Three Financial Characteristics of the Pharma Business
In this first blog of a series focused on participation in clinical trials, we shall review three financial characteristics of the pharma business that may not be well known to the general public, the characteristic of payoff distributions associated with single drugs compared to portfolios of drugs, the profits of large pharma companies and their ownership. [To simplify the text, we use the word “drug” to describe all organic synthetic molecules, biologics, and whole cell therapies, regardless of their phase of development]
Although the pharmaceutical business is large with 11.5 trillion cumulative revenue over the period 2000- 2018 (1), it remains a risky business when examined after segmentation by therapeutic area or an individual drug in development. A rather comprehensive 10-year study reports that only 5.1% of new cancer drugs tested in Phase I are likely to receive FDA approval. The success rate from Phase 1 to Phase 2 reaches 63%, only to drop to 25% from Phase 2 to Phase 3. Worst news yet, the LOA (likelihood of approval) for solid tumor programs is only 4.1%, versus 8.1% for hematologic programs (2).
Also Read: Challenges of Clinical Trial Recruitment
Like any high-risk investments, drug development programs taken one by one, at the beginning of their journey (Phase 1) have an asymmetrical payoff distribution with high returns for rare events (the approval of the drug and its successful entry in the market to generate revenues). From then on, the (expected) payoff distribution for a single drug becomes more symmetrical as the drug graduates through the phases of development. At the transition from pre-clinical to clinical phase the payoff distribution for a typical drug (very predictable “me-too” drugs are an exception) is very skewed to the left with a high probability of failure and a long tail of improbable high return events (approvals + acceptance on formularies) to the right. The distribution flattens as the drug progresses and at launch, the payoff distribution corresponding to lesser or greater expected revenues in the years post launch is symmetrical around a “reasonable” scenario. A large pharma with many drugs at different stages of development can afford to represent its investments (its large portfolio) in a single overall payoff distribution that is symmetrical around the “reasonable” scenario, but even large pharma payoff distributions can be shaken by large impact events such as the withdrawal of successful drug or the addition of a new indication. In contrast, small pharma companies (this includes small biotech firms) have (by definition) a smaller portfolio (and sometimes, only one drug). They cannot escape from the asymmetrical payoff distribution. Investors who back them, such as venture capitalists, know this very well and redistribute their risk across several small pharma companies.
Another financial characteristic of large pharma companies is that their profits, as a fraction of top revenues, are high compared to other industries (13.8%; 95% CI: 10.2%-17.4%) (1). In fact, large pharma companies are not only highly profitable, they also are highly predictable. Indeed, the time required to cause major changes to the structure of their portfolios is exceptionally long (and reflects both the duration of the development process, 3-7 years, and the period of market exclusivity), with the result that their shares are very stable and keep on giving a steady return regardless of the overall state of the economy. This profile is particularly attractive to retirement funds which are large shareholders of those companies. In contrast, small companies are largely owned by venture capitalists and hedge funds before their IPO which is the exit point many of these investors look for. Being aware of long-term risks, those investors will, in general, push for an IPO to take place well before the drug they support is submitted to the FDA for approval.
When the public blames large pharma for egregious profits, it should keep in mind that those high profits and predictability is what makes owning shares of those companies particularly attractive to pension funds. If big pharma management were to declare a ceiling on profits at a lower level, to improve their image in the eyes of their detractors, by lowering the acquisition price of drugs, pension fund managers would run to the hills. Large pharma management simply has no choice but to extract the maximum profits that the market (insurers) will bear.
- Ledley et al. JAMA, 2020; 323(9): 834-843 https://jamanetwork.com/ on 02/04/2021
- Thomas et al. Clinical Development Success Rates 2006-2015 – BIO, Biomedtracker, Amplion. Bioindustry Analysis
Chief Medical Officer and Co-founder
Pharma industry veteran with 30+ years in large Pharma & in leading small biotechs, spearheading large initiatives and securing funding, psychiatry practice and research for 10+ years.