[Ip-health] FT (The Big Read): Valeant: The harder they fall

Thiru Balasubramaniam thiru at keionline.org
Tue Mar 29 05:23:29 PDT 2016


March 28, 2016 7:26 pm

Valeant: The harder they fall

David Crow

The chief executive believed the drugmaker should be an acquirer, not a
target. Now it has to pay off its debt

In the spring of 2014, as the drugs industry was gripped by a dealmaking
frenzy, executives from Pfizer sat down for dinner with their counterparts
at Valeant, the fastest-growing company in the sector.

At some point during the meal, the executives from Pfizer, the world’s
second-largest pharmaceuticals group, raised the idea of buying the
Canadian company, according to people briefed on the negotiations. At the
time, Mike Pearson, Valeant’s chief executive, was earning plaudits for a
four-year streak of growth in which the company’s market value rose almost

People close to Pfizer say the discussions were tentative but they were
sufficiently serious to warrant consideration by Valeant’s board. Some of
its directors and investors, reflecting on the rapid growth under Mr
Pearson’s leadership, thought it was time to sell while they were ahead. If
they had, the Valeant story might be quite different.

Instead, just two years later, Valeant finds itself fighting for survival.
Its shares have crashed after the company uncovered accounting
irregularities, warned of a potential default on its $30bn of debt and
revealed it is under investigation by the US Securities & Exchange

Investors have lost billions: Bill Ackman, the hedge fund tycoon who is one
of the company’s largest shareholders, suffered a paper loss of more than
$1bn on his Valeant stock in a single day this month. Pershing Square, his
hedge fund, is down roughly 25 per cent so far this year, in large part
because of his big bet on the drugmaker.

Last week, Mr Pearson paid for the crisis with his job.

“Everything is coming home to roost,” says David Maris of Wells Fargo, one
of the few analysts who advised investors to sell Valeant shares. “It was
heralded as a new type of company, with a new type of CEO, but to me it has
always looked like a child of the 1980s — acquiring assets, and then
stripping down.”

Mr Pearson opposed selling the company in 2014, according to a person
familiar with the matter, and instead focused his energies on an ill-fated
attempt to buy Allergan, the maker of Botox. When that pursuit failed, he
switched his attention to other deals and took on more debt to fund them.

For a while, his decision not to sell was vindicated: last summer, the
company reached a market valuation of roughly $90bn, more than some of the
best-known names in pharmaceuticals, such as GlaxoSmithKline, and about
double the level when it held talks with Pfizer.

Proof of concept

At Valeant, Mr Pearson was able to put into practice the theories he honed
during his 23 years as a management consultant at McKinsey, where he
regularly offered advice to large healthcare groups. The playbook was
simple: buy rival companies, cut the research budget, raise the price of
their medicines, fire their scientists, repeat.

“We used to have Mike in here all the time,” recalls an executive at a
large US drugmaker, who says Mr Pearson sometimes expressed frustration
that companies did not act on his advice.

When he got the chance to implement the strategy in real life, it appeared
as though he had been right all along. Some pharmaceutical executives say
their investors started to ask whether they should not be more like Valeant.

With the benefit of hindsight, a few large Valeant investors say they
always had misgivings. “Valeant has been one of those companies where you
could see the writing on the wall, but you have to wait until performance
suffers before you can act,” says a large shareholder.

Yet for others, the company appeared as though it was a Wall Street dream
come true. Like the chief executive, many of the top brass hailed from
McKinsey , while Howard Schiller, chief financial officer from 2011 until
last summer, spent 25 years as an investment banker at Goldman Sachs. Two
of the best known names in activist investing — Jeff Ubben’s ValueAct and
Pershing Square — were shareholders.

As Valeant grew larger, its ties to Wall Street became stronger. From 2013,
it generated $400m of fees for investment bankers, whose analyst colleagues
pumped out research advising investors to snap up the shares.

