Pharma needs an injection of financial engineering "You're going to need a bigger boat," says the police chief played by Roy Scheider in the film Jaws, when he first catches sight of the shark. Faced with cancer, diabetes and Alzheimer's, we need a bigger investment vehicle. As life expectancy rises and deaths from conditions such as heart disease fall, the challenges facing healthcare companies are growing and getting more complex. Yet equity investors - both venture capitalists and public shareholders - are increasingly wary of losing money on hunting for new drugs. John Gapper The resignation last week of David Brennan, chief executive of AstraZeneca, set the tone for another poor earnings season for pharmaceutical companies, which are falling off the long-feared "patent cliff." Patents on heart blockbusters such as Pfizer's Lipitor and Sanofi's Plavix are expiring with little sign that the industry can replicate them. Venture capitalists have reduced investment in biotech, having failed to obtain a suitable return, and public spending on research is under strain in the US and other developed economies. "We are investing a lot, both public and private, and not seeing a lot coming out," admits Margaret Hamburg, commissioner of the US Food and Drug Administration. Maybe it is time to think the unthinkable - that if equity investors are no longer willing to support medical research, someone else must instead. Andrew Lo, a finance professor at the Massachusetts Institute of Technology, says it could be debt investors through CDOs - collateralised drug obligations. This sounds like a crackpot idea, given the role of collateralised debt obligations in inflating the housing bubble and the fact that research projects - the underlying assets in Prof Lo's scheme - start without revenues. But the pharma industry has struggled for a decade to find a better one, so why not give it a shot? Prof Lo and his fellow researchers floated the idea this week at the Milken Institute Global Conference in Los Angeles, causing a stir among the pharma executives and scientists who had converged to discuss the difficulties facing the industry. It was a suitable forum to advocate the financial engineering of health. Michael Milken, whose think-tank runs the event, was a pioneer of the high-yield bond finance market in the 1980s (and later spent two years in jail for securities fraud). He has also given money to medical research and pushed for the acceleration of drug innovation, having himself had prostate cancer. New money is urgently needed for early-stage research - the phase in which potential new medicines are identified before being developed and put through clinical tests. Venture capitalists have been put off by the fall in the number of start-ups that make it to initial public offerings - US venture investment in biotech fell 43 per cent in the first quarter. Meanwhile, pharma companies that were once high-growth stocks trade below the ratings of Coca-Cola or Unilever. "One of the most frustrating things is that people who bring you sugared drinks and potato chips have higher multiples than an industry that will save your life," says Chris Viehbacher, Sanofi's chief executive. The pharma companies that have kept focused on drug research rather than diversify into areas such as consumer medicine or vaccines have suffered the most. Mr Brennan's resignation followed pressure from investors for the company to curb research. Such pressure, together public deficits are having an effect. Research and development by drugs companies in the US fell last year by $1.2bn, while the budget of the US National Institutes of Health - the main vehicle for public investment in health research - was reduced for the first time. Investors are behaving rationally - returns on research have been poor since the 1990s blockbuster era. The failure rate of new drugs in clinical trials has risen steadily and efforts by drugs companies to increase productivity - such as organising research more like biotech start-ups - have not helped much. For society, however, the result is disastrous. Genetic science has become so complex that a lot of expensive research is needed to identify treatments for illnesses such as Alzheimer's. Yet equity investors can improve their performance by taking their cash elsewhere. Prof Lo's idea is to enlist debt investors who would be happy with lower returns, as long as they are steady, and to put investment into research projects rather than into companies. He would spread the risk by identifying 150 ideas and raising enough money to develop them for 10 years - perhaps $50bn-$100bn. Most would fail but if a few worked, they would pay off the CDO structure. The housing bubble ended badly but it proved that, in Prof Lo's words, "by using the techniques of financial engineering, we can create enormous pools of capital." The idea is unproved - Prof Lo's paper on the subject has yet to be published and it is easy to identify pitfalls. The fund would have to wait a long time before any cash materialised, it would require the equivalent of a rating agency to identify good projects and none might become blockbusters. But it is appealing, not merely for an industry that needs help, but for structured credit itself. The housing bubble gave CDOs and financial engineering a deservedly bad reputation. If the same techniques were used to aid medical research, Wall Street might improve its image. There is a risk of repeating the housing debacle and attracting hot money to bad ideas, ending with investors losing billions. It would still be better than the alternative: a slow drift into underinvesting in health. As Prof Lo says, "if there's a cancer bubble, I can live with that."