Volume 12, No. 1, First Quarter 2014

NEW FINANCING METHODS IN THE BIOPHARMA INDUSTRY: A CASE STUDY OF ROYALTY PHARMA, INC.

by: Andrew W. Lo and Sourya V. Naraharisetti

The biotechnology and pharmaceutical industries are facing significant challenges to their existing business models because of expiring drug patents, declining risk tolerance of venture capitalists and other investors, and increasing complexity in translational medicine. In response to these challenges, new alternative investment companies have emerged to bridge the biopharma funding gap by purchasing economic interests in drug royalty streams. Such purchases allow universities and biopharma companies to monetize their intellectual property, creating greater financial flexibility for them while giving investors an opportunity to participate in the life sciences industry at lower risk. Royalty Pharma is the largest of these drug royalty investment companies, and in this case study, we profile its business model and show how its unique financing structure greatly enhances the impact it has had on the biopharma industry and biomedical innovation.

Stakeholders Perspectives on Norwegian Investment Responsibility

by: Sarah Takaki

The Strategy Council for Norway's Government Pension Fund Global, supported by the Norwegian Ministry of Finance, hosted the Responsible Investment Conference held in Oslo on 20 June 2013. The conferences goal was to facilitate dialogue with stakeholders on environmental, social, and governance (ESG) issues to inform the Strategy Councils forthcoming report on the Funds responsible investment strategy. The summit was organised into three sessions, each of which focused on one ESG issue and featured speakers from Norwegian and international organisations. Overall, participants commended the Funds achievements to date while proposing a variety of new initiatives and highlighting the challenges faced by the Fund.

Norway’s Summit on Responsible Investing

by: Mitch Towner

This is a summary of the issues discussed at the 2013 Investment Strategy Summit of the Norwegian Government Pension Fund Global. The emphasis of the summit was responsible investing with a special emphasis on ways to strengthen the Funds work on responsible investment. The summit brought together experts (both practitioners and academics) and discussed ethical issues, financial performance, and activist investors in the context of social, environmental, and governance concerns.

The Performance of Leveraged and Inverse Leveraged Exchange Traded Funds

by: Brian J. Henderson and Gerald W. Buetow

We document significant abnormal daily returns to leveraged and inverse leveraged exchange-traded funds (ETFs). Abnormal returns are positive for leveraged funds and negative to inverse leveraged funds, and the magnitude increases in the absolute value of the leverage multiple. We propose and test a model linking the abnormal return performance to transactions costs associated with the frequent (daily) rebalancing necessary to maintain target exposures as well as other costs including the swap financing costs and the cost to borrow in the lending market. In the full cross-section, the results suggest funding costs associated with achieving leverage impact returns negatively (positively) for leveraged (inverse leveraged) funds. Capitalizing on a key institutional feature, analysis of pairs of mirror funds reveals transactions costs associated with the maintenance of daily leverage multiples meaningfully impact fund returns. The results are also consistent with inverse leveraged funds bearing the cost-to-borrow to the benefit of the leveraged (long) funds.

Sovereign Wealth and Risk Management: A Framework for Optimal Asset Allocation of Sovereign Wealth

by: Zvi Bodie and Marie Briere

This paper sets out an analytical framework for optimal asset allocation of sovereign wealth, based on the theory of contingent claims analysis applied to the sovereigns economic balance sheet. A country solves an asset-liability management problem involving its sources of income and its expenditures. We derive analytically the optimal asset allocation of sovereign wealth, taking explicit account of all sources of risks affecting the sovereigns balance sheet. The optimal composition of sovereign wealth should involve a performance-seeking portfolio and three hedging demand terms for the variability of the fiscal surplus and external and domestic debt. A real-life application of our model in the case of Chile shows that its sovereign investment is under-diversified.

The Interest Rate Sensitivity of Tax-Exempt Bonds Under Tax-Neutral Valuation

by: Andrew Kalotay

We explore the effect of taxes on the prices of municipal bonds. Although interest is tax-exempt, the gain resulting from purchasing a muni at a deep discount below the so-called de minimis threshold is subject to severe tax treatment. The gain is taxed as ordinary income at maturity; currently for a typical investor the applicable rate is roughly 40%. Thus, purchasing a bond at 80 would trigger an 8-point tax liability.

The paper develops a rigorous approach to the pricing of munis by incorporating taxes into the industry-standard OAS-based valuation framework. The key concept is tax-neutral value, which is simply the fair value that takes into account potential tax payments. Tax-neutral valuation allows us to explore how muni prices respond to changing interest rates. The basic insight is that due to the interaction of the purchase price and the related tax payment, discount tax-exempt bonds are significantly more sensitive to interest rates than taxable bonds. For example, currently the duration of a 10-year taxable bond is roughly 8.5 years, while that of a 10-year muni can exceed 13 years.

Tax-neutral valuation provides the foundation for accurately projecting the prices of munis under various interest rate scenarios. The primary application of this approach is risk management, including hedging. It is also essential for determining the optimum time to recognize a loss in order to maximize after-tax performance.

Risk Return Analysis

by: Harry M. Markowitz and Kenneth A. Blay • reviewed by: Mark Kritzman

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

An Introduction to Peer-To-Peer Loans as Investments

by: Ethan Namvar

This paper constitutes a discussion of the rise of Peer-to-peer loans as alternative investments. Peer-to-peer loans are being incorporated into portfolios in the interest of diversification. This paper outlines this strategy and provides a guided tour of this new alternative asset class along with the current risks and barriers.

Practitioner’s Digest • Vol. 12, No. 1

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.