But last summer marked the end of the good times . Short-sellers, who
profit from driving down a company’s shares, started questioning Valeant’s
financials and asked whether it was “Enron, part deux” — a reference to the
fraud-ridden energy company — while politicians lambasted it for “gouging”
customers with big rises for the price of its drugs.

Short-sellers zoned in on the drugmaker’s relationship with Philidor, a
chain of mail order pharmacies that Valeant controlled through a $100m
option agreement it had kept hidden from investors. The company denied any
wrongdoing, but has since admitted it improperly accounted for about $80m
of sales made through the pharmacies.

Valeant booked sales when its products were delivered to Philidor, rather
than waiting for the drugs to be dispensed to patients, as it should have
done. To compound matters, it double-counted some revenue when the products
were sold to the customer.

The $80m is a relatively small figure in the context of the $2.8bn of
revenue that Valeant made in the fourth quarter of last year, but as one
large investor puts it: “It’s not the dollar amount — when management does
something like this, you’ve got to blow them out.”

US authorities, including the SEC and two state attorneys-general, have
opened investigations into Valeant.

‘Tone set at the top’

Over Christmas, Mr Pearson was hospitalised with pneumonia. Mr Schiller,
the former finance director, stepped in, and friends said he hoped he would
secure the position permanently. But after two months of sick leave, and
much procrastination among Valeant’s directors over whether to reinstate
him, Mr Pearson returned to the company this month.

An internal probe into Philidor was taking longer than expected, preventing
the group from filing its annual earnings statement with the SEC. Mr
Pearson cancelled an earnings release, already twice delayed, scrapped
profit targets for the second time in five months and tried to plot the
company’s comeback.

As second acts go, it could not have been more disastrous. During a
conference call with analysts and investors two weeks ago — Mr Pearson’s
first public outing since coming back — Valeant raised the prospect that
the company might default on its debt, bungled the release of new, lower
profit targets and admitted that several core franchises were
underperforming. Its shares lost 50 per cent of their value in a single day.

With that, Mr Pearson sealed his fate. “The chief executive of the company
had presided over a complete loss of confidence,” says one big shareholder.
“Mike had to go.”

Valeant has tried to hit the reset button before, but it has attempted
nothing as drastic as it did last week. As well as announcing the
appointment of Mr Ackman to the board and the departure of Mr Pearson, who
is staying on during the search for his successor, the company blamed its
accounting problems on Mr Schiller’s “improper conduct” during his tenure
as CFO.

Mr Schiller was blindsided by the public accusation, according to people
close to him, but responded to the claims with a strongly worded denial. He
has resisted requests from Valeant’s directors to resign his seat on the

The attempt to defenestrate him is partly down to a tussle between Valeant
and its auditor, PwC, which is reluctant to sign off the annual accounts
unless somebody is blamed for providing it with erroneous figures,
according to people briefed on the negotiations. Given that Valeant
misstated revenues for two separate quarters, there are a series of
financial statements that, in the company’s own words, “should no longer be
relied on” — and many of them bear a stamp of approval from PwC.

Unless Valeant files the annual report by the end of next month, its
lenders could call a default on part of its debt. The company says it is
confident it can meet the deadline but is still seeking a waiver from the
banks. Creditors say they are likely to grant one, since they have little
incentive to pull the plug.

Most striking was the company’s repudiation of its hard-charging culture.
Valeant said the “tone at the top of the organisation” and the “performance
based environment” with targets that were linked to pay “may have been
contributing factors in the improper revenue recognition”.

It was a remarkable admission for a company that had lauded its
compensation plan as one of the best examples of aligning a chief
executive’s interests with those of shareholders. ValueAct, the hedge fund
which helped design the scheme, had repeatedly boasted of its involvement.
Over the past year, Mr Pearson’s net worth, which comprises predominantly
Valeant shares, has plummeted from more than $1bn to an estimated $175m.

