April 23, 2014

Prominent activist investor Mr William Ackman of Pershing Square Capital – famous in Canada for having trounced the board of a company (Canadian Pacific Railroads) top-heavy with establishment figures – has teamed with serial acquirer Valeant Pharmaceuticals International (VRX  on both the NYSE and TSX) to launch a strikingly large and bold $US 45.6 billion bid for Allergan, a cosmetic pharmaceutical company perhaps best-known as the maker of botox. The combined company, to quote Valeant’s CEO would become an “unrivaled pltaform with leading positions in ophthamology, dermatology, aesthetics, dental and emerging markets”.

The bid is, as noted above, striking on several levels. The deal size is effectively the same size as Valeant equity market capitalisation (the company has an enterprise value of slightly over $US 60 billion). The proposed per share price of $152.89 represents a 31% premium to the “unaffected” share price of $116.63 (a statement some risk arbs disagree with) and consists of $US48.30 per share of cash and 0.83 Valeant shares. Valeant believes that it can cut $2.7 billion in costs at Allergan: at a <10% corproate tax rate and a EV/EBITDA ratio of 21x (yes, twenty one times) that could be worth roughly $25 billion. Given this, some risk arbs are holding out for a higher offer.

Secondly, Valeant secured debt financing of $15 billion from one Canadian and one British bank. Presumably they are comfortable regarding the prospects for loan syndication (or have already done so). Valeant also secured a commitment from Pershing Square to buy at least $400 million of Valeant shares (at a discount) and hold them for a year or more in the event that the M&A transaction is consummated.


Thirdly, and perhaps most relevant for a strategy-oriented blog, is the fact that this bid creates a new twist on the classic M&A technique of the “dawn raid”: the process whereby a corporate acquirer would build up a near-10% position in the shares of a target (i.e. just below the public disclosure threshold) before launching a sudden and unsolicited bid. In this instance it was not Valeant acquiring a 10% block but an ally (Pershing Square Capital Management).

Whilst Pershing Square’s resources were topped up with $76 million of cash from Valeant, the reality is that an activist fund amassed a significant stake in a company and then helped broker an M&A transaction. Some observers have suggested that this could constitute a new way (or, given that it has been called a Trojan Horse technique, a very old way) to amass a position in support of a deal whilst also benefiting from material non-public information. In effect one amasses a stake with the intention of tipping the company into play.

In today’s deal market corporations with sizeable cash flows can raise long-term debt at historically low rates. Now they can marry that to the resources of an activist fund. Any disclosure of a 10% stake can leave a board guessing: is it merely to demand corporate change or is it the precursor of a bid?

In fairness to Pershing Square, a 13D filing was made with the SEC when the fund reached 5% (though the partnership with Valeant was not disclosed). Pershing Square could have waited until the 10% threshold to make this filing. On the other hand  there is a legitimate debate about what constitutes material non-public information (Valeant’s desire for Allergan? Pershing Square’s desire to assist Valeant and tip Allergan into play?) and, further, what constitutes the fiduciary duty to the holder of the non-public information.

It has been reported in several reputable newspapers that Mr Ackman originally intended to build a stake in Valeant (which, noting that the shares had doubled over the past year,  hardly seemed a poorly run company in need of the attentions of an activist) and, on visiting management, learned that they had recently been rebuffed in their attempts to buy Allergan. It was at that point that Mr Ackman is said to have proposed the notion of Pershing Square amassing a stake and then backstopping at least $400 million of equity in Valeant.

We believe that this will require CEOs and boards to be substantially more attentive to – and communicative with – shareholders amassing significant positions. They will have to do so within the context of an analysis of the M&A strategies of their industry rivals.


Allergan responded by adopting a shareholder rights plan (a so-called “poison pill”): the one year shareholder rights plan caps ownership at 10% before triggering . It is interesting that this is happening at the same time that Sotheby’s has been locked in a struggle with another activist fund: Mr Daniel Loeb’s Third Point. Mr Loeb has pressed for changes in the art and auction house’s operations and the replacement of three directors; in his typically acerbic manner he branded Sotheby’s “an old master painting in desperate need of restoration”. Third Point was joined in its assault on the venerable auction house by Eton Park and Mercato Capital Management: two other activist hedge funds.

Sotheby’s responded in October with a so-called “low threshold” poison pill: this sets a 20% limit for “passive” investors and a 10% limit for activist investors, though the definitions are sure to be subject to intense scrutiny, interpretation and re-interpretation. The poison pill is only one year in duration but can be renewed at will.

Third Point responded with a court challenge that alleged that this limited their ability to buy shares above 10% and therefore increase its odds of winning the proxy contest over board composition.

The proxy contest is to unfold at the May 6 annual meeting. ISS has recommended that shareholders vote for 2 of Mr Loeb’s 3 candidates, noting that the two (Mr Loeb himself and an investment banker) are well-known art collectors. Rival proxy adviser Glass Lewis & Co has taken a contrary view, encouraging  shareholders to vote against Mr Loeb and noting that Sotheby’s has been proactive in addressing shareholder concerns.

Third Point is also facing off against Sotheby’s in Delaware Chancery Court. Whilst poison pills in the US were developed against corporate raiders, and were upheld as a viable tool for boards of directors to use against so called “asset strippers” (many articles mention Mr Carl Icahn and TWA in this context), their original design (and the jurisprudence upholding them) were not designed for an era of activist investors.

A recent noteworthy and relevant case was Air Products versus Airgas. In 2011 Delaware Chancery Court ruled that a board acting in good faith could put a poison pill in place even if a hostile offer was fair and the shareholders of the company appeared inclined to accept the offer. If the shareholders were violently opposed to this course of action then they had redress through changing the board of directors.

Sotheby’s 10% threshold poison pill is purely designed to ward off an activist fund. If the intention is simply to avoid a change in direction of a firm, and/or change in the composition of a board, then it is harder to argue about the viability of a poison pill, and many observers had suggested that Third Point had a good case to make in court.

Allergan’s low threshold  poison pill  seems set to complicate this as it is designed to innoculate the company against a combination of  an activist fund and a predatory corporate purchaser. It is curious that Sotheby’s had claimed in its defence that its pill was aiming to “protect shareholders from coercive or otherwise unfair takeover tactics”.

We expect this to be an area of intense debate in 2014.


One lesson is that deal-making within a sector seems to spark more transactions, and that M&A can cast a rather clear light on questions of strategic focus.

The pharmaceutical and medical markets have recently seen other significant deals distinctly different in tone and ambition from the Valeant/Allergan situation.

For example GlaxoSmithKline of the U.K. and Novartis of Switzerland announced $25 billion of transactions designed to allow each to focus on core areas of operation. Novartis bought GlaxoSmithKline’s cancer drug business for ~$US16 billion whilst the latter paid ~$US 7 billion for the Swiss firm’s over-the-counter pharmaceutical operations. Novartis also announced a deal with Eli Lilly to sell its veterinary medicine division for ~$5 billion and has furthermore put a flu vaccine division on the block.

In a similar vein, Zimmer Holdings is to acquire Biomet Inc. in a friendly transaction valued of $13.4 billion (cash and shares). The two firms both produce dental, surgical and orthopaedic products. (Inter alia Biomet was acquired in 2007 by a syndicate composed of Blackstone, KKR, Goldman Sachs Private Equity and TPG Capital. They paid $11.3 billion for the firm.)

As is discussed below, Valeant’s value proposition is built around cost-cutting, limited R&D, a focus on a broad array of simple consumer-oriented products in relatively neglected segments and leveraging a low tax rate into M&A synergies. The M&A strategies underscored by the GlaxoSmithKline/Novartis trades are built around investment in new products and strategic clarity.

Within this context Valeant invests about 3% of revenues in R&D and posts a pre-tax return on invested capital of roughly 10%. In aggregate the industry spends 18%-20% on R&D and generates an ROIC that, at almost 30%, is basically three times higher than that of Valeant .

It is therefore fair to argue that there could be significant negative consequences for innovation if the entire pharmaceutical industry adopted Valeant’s approach.

What Valeant may do is help impel moves towards greater sharing and understanding of fundamental research. Some companies  – Montreal’s Sparkup Inc. is undoubtedly the leader –  are building impressive platforms designed to link fundamental research at universities with corporations and investors that can more effectively deploy this research.


This does not mean that it isn’t worthwhile understanding the Valeant case study.

Valeant’s CEO Mr J. Michael Pearson is an ex-McKinsey & Co. consultant with decades of experience in the pharmaceutical sector. Whilst nominally based in a suburb of Montreal (and therefore a beneficiary of Canada’s generous R&D tax credits and generally lower corporate tax regime) the firm is run from famously modest headquarters in New Jersey. (So modest, in fact, that they had been abandoned by the YMCA as being excessively worn and shabby.)

Mr Pearson came to the CEO suite in 2008 after having initially been hired by Valeant as a consultant. The company was then based in California and generated less than 1/6 of its current $6 billion in annual sales. Mr Pearson had blunt advice for the board: cut R&D, abandon crowded markets, focus on unloved segments that were largely consumer-oriented, slash overhead and grow through M&A.

The last point is telling: Valeant’s M&A tally board now runs at $19 billion, a sum that will more than treble if the Allergan deal is consummated.

The transformative transaction was the 2010 purchase of Montreal-based Biovail, which gave the company scale as well as a very low tax rate. Other noteworthy transactions – both successful as well as not – included:

1. Failed bid for Cephalon (2011). Valeant bid $5.7 billion for Cephalon, a biopharmaceutical firm. Cephalon accused Valeant of low-priced opportunism and found a white knight saviour in the form of Teva Pharmaceutical, which paid $6.8 billion for the firm.

2. Natur Produckt International (2012): Valeant paid $180 million for this Russian maker of cold medicines, showing that it had no issue with adventurous geographies.

3. Medicis (2012): In keeping with the consumer -oriented strategy, Valeant spent $2.6 billion to acquire this Arizona skin-care products firm.

4. Failed bid for Actavis (2013): Actavis, a maker of generic pharmaceuticals rebuffed ouvertures from Valeant. The proposal was apparently for a $13 billion all-share transaction. Actavis instead opted to purchase Warner Chilcott for $5 billion in shares.

5. Bausch & Lomb (2013): At $8.7 billion this was the largest deal to date. A private equity consortium led by Warburg Pincus sold the firm to Valeant for $4.5 billion in equity value, and Valeant assumed $4.2 billion in debt.

Valeant’s deal making is apparently best described as decisive. Due diligence focuses on essentials, eschewing the laborious, thorough, time-consuming and costly examinations favoured by lawyers. The company focuses on the major issues. Integration is also meant to move quickly, with Valeant’s culture dominating. Decisions on people are made exceptionally rapidly.

This mindset has clearly worked well in the consumer-oriented and generic segments that have been Valeant’s focus to date. Whether these lessons are applicable to other parts of the pharmaceutical markets – segments wherein effectively harnessing R&D is critical to growth and profitability – is rather more open to debate.