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Canfinancialengineeringcure

cancer?
Anewapproachtofundinglargescalebiomedicalinnovation

AndrewW.Lo
(jointworkwithJoseMariaFernandezandRogerM.Stein)

SloanReunion2012
Sloan
Reunion 2012
June8,2012
The contents of this presentation are based on the research carried out at the MIT Laboratory for Financial Engineering by Jose
Maria Fernandez,, Roger
g
M. Stein and Andrew W. Lo. For total or p
partial reproduction
p
please contact jjose
p
maria.fernandez@sloan.mit.edu
2012byJoseMariaFernandez,RogerM.Stein,AndrewW.Lo
AllRightsReserved

Summary
Biomedicalinnovationhasthreeimportantcharacteristics:
Expensive,risky,andlengthy

Traditionalfundingvehiclesarenotideal(private/publicequity)
Riskisoneofthemainissues(complexity,FDA,patentcliff)
Ri ki
fth i i
(
l it FDA t t liff)
Diversificationisthesolution:largepooledvehicleslowerrisk
Withsufficientdiversification,longtermdebtispossible
Morepatientcapital,butstillimposesdiscipline(interestpayments)
Muchlargerpoolofcapital,allowinggreaterparticipation
Thefinancialtechnologyandinstitutionsalreadyexist

Thenaturalscalerequiredis$5to$30billion
Thenat ralscalereq iredis$ to$30billion
Usingfinancialengineering,thisisachievabletoday
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Slide2

Lessonsfromthefinancialcrisis?
Pension
Funds

Foundations,
Endowments

In
nsurance &
CDS Market

Sovereign
Wealth Funds

Ra
ating
Age
encies

Mutual
F d
Funds

Commercial Banks

$$$$$$

Investment Banks
Mortgage Companies
Fannie Mae

$$$$$$

Freddie Mac
Politicians

$$$$$$

Hedge
Funds

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2012byFernandez,Stein,andLo
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Slide3

Lessonsfromthefinancialcrisis?
Real Home Price Index (1890-2006)
200

Index o
or Interest R
Rate

180
160
140
120
100
80
60
1880

1900

1920

1940

1960
Year

Source: Robert J. Shiller, Irrational Exuberance, 2nd. Edition.

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2012byFernandez,Stein,andLo
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1980

2000

2020

To get back to longrun average, we need


45% real drop
( 35% nominal
(=
i ld
drop))
Slide4

Considersimplesecuritizationexample
90%

$1,000

$1,000

I.O.U.
10%

Price = 90% $1,000 + 10% $0


= $900

$0 (Default)

90%

$1,000

$1,000

I.O.U.
10%

9/21/2010

Price = 90% $1,000 + 10% $0


= $900

$0 (Default)

2010 by Andrew W. Lo All


Rights Reserved

Slide 5

Considersimplesecuritizationexample

$1,000

$1,000

I.O.U.

MBS

Senior Tranche

Portfolio

$1,000

$1,000

MBS

I.O.U.

Junior Tranche
9/21/2010

2010 by Andrew W. Lo All


Rights Reserved

Slide 6

Considersimplesecuritizationexample
AssumingIndependent
Defaults

$1,000
I.O.U.

Portfolio

Portfolio
Value

Prob.

$2,000

81%

$1,000

18%

$0

1%

$1,000
I.O.U.

9/21/2010

2010 by Andrew W. Lo All


Rights Reserved

Slide 7

Considersimplesecuritizationexample
AssumingIndependentDefaults
$1,000
MBS

Senior Tranche

$1,000
MBS

Portfolio
Value

Prob.

Senior
Tranche

Junior
Tranche

$2,000

81%

$1,000

$1,000

$1,000
$
,

18%

$1,000
$
,

$0
$

$0

1%

$0

$0

Bad State
For Senior
Tranche (1%)

Bad State
For Junior
Tranche (19%)

Junior Tranche
9/21/2010

2010 by Andrew W. Lo All


Rights Reserved

Slide 8

Considersimplesecuritizationexample
AssumingIndependentDefaults
$1,000
MBS

Senior Tranche

$1,000

Portfolio
Value

Prob.