After last week’s “reset”, shares in Valeant staged a rally but they gave
up their gains on Monday following news that Mr Pearson had been subpoenaed
to appear before a Senate committee on drug pricing. The rally had given
some investors hope that the worst was over, though its equity value of
$9.1bn is almost a tenth of what it was worth last summer. Valeant’s
supporters argue it will be relatively simple to find a new chief
executive, while the investigation into Philidor is almost complete and has
not yet uncovered further problems. “It’s an easy fix,” says one investor.

‘A syllogistic fallacy’

Yet even if Valeant finds a new chief executive and files audited accounts
with the regulator on time, many say it still faces an existential crisis.

“The problem is the whole company is built on a syllogistic fallacy,” says
Mr Maris, referring to Valeant’s belief that it can succeed in
pharmaceuticals without finding new medicines. “Telling a drug company not
to invest in research because it can be unproductive is a bit like telling
an oil prospector not to waste their time digging holes.”

Mr Maris says many of the tricks in Mr Pearson’s playbook no longer work.
The company, already groaning under its debt, will be unable to embark on
another deals spree, while price hikes of the size it used to rely on are
now politically impossible. Having refrained from investing in its in-house
research, it has no blockbuster drugs in its pipeline.

Most pressing is Valeant’s $30bn of outstanding bonds and loans, which now
dwarf the company’s market capitalisation. Aside from the urgent issue of a
technical default, the company has a punishing repayment schedule in the
coming years. In 2018, it will have to pay almost $4.5bn, rising to $8.4bn
in 2020.

“The bond guys hold all the cards now,” says Jim Sanford, a portfolio
manager at Sag Harbor Advisors. “It’s not just about avoiding a technical
default — they’re going to have to start selling things that are dilutive
to earnings just to meet their debt requirements.”

While even Valeant’s biggest detractors concede it is not the second Enron
— its drugs are still prescribed in large numbers — this is scant comfort
to investors who have lost billions.

David Pyott, the former Allergan chief executive, compares Valeant not with
Enron but to Tyco, the security systems company that blew up after a
decade-long buying spree. He first made the comparison while fending off a
hostile bid from Valeant. “I think the Tyco analogy is much better,” Mr
Pyott says now. “Most of it gets parcelled up in pieces to be sold off, and
all that’s left is a rump.”

Additional reporting by Stephen Foley

Consultancy connection: Pearson brought McKinsey ethos and staff to Valeant

Mike Pearson was offered the job of Valeant chief executive in 2010 while
he was working for McKinsey as consultant. The board invited him to deliver
a presentation, in which he argued the company should merge with Biovail, a
Canadian company that “had a great tax rate”.

Shortly after Mr Pearson was hired, he completed the merger, securing one
of the lowest tax rates in the industry, allowing him to squeeze maximum
profits from the string of deals he would go on to complete.

The philosophy he honed at the consultancy underpinned everything he did at
Valeant . “Our strategy is basically the education I had through McKinsey,”
he said in 2014.

Years after Mr Pearson took the top job at Valeant, he still sought advice
from people he knew at McKinsey, where he had spent almost 25 years, and
repeatedly turned to former colleagues to fill the senior ranks at the

Last year, he tapped up Robert Rosiello, a 30-year McKinsey veteran, to be
the chief financial officer. As senior partner in charge of McKinsey’s
merger practice, Mr Rosiello had worked on many of the deals that reshaped
the sector.

Ari Kellen, who joined Valeant’s executive team in January of 2014, was
another old hand from McKinsey, where he’d worked for 22 years. Ryan
Weldon, who left Valeant in 2014, hailed from the management consultancy

The McKinsey connection extended beyond the executive suite and into the
boardroom. Ronald Farmer, appointed to the board in 2011, is director
emeritus of McKinsey, where he spent 24 years.

Mr Farmer was part of the committee that awarded Mr Pearson his pay
package, which Valeant recently identified as a catalyst for its problems.

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