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Pharma M&As: value creator or value destroyer?

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Anil Khanna, Partner, Tai Pi Advisors analyses the trend of rising M&As in the pharma industry and examines its causes and implications

Anil Khanna

What is it with M&As that they make the adrenalin skyrocket, or generate a strong urge to ‘go for the kill’? Perhaps a burning desire to be a leader or eliminate the competition, or is it just the ‘sex appeal’? What makes companies/ people to focus on the ‘price’ of a particular acquisition, than what is its true ‘worth’? While there is no conclusive view on their success, M&As continue unabated. It seems that the pharma industry is probably following the advice of Mario Joseph Gabelli – an investment advisor, financial analyst and Chairman of Gabelli Asset Management Company. He says, “How do you make money? Spinoffs, split-ups, liquidations, mergers and acquisitions”.

Before we go into the drivers of M&A in the pharma industry, let’s take a look at the M&A activity in 2015, both globally and in India.

The cumulative deal value doubled in 2015 largely due to the announced acquisition of Allergan by Pfizer. This mother-of-all deals worth $ 160 billion skewed the data significantly.

Figure 1: 2015 overview

However, the unexpected significant tax regulatory changes introduced by Obama’s treasury administration have killed this deal for the moment. The deal was primarily based on the logic of escaping higher taxes in the US (a process called inversion). However, the abrupt change in the rules made no sense at all, with the tax benefits evaporating completely. It left many people agitated due to the change of rules in the middle of the game. Wall Street experts are saying that it’s the failure of the leadership at the treasury department.  In fact, it can possibly be called the ‘Vodafone moment’ of the US government, as the rules were changed specifically to kill this deal!

However, with the exclusion of the Pfizer-Allergan deal, the number and value of deals between the US and Western Europe went down in 2015, and much less money was spent on targets located in Western Europe, as compared to 2014, largely due to a wave of ‘tax inversion’ deals in 2013 and 2014.

In the Indian market too, 2015 saw an increase in M&A activity, with value of deals reaching $3.7 billion. Of this, outbound deals contributed around $2 billion, largely due to generics consolidation in the US market. The biggest deal was acquisition of Gavis Pharma and Novel Labs by Lupin for $880 million. Here Lupin, took debt in the US market in the foreign currency, and gave corporate guarantee backed by the parent company, since the US subsidiary’s balance sheet wasn’t big enough to justify such a huge loan. Much earlier, Wockhardt had also taken a similar route. This route enabled the Indian company to take a low cost foreign currency loan and also avoid all the risks on account of currency movement or the change in business movement. These deals were valued at 16 times EBITDA multiple. Again some analysts felt it was a high price!

The other notable deal in the Indian market was acquisition of InvaGen Pharma and Exelan Pharma by Cipla for $550 million, valued at 2.4 times in trailing twelve months (TTM) June 15 revenue. As in the case of Lupin, this all cash deal, would be largely funded by its own cash accruals.

Increasing valuation?

Another interesting point is that apart from a growing number of M&As in the pharma sector, the valuation of the acquisitions are also on the rise. Check Figure 2, which shows the pharma EBITDA multiples for the last 10 years, explains this point succinctly.

Figure 2: Increasing valuation of M&A deals

Who is to be blamed for this phenomenon? Company CEOs or the investment advisors? As, Warren Buffet once said, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from the people who take subway.” Sure investment advisors stand to gain from higher valuations, and may shift from the subway to  a limousine for themselves! But it shows the desperateness of the pharma industry as well.

India also saw one well-known case of over paying, and that was acquisition of Piramal domestic formulation business by Abbott at 9x revenue of nearly Rs 2000 crores (excluding the OTC business) in 2010. Analysts were of the opinion that the price was too high, as among the 400 odd brands portfolio, there was a long tail of brands with revenue of less than Rs five crores, and 9x sales multiple wasn’t justified for these tail brands. It was clearly felt that Abbott was desperate to do this deal to catapult to the No.1 position in the Indian domestic formulations market. But, it will take many years for Abbott to recover the investment it made.

What are the drivers of pharma M&As?

There are typically four strategic imperatives for the pharma companies, leading to possible M&As. (Check Strategic imperatives on page 18)

Strategic imperatives 1: Improve R&D Pipeline


In these cases, the bigger company brings its capability to find the best R&D technology, fund it and handle regulatory issues, while the innovator company helps complement the product portfolio or assist in salvaging the sagging sales of some products

Strategic imperatives 2: Market Share


In such cases, the benefits are optimum capacity utilisation of the acquired company, more dominant presence in the markets that they are present, and good quality at low-cost.