Senior
Tranche

Junior
Tranche

$2,000

81%

$1,000

$1,000

$1,000

18%

$1,000

$0

$0

1%

$0

$0

Price for Senior Tranche

= 99% $1,000 + 1% $0
= $990

Price for Junior Tranche

= 81% $1,000
$1 000 + 19% $0
= $810

MBS

Junior Tranche

9/21/2010

2010 by Andrew W. Lo All


Rights Reserved

Slide 9

Considersimplesecuritizationexample
NonInvestmentGrade

Similar to
Junior
Tranche?
Similar to
S i
Senior
Tranche?

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2012byFernandez,Stein,andLo
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Source:Moodys.

Slide10

Lessonsfromthefinancialcrisis?
U.S.BondMarketDebtIssuance($Billions)
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

Municipal
185.2
220.7
286.8
227.5
200.8
287.7
357.5
357.5
382.7
359.8
408.2
386.5
429 3
429.3
389.5
409.8
433.1

Treasury1
612.4
540.0
438.4
364.6
312.4
380.7
571.6
571.6
745.2
853.3
746.2
788.5
752 3
752.3
1,037.3
2,185.5
2,303.9

MortgageRelated2
479.7
577.6
1,118.1
985.4
660.0
1,663.9
2,283.0
3,084.3
1,879.0
2,182.4
2,088.8
2 186 2
2,186.2
1,362.2
2,041.4
1,742.7

Corporate
Debt3
343.7
466.0
610.7
629.2
587.5
776.1
636.7
775.8
780.7
752.8
1,058.9
1 127 5
1,127.5
707.2
901.8
1,062.7

FederalAgency
Securities
277.9
323.1
596.4
548.0
446.6
941.0
1,041.5
1,267.5
881.8(4)
669.0
747.3
941 8
941.8
984.5
1,117.0
1,032.6

AssetBacked
168.4
223.1
286.6
287.1
281.5
326.2
373.9
461.5
651.5
753.5
753.9
509 7
509.7
139.5
150.9
109.4

Total
2,067.2
2,350.5
3,336.9
3,041.8
2,488.8
4,375.6
5,264.2
6,717.0
4,524.3
5,512.1
5,823.9
5 946 8
5,946.8
4,620.2
6,806.4
6,684.5

Interestbearingmarketablecouponpublicdebt.
IncludesGNMA,FNMA,andFHLMCmortgagebackedsecuritiesandCMOsandprivatelabelMBS/CMOs.
3 Includesallnonconvertibledebt,MTNsandYankeebonds,butexcludesCDsandfederalagencydebt.
4 Beginningwith2004,SallieMaehasbeenexcludedduetoprivatization.
Beginning with 2004 Sallie Mae has been excluded due to privatization
2

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2012byFernandez,Stein,andLo
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Source: SIFMA
Source:SIFMA
Slide11

Considersimplesecuritizationexample
AssumingIndependentDefaults
$1,000
MBS

Senior Tranche

Portfolio
Value

Prob.

Senior
Tranche

Junior
Tranche

$2,000

81%

$1,000

$1,000

$1,000

18%

$1,000

$0

$0

1%

$0

$0

$1,000
MBS

ButWhatIfDefaultsBecome
Hi hl C
HighlyCorrelated?
l t d?

Junior Tranche

9/21/2010

2010 by Andrew W. Lo All


Rights Reserved

Slide 12

Considersimplesecuritizationexample
S&PCaseShillerComposite10Index(nominal)
250

20
June 2006: 226.29
Effective Fed Funds Rate
S&P/CaseShiller Composite 10

200

33.5%

16

12

Index Le
evel

150

July 1996: 78.10


April 2009: 150.44

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2012byFernandez,Stein,andLo
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Jan-13
J

Jan-12
J

Jan-11
J

Jan-10
J

Jan-09
J

Jan-08
J

Jan-07
J

Jan-06
J

Jan-05
J

Jan-04
J

Jan-03
J

Jan-02
J

Jan-01
J

Jan-00
J

Jan-99
J

Jan-98
J

Jan-97
J

Jan-96
J

Jan-95
J

Jan-94
J

Jan-93
J

Jan-92
J

0
Jan-91
J

0
Jan-90
J

Jan-89
J

50

Jan-88
J

Jan-87
J

100

Effective Fed Funds


s Rate (%)

Updated June 1, 2012

Slide13

Considersimplesecuritizationexample
AssumingPerfectlyCorrelatedDefaults
$1,000
MBS

Senior Tranche

$1,000

Portfolio
Value

Prob.

Senior
Tranche

Junior
Tranche

$2,000

90%

$1,000

$1,000

$0

10%

$0

$0

Bad State
For Senior
Tranche (10%)

MBS

Bad State
For Junior
Tranche (10%)

Junior Tranche

9/21/2010

2010 by Andrew W. Lo All


Rights Reserved

Slide 14

Considersimplesecuritizationexample
AssumingPerfectlyCorrelatedDefaults
$1,000
MBS

Senior Tranche

Portfolio
Value

Prob.

Senior
Tranche

Junior
Tranche

$2,000

90%

$1,000

$1,000

$0

10%

$0

$0

Price for Senior Tranche

= 90% $1,000 + 10% $0


= $900 ((was $990)

Price for Junior Tranche

= 90% $1,000 + 10% $0


= $
$900 ((was $
$810))

$1,000
MBS

Junior Tranche

9/21/2010

2010 by Andrew W. Lo All


Rights Reserved

Slide 15

Wheredidallthemoneygo??
MortgagesOutstandingandEquityExtractions

9/10/2009

2009 byKhandani,Lo,and
Merton
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Slide16

Howcouldthishavehappenedtous?
HallofShame?:
Homeowners
Commercialbanks
InvestmentbanksandotherissuersofMBSs,CDOs,andCDSs
Mortgagelenders,brokers,servicers,trustees
Creditratingagencies(S&P,Moodys,Fitch)
Insurancecompanies(multiline,monoline)
I

i ( ltili
li )
Investors(hedgefunds,pensionfunds,mutualfunds,others)
Regulators(SEC OCC CFTC Fed etc )
Regulators(SEC,OCC,CFTC,Fed,etc.)
Governmentsponsoredenterprises
Politicians
Isthefinancialsectorbecomingtoobig?
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2012 by Fernandez, Stein, and


Lo All Rights Reserved

Slide 17

Isthefinancialsectorbecomingbigger? Yes!

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2012 by Fernandez, Stein, and


Lo All Rights Reserved

Slide 18

Why?
WorldPopulation,10,000BCto2011AD

Source: U S Census
Source:U.S.Census.
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Slide19

Innovationrequirescollaboration
Collaborationrequiresfinancialinfrastructure

Privateinvestment
P
i t i
t
t
Wellfunctioningcapitalmarkets
P
Properdesignofsecurities
d i f
ii
Accounting,legal,regulatorystructures
Systemicstability
bl

andalignedincentives(human
andalignedincentives(human behavior)

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Fearworksfaster
Greedlastslonger

2012byFernandez,Stein,andLo
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Slide20

Anexample
TheDARPAnetworkchallenge
Find10redballoonsinfixedlocationsinU.S.
Find10redballoonsinfixedlocationsinU S
$40Kprizetofirstteamtofindall10locations
MITteamwon
8:52:41!
How??
Financialengineering!
$4,000perballooniftheywon
= $2,000tolocator+
$1,000topersonwhoaskedlocator+

h k dl

$500topersonwhoaskedperson+
+remaindertocharity

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Slide21

Anexample
E=mc2

Real Home Price Index (1890-2006)


200

Index o
or Interest R
Rate

180
160
140
120
100
80
60
1880

1900

1920

1940

1960

1980

2000

2020

Year
Source: Robert J. Shiller, Irrational Exuberance, 2nd. Edition.

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2012byFernandez,Stein,andLo
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Slide22

Thepowerofglobalcapitalmarkets
Whatifwecouldfocusthispowerforgood?
Financialengineeringwitha
Financialengineeringwithaconscience
conscience
Applyexpertisetotacklingsocietysbiggestchallenges
Facilitatecollaboration,collectiveintelligence
Facilitatecollaboration collectiveintelligence
Withtheproperfinancialengineering,webelievewecan
solve thefollowingproblemswithinthenext20years:
1. Cancer
2. Energycrisis
3. Globalwarming
How?
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Slide23

Curingcancer
Cancerisacomplexandgrowingconjointofover200diseases
Manypossiblemechanismsforfightingcancer:
over900drugsandvaccinesbeingdeveloped
Inventoryof20+yearsoflatestagedrugstobefinanced(StewartandNaeymiRad,2010)

Pharma cannotpursuemorethanafew;VCresourcesarelimited
p
R&Dproductivityhasfallenoverthepastfewyears
FDANewDrugApprovals
60
53

Newmolecularentities

totalapprovals

50

Biologicslicenseapplication
39

40
30

35
31

30

29

27

25

24

21

21

18

17

20
10
3

7
3

18

24

21

19

16

15

0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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Slide24

Curingcancer:wouldyouinvest?
Wouldyouinvestinasingledrugdiscoveryproject?
Considerthefollowingstylizedexample:

Investmentpernewcompound$200MM
5%successrate,10 yeardevelopmentcycle
5%successrate,10yeardevelopmentcycle
Netincomeofapprovedblockbusterdrug=$2b/yearfor10years
PV10 (y1120@10%costofcapital)=$12.3b

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Slide25

Curingcancer:wouldyouinvest?
Wouldyouinvestinasingledrugdiscoveryproject?
Considerthefollowingstylizedexample:

Investmentpernewcompound$200MM
5%successrate,10 yeardevelopmentcycle
5%successrate,10yeardevelopmentcycle
Netincomeofapprovedblockbusterdrug=$2b/yearfor10years
PV10 (y1120@10%costofcapital)=$12.3b
SUCCESS:51%=(12.3/0.2)1/10 1
Return:

E[R]=11.9%
FAILURE:100%

Ri k S d dd i i f
Risk:StandarddeviationofannualizedROI:
li dROI 423.5%
%

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Slide26

Curingcancer:wouldyouinvest?
Whatifyouhadtheoptionofinvestingin150newdrug
programsatthesametime?
ROIandProbabilities

Probabilityofatleast5successesis87.4%
ROI(exactly5success)=(5*12.3/30)^0.11=7.4%

MITLFE

Risk

StandarddeviationofannualizedROI
StandarddeviationofannualizedROI=
=423%150)=34.6%

2012byFernandez,Stein,andLo
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Slide27

Curingcancer:wouldyouinvest?
Approved
PhaseIII
Phase II
PhaseII
PhaseI

WD/Sold
WD/Sold

WD/Sold
WD/Sold
/ ld

Approved

PhaseIII

PhaseII

PhaseI

WD/Sold
WD/Sold

WD/Sold
WD/Sold
Approved
Ph
PhaseIII
III
PhaseII
PhaseI

150

WD/Sold
WD/Sold

WD/Sold
WD/Sold
Year 1
Year1

MITLFE

Year 2
Year2

Year 3
Year3

Year 4
Year4

2012byFernandez,Stein,andLo
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Year 10
Year10
Slide28

Curingcancer:wouldyouinvest?
E i
Equity
ABonds

Residual
R id l
InterestPayments

I t
tP
t
A Bonds
Aa
B d InterestPayments

Aaa Bonds InterestPayments

Year1
Year 1
MITLFE

Year2
Year 2

Year3
Year 3

Year4
Year 4

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Year10
Year 10
Slide29

Curingcancer:wouldyouinvest?
Giventhereductioninrisk,debtfinancingisnowpossible!
Defaultprobabilityisdeterminedbytheprobabilityofhits:
Defaultprobabilityisdeterminedbytheprobabilityofhits

$16.8BofAaa debtcanbeissued
Withsecuritization,debtcapacitymaybeevenlarger

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Slide30

ResearchBasedObligations(RBOs)

Business structure of a biomedical megafund SPV


Funds are raised from retail or institutional investors (1) through the capital markets issuance (2) of various types
of debt and equity. These funds are invested in molecules being developed to cure cancer (3). Some funds are
reserved to pay for later clinical development costs and, if required, to cover the first few periods of coupon
payments. The portfolio of drugs is developed over time (4). At any time a compound can be discontinued, move
to the next phase or even two phases ahead based on the results of the trials done. It is also possible that
compounds are sold prior to their FDA approval for marketing if it is necessary to monetize them to cover some
of the fund interest or principal payments. Any com pound that is approved for marketing as a new drug is sold
to a biopharma company. At the end of the life of the fund, all remaining compounds in the portfolio are sold (5).
After bondholders are paid back (6), the residual cash is used to pay back the equity holders (7).

