Say it costs $1 billion to bring a new drug to market (more on this later); that means we could have 29 new drugs being financed instead of having your Visa or Mastercard processed with slightly more efficiency. I am simplifying, of course, but the same argument has been held for growing government debt crowding out private investment. Within the private sector, there are also such “crowding out” phenomena, and this is one of them.

No value judgments

Note that these points do not constitute a value judgment. I have nothing against private equity and truly believe that value creation is a good thing. Even the much maligned Gordon Gekko - glaring out at the top-heavy phalanx of vice presidents at the Teldar Paper shareholder's meeting - had a valid point. But we, as a society, should not kid ourselves that these debt-financed investments will be directed toward fostering innovation. It would be irresponsible of KKR and of its investors to think otherwise.

So why doesn't this money go toward more research and development - in particular to medical technology or pharmaceutical discovery? As many have noted (including the Economist last March), corporate R&D has decidedly shifted toward the “development” side and largely away from R&D in general. To many firms, the returns on capital from R&D - especially in the context of this bias towards debt financing - have simply not been great enough to justify more effort. The KKR-First Data deal is simply an acknowledgment of that on a grand scale.

With respect to pharmaceutical discovery, one cannot simply blame investors or management for such decisions, since frankly the underlying paradigms of drug design seem to be fatally flawed. This may be a surprise to some, but basically we know very little about how drugs bind or act to their targets. The genomic revolution promised thousands of new targets - and a brave new world in medicine - but relatively little has come of that. This past week, the American Chemical Society held its annual meeting in Chicago where Prof. George Whitesides - the renowned Harvard chemist - was awarded the industry's highest honor - the Priestley Medal. In his acceptance speech, he commented on this problem (so you don't need to take my word on it) as follows:



Sobering words

While in college, I attending several of Prof. Whitesides' lectures and I can truly say he is an optimist at heart. His comments here are thus especially sobering. In this regard, I would agree with KKR and most investors that throwing $29 billion at pharmaceutical drug development using the current paradigms would likely not return as much value as investing in better credit card processing. Scary as that sounds; that's what the market is telling us.

Like the famous Indian legend of the three blind men and the elephant, we have glimpses of the fundamental process of molecular interaction but by no means a full view. There has been much turmoil in the pharmaceutical industry, as Michael Rosen has also commented on in his column. Many of us, myself included, have proposed on improved business models and R&D processes in order to solve the pharmaceutical pipeline problem.

Ultimately, however, in the absence of a more complete understanding of protein-ligand interactions, the sparse drug pipeline will largely remain a wasteland, which despite the great benefits to society from improved medicines, investors will continue to shy away from.

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