Cost of Biotech Capital: Incorporating Development Risk into VC’s Target Return

Although the average biotech investor probably understands the term “cost of capital” and general CAPM theory, there still seems to be much confusion around how to incorporate the binary risk of drug development into discount rates and required IRRs. CAPM and portfolio theory tells us that investors are only compensated for correlation to general macroeconomic risks – i.e. risks we can’t diversify away. Thus, taking on so-called “idiosyncratic risks”, such as the binary risks of clinical trials, should not theoretically garner an investor any extra return (assuming the clinical trial risks are not correlated across a wide portfolio of investments, which may or may not be an appropriate assumption¹). Why then, do we see VCs demand gross² IRRs of 35%-60% per each investment (dramatically higher than CAPM would dictate) to compensate for drug development? The answer lies in the difference between a portfolio’s ultimate expected return (i.e. a VC investor’s cost of capital) and an individual investment’s target return.

                Andrew Metrick, my former professor at the Wharton School, clearly explains the difference in his book “Venture Capital and the Finance of Innovation” (http://www.amazon.com/Venture-Capital-Finance-Innovation-Metrick/dp/0470074280). The general financial theory he describes is also used widely in the BioPharma industry to calculate eNPV (expected or risk-adjusted NPVs). We used this theory at Genzyme, and I know it is used at many other major BioPharma companies to value their pipelines. The basic idea is to probability-adjust cash flows (or the numerator) for the binary risk of drug development (probability of technical success) and not incorporate that risk into discount rates (or the denominator). For example, to determine the value of an early-stage acquisition target, you would multiply the stream of potential cash flows by the probability of each of them actually occurring and then discount back using a discount rate determined by either (i) the general CAPM equation R_Discount = R_F + β(R_M - R_F) or (ii) a more elaborate model, such as the Pastor-Stambaugh model (PSM) that incorporates additional factors for value, size, and liquidity (for simplicity, assume no debt). The discount rate used by most BioPharma’s is ~10-15%. However, many VCs will use the following equation to move the idiosyncratic (or binary) risk (i.e. “p”) into the target discount rate (i.e. Target Return):

p/(1+ R_Discount)^Time = 1/(1+Target Return)^Time

For a project that has a p = 20% chance of exiting for some fixed amount of money and an 80% chance of exiting for $0 in Time = 5 years, with a standard R_Discount of 15%, the Target Return or Target Discount Rate = 58.7%.

.20/(1+.15)^5=1/(1+.587)^5

When VCs say their discount rate or required IRR is 58.7% to adjust for development risk, this really translates into the 15% discount rate we normally think of adjusted for probability of technical success. No investor actually expects to receive a 58.7% return for the entire portfolio. As is often said in the VC world, the winners have to make up for the losers so the returns can average out to a reasonable compensation for taking macroeconomic or non-diversifiable risk (and possibly adjustments for size, value, and liquidity).

Notes

 (1) These days, the big question is which biotech start-up risk is diversifiable and which is correlated to the general economy (i.e. macroeconomic risk) and affects β. Certainly capital availability, which plays a significant factor in the success of biotech start-ups, is greatly tied to the macroeconomy. However, this is perhaps already captured in the “size” factor of the PSM model. Other factors, such as FDA regulatory requirements or access to patients for clinical trials, are also tied to the general political environment and perhaps cannot be diversified away.

(2) Note that a VC’s gross IRR and net IRR differ due to fund management fees and carry.