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Slide31

ResearchBasedObligations(RBOs)
Istherecapacity/appetitefrominvestors?In2010:
U.S.bondmarket:$35T
U S b d
k t $ T
Mutualfunds:$12T
Moneymarketfunds:$1T
Norwegiansovereignwealthfund:$537B
CalPERS:$226B
Targetreturnof126publicfunds(2010):8%
T
t t f 6 bli f d (
) 8%
I
In2010,thesizeoftheentireVCindustrywas$176B
th i fth ti VCi d t
6B

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Slide32

ResearchBasedObligations(RBOs)
Howdoesthismodeldifferfromexistingsolutions?
Debtfinancingthroughriskmitigation(comparedto
Debt financingthro ghriskmitigation(comparedto 150companies!)
0companies!)
Industryriskinsteadofsinglecompany risk
Investinginintellectualproperty,notexistingcompanies
Investinginintellectualproperty notexistingcompanies
Investinginearlystageprojects(valleyofdeath),notjustmatureproducts
Capitalstructureofthefundbettermatchesinvestorpreferences
Accesstovastlylargerpoolsofpotentialinvestors
Longtermdebtfacilitatespotentiallylongerinvestmenthorizons
Long termdebtfacilitatespotentiallylongerinvestmenthorizons
Allstakeholdersbenefit(investors,managers,researchers,insurers,
regulators patients)
regulators,patients)
Fundingmechanismcreatesanew,morepowerful,andsustainablebridge
p
betweencapitalmarketsandscience
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Slide33

ResearchBasedObligations(RBOs)
Howwouldvariousstakeholdersbeaffected?
VCs:reducesfuturefinanceriskstotakeonprojectscurrentlyunfunded
VCs reducesfuture financeriskstotakeonprojectscurrentlyunfunded
Biopharma:largersupplyofdrugstodistribute,lowerrisk,greaterliquidity
Drugdevelopmentcompanies:morebusiness,resources,andliquidity
Drugdevelopmentcompanies morebusiness resources andliquidity
Investors:newsupplyofinvestableassetswithlesscorrelatedreturns
Healthinsurancecompanies:newwaystohedgetheirbalancesheets
Healthinsurancecompanies newwaystohedgetheirbalancesheets
Investmentbankers:newbusinessusingexistinginfrastructure,PR
Government
Government,regulators:newopportunitiestoincreaseprivatesector
regulators newopportunitiestoincreaseprivate sector
involvementinthefundingofinnovation;jobs;politicallypopularissue
Foundations:newchannelthroughwhichtosupporttheirgoals
Society: New,faster,cheapercures!

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Slide34

ResearchBasedObligations(RBOs)
Whataresomeofthepotentialchallenges?
Size:managinglargeportfoliosofcomplexR&Dprojectsmayrequirenew
managementandgovernancestructures(e.g.,ManhattanProject)
Centralization:mustpreservethebenefitsofdiversityasscaleincreases
p
y
Capacity:isthetalentpoollargeenoughtomatchthescaleofthisventure?
Complexity:caninvestorsunderstandtherisksandrewardsofRBOs?
p
y
Excesses:ifsuccessful,thepotentialforabusewillalsoincrease
Ethics:howtobalanceprofitmotivevs.socialobjectivesforcures?

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Slide35

ResearchBasedObligations(RBOs)
WithSomeImagination,ThisCanBeAchieved!
Imaginecreatinga$30B
Imaginecreatinga$30BCureForCancermegafund
CureForCancer megafund
Imaginecreatinganadvisoryboardofexperts:
FrancisCollins
FrancisCollins,EricLander,BobLanger,PhilSharp,HaroldVarmus,
EricLander BobLanger PhilSharp HaroldVarmus
CraigVenter;WarrenBuffett,BillGates,JacobGoldfield,BobMerton,
JimSimons,GeorgeSoros,BillSharpe

IImagine10MMhouseholdsinvesting$3,000each
i MMh
h ld i
ti
h
Imaginecorporatepensionfunds,foundations,
endowments,insurancecompaniesinvestingaswell
d
t i

i i
ti ll
Imaginegovernmenttaxincentives,credit
enhancement,etc.(thinkFannieMae,FreddieMac!)
h
t t (thi kF
i M F ddi M !)

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Slide36

Conclusion

Don tDeclareWarOn
Dont
Declare War On
Cancer

PutAPriceTagOnIts
Put
A Price Tag On Its
HeadInstead!

WithSufficientScale,WeCanDoWellByDoingGood
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Slide37

Conclusion
NotToTry?
CanWeAffordIt?
heartdisease,Alzheimers,dementia,
diabetes,obesity,H1N1,energycrisis,
cclimatechange,solarflares
ate c a ge, so a a es

WiththeProper
With
the Proper
Financial Structure,
FinancialStructure,
Anything IsPossible!

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Slide38

ThankYou!