Strategic imperatives 3: Improve Product Portfolio


Here the rationale is to provide comprehensive solutions for a particular therapeutic area and that therapeutic segment is large enough to justify the price.

Strategic imperatives 4: Increase market access through consumer oriented brands


The focus is on marketing consumer products with a medical claim and leveraging their superior consumer marketing and branding prowess

In fact, the portfolio deals, (as mentioned in Table 1 on page 20), would be the flavour going forward for several years, and we may see more of such deals in future. Novartis clearly showed the industry a new way to deal making in 2014  through a three way swap between Novartis, GSK, and Eli Lilly.  In one stroke it strengthened Novartis’ position in oncology, GSK’s in vaccines and created a JV in OTC, and relieved Novartis of its unwanted animal health business, which went to Eli Lilly.

Table 1: Some of the key portfolio deals in 2015

The idea is to sell sub-critical businesses to other players who can manage it better and vice versa.

Tax inversion – a major ‘financial’ deal driver

It’s not something which is new. It has been in vogue since 1982. The first major inversion took place in 1982, when New Orleans construction firm McDermott shifted to Panama, switching its corporate headquarters to the Central American country and slashing the tax rate on its earnings.

Figure 3: Number of deals involving ‘tax inversion’ during previous years

Pharma companies have used this method very often, leading to strong protest (Check Figure 3, Figure 4). The US President, Barack Obama has called such companies ‘corporate deserters’ who are being ‘unpatriotic’ by seeking to reduce their contribution to the US coffers.

Figure 4: The tax saving is quite significant

What’s next for Pfizer now?

Whatever options Pfizer may choose to make, one thing is for sure – it doesn’t have the option of standing still. It either grows or splits.

While Pfizer has announced that by the end of this year it will take a decision to split the business in two parts – “innovative and established businesses”, experts do not believe it completely.

Already people are talking of acquisition options like Shire, GlaxoSmithKline and AstraZeneca. Incidentally,  shares of all these companies   gained value after the announcement of the collapse of Pfizer – Allergan deal.

Whatever strategic routes Pfizer may choose to take – split or acquire, one thing is for sure – future deals by Pfizer can’t be ruled out. Even if it decides to split, it will be looking at acquisition opportunities in the form of companies with innovative product pipelines. It’s simply the law of numbers – when you are this big, you have to keep demonstrating that you have the guts to keep doing new things and continue to hold the pole position that you have now. So, expect the deal-street to continue buzzing!

Do pharma M&As always work?

Despite these strong strategic imperatives and a wave of M&As, there are numerous cases where pharma M&As not working out as anticipated.

It is an accepted fact that more than 80 per cent of mergers do not increase shareholder returns and have a failure rate of between 50 per cent and 85 per cent.

Similarly, slightly dated findings from Burrill & Co on the biotech industry highlighted the same point.

The study analysed that on December 31, 2000 the combined market capitalisation of 17 of the industry’s most active acquirers was $1.57 trillion.

When the combined value of the acquisitions these companies completed during this time, $425 billion, is added, close to $1 trillion in value has been lost during the last decade.

So there is enough proof that large numbers of deals don’t create anticipated value. Deals may go wrong in so many ways, ranging from adhocism, to inadequate due-diligence, to nature of the business (being a regulated sector, government policy changes can impact the outcome of the deal),to clashing cultures, to distracted leadership and any other submerged issues.

For instance, Dr. Reddy’s Laboratory acquisition of Betapharm didn’t prove to be successful. The issue here wasn’t the price (though some analysts felt otherwise), or the funding. DRL had enough funds to finance the deal and then take part-debt. However, since acquisition, Betapharm revenue has been on a decline. The problem, of course, had nothing to do with DRL. Within months of the acquisition, the German government changed its procurement policy, shifting to a tender-based system for a substantial number of drugs. This reduced drug reference prices. So, what was aimed at securing access to the second-largest generics market after the US turned into a liability. Hence regulatory environment, not in the company’s control, can mar the deal as well.

Similarly, acquisition of Piramal by Abbott and that of Ranbaxy by Sun Pharma had cultural and people issues. Both Ranbaxy and Abbott had  the ‘MNC way of working’, which made integration difficult. Likewise, many Ranbaxy people chose to quit rather than opting to work with the merged entity.

Daiichi’s acquisition of Ranbaxