J.D. Candidate, Columbia Law School2017
Editor-in-Chief, Columbia Journal of European Law
Introduction – What is at Stake for UK Pharma
The British pharmaceutical industry employs 183,000 people and accounts for annual sales worth £ 56 billion (€ 71.39 billion). Its leaders have been vocal opponents of the UK referendum to leave the EU. Their comments refer to a number of negative implications for pharmaceutical companies, including the loss of their investment in achieving regulatory alignment for drug development under the European Medicines Agency (EMA), the cost and instability that will result if that regime must be revised in the UK, and the loss of the convenience of the EU’s Unitary Patent system. Of course, any discussion of the effects of a Brexit are speculative in the absence of information concerning agreements that may be reached between the UK and the EU in the aftermath. However, it is relatively clear that the EU is an important source of funding for scientific research in the UK and that its contribution to that end will be affected by a Brexit. This post therefore attempts to explain the importance of EU financing for scientific research in the UK by examining current models of risk financing in the pharmaceutical industry.
Some statistics are necessary to lay the foundation for what is at stake. Estimates have claimed that as much as £ 8.4 billion (about € 10.64 billion) in European funding for scientific research in the UK over the next four years could be compromised by a Brexit. For comparison, total spending on research and development (R&D) in the UK pharmaceutical sector was € 5.187 billion in 2012 and € 4.608 billion in 2013. The UK is also a net recipient of academic research support from the EU, taking in € 3.4 billion more than it contributed from 2007 to 2013. Looking forward, the European Commission’s Horizon 2020 initiative earmarked € 7.472 billion in funding for health research. It is therefore no surprise that UK pharmaceutical leaders have warned of a potential “significant research funding gap” should the Out Campaign succeed.
Pharmaceutical Risk Finance and Stages of Drug Development
Sources of R&D financing vary along the stages of development that a potentially valuable compound must go through. It is estimated that between 1 and 2 out of every 10,000 compounds synthesized by researchers will eventually become a marketable pharmaceutical product. Because the likelihood of valuable results is so low relative to cost, initial discovery research is largely funded by government and philanthropic entities as a public benefit. In recent years the UK pharmaceutical sector has sought to decrease the share of its R&D spending devoted to basic science, with the relevant proportion falling from 25% to 15% from 2009 to 2014.
As drugs pass from basic science into pre-clinical animal studies and “proof of concept” studies (often referred to as Phase I and Phase II clinical research), raising funds can be particularly difficult. Risk is still considered high and potential return may be low, especially when the drug under development is designed to treat a small patient population. Public-Private Partnerships are especially important at this stage. Finally, late-stage (or Phase III) development and ongoing studies after a drug is brought to market (Phase IV) are generally funded by the industry and especially by large manufacturers. However, it is important to note that even drugs that make it to the clinical development stage are characterized by a large degree of risk: the chances that clinical trials will fail and the entire investment will be lost vary from 30-55%, depending on the phase of research. Due to the size and scope of Phase III trials and related expense, failure at that stage can be massively damaging for a company. The total cost of researching and developing a new drug is estimated at € 1.172 billion over 12-13 years, much of which will have already been spent if a drug fails at Phase III.
The Problem with Losing Public Funding
At present, return on investment for pharmaceutical R&D is practically zero, and in the case of some companies may even be negative. There is widespread agreement that the industry is currently facing a shortage of suitable new drug-candidates in which to invest. Less basic science funding further decreases the likelihood of discovery of potential new drugs within the UK. It also means that, with fewer candidates and less well-funded testing earlier in the process, those candidates that are promoted to the pre-clinical and early-clinical stages might be less well-vetted and more susceptible to costly, late-stage failure. That is to say, a decrease in spending earlier in the pipeline increases risk later in the pipeline, which is likely to have an effect on cost of capital at later stages. Indeed, it has been argued that cuts in public support for research are related to difficulty in raising private investment capital for drug development later in the pipeline. Venture capital firms have recognized these challenges, and their participation in pharmaceutical R&D investment has slowed considerably in recent years. Even for late-stage drug development, the financial crisis had a significant inhibitory effect on investment, as such projects are seen as large, relatively undiversified, and insufficiently transparent.
Efforts to Address and Distribute Risk
Pharmaceutical companies have already gone through a period of attempting to externalize R&D costs in the past decade and a half. Not only do the existing solutions appear to be inadequate to render investment in pharmaceutical R&D profitable, but many of them may become less advantageous for UK companies in the event of a Brexit. Participants of different sizes within the industry attempt to adjust their risk exposure along the drug development pipeline. Smaller companies that have innovation-related expertise, but that lack the capital to carry out large-scale, late-stage trials necessary to bring a drug to market, often serve as incubators for new drug candidates for larger companies. Deals involve selling options on licenses early in the development process, co-development that may involve on-site collaboration (where an operator with both investment capital and excess capacity provides laboratory space and operational support in exchange for preferred rights), and equity investments. The basis of such deals is that the value created in development lies in preferential rights and access to information generated in the course of research, rather than in control over the direction and management of R&D operations.
Larger companies, such as Novartis and GlaxoSmithKline, have established VC arms to invest in smaller companies, thereby gaining access to information and rights in early-stage technologies. Such investment operations tend to be modest, however, relative to the firms’ overall R&D expenditures. Companies have also formed investment consortia to join with external investment funds in promoting early-stage development, including investing in university-IP spinoffs. Collaboration between pharmaceutical companies of different sizes is growing in importance, as large companies now recognize that long-term profitability in the industry depends heavily on externally-sourced assets. Unfortunately, this recognition is expected to increase competition and drive up the price of such assets, thus further diluting the ultimate value of investment in R&D from the standpoint of large pharmaceutical companies.
To offset the difficulty in raising R&D capital, pharmaceutical firms have sought to reduce R&D costs in a number of ways. One strategy is to displace risk prior to the completion of proof-of-concept studies by outsourcing conduct of such studies to operators in low-cost countries (especially to India and China). If proof-of-concept studies are successful, the outsourcing firm regains rights to the compound in exchange for later milestone payments, royalty payments and co-promotion rights in particular geographies. From the standpoint of UK policymakers and industry participants that specialize in early-clinical development, such arrangements are not preferable. Some firms might seek to reduce cost by improving the efficiency and productivity of their clinical research through enhanced information systems. However, it appears that markets may be skeptical of such efforts: Quintiles’ recent attempt to reduce its R&D bill by merging with IMS Health, which will provide it with access to huge stores of information that it hopes will improve clinical operations, was met by a 10% fall in share value for both companies. For these reasons, putting additional pressure on UK pharmaceutical firms to reduce R&D costs is not desirable from a British standpoint.
Brexit would affect these arrangements in the UK in a number of ways. Obviously, loss of European funding for academic science would directly impact the role that universities can play in development. More importantly, cooperative financing arrangements benefit from regulatory coherence. Even assuming that researchers’ ability to move and work across state borders would be unaffected by the UK’s departure from the EU, to the extent that co-development arrangements involve sharing clinical data and even laboratory space among operators based in different member states, the benefits of uniform regulation under the EMA are enhanced. Especially under such arrangements, the UK’s ability to influence EMA regulations is important.
In the near-term, Eli Lilly CEO John Lechleiter’s suggestion that a Brexit would not hurt his company’s sales is probably accurate. Of course, pharmaceutical revenue is generated by drugs that are already on the market. In the long-term, loss of EU support for R&D, especially early-stage research, could have a significant impact on revenue. While certain sources of EU funding, such as the EIF, would not inherently be foreclosed to UK companies if Britain leaves, a look at Switzerland (despite its status as Brexiters’ favorite pharmaceutical comparator) suggests that such funding opportunities would be severely impacted. While the Swiss drug industry is currently thriving, a 2015 report by Swiss pharma research association Interpharma noted that the country is beginning to lag behind its European competitors in clinical research productivity.
It is unclear where or even whether the research funding gap might be made up. In light of the National Health Service’s well-known budgetary crisis, it seems unlikely that the British government will substantially increase funding for health research in the near-term. Perhaps further financial innovation will free up private investment capital: for example, the idea of investment insurance at various stages of the development process has been suggested. However, to date no suitable counterparty has emerged to make such a scheme viable, and, in any case, insurance is unlikely to support early-stage research where project-specific risk information is practically unavailable.
While this paper has focused on the financial difficulties in the industry that are likely to result from a Brexit, the human cost must be mentioned as well. Productivity in the pharmaceutical sector is hopefully at some level concerned with benefitting patients and curing disease. While it is at most a marginal issue in the larger debate about whether Brexit is good for the UK, the long-term impact on the British pharmaceutical industry and its future role in medical advancement should at least be considered a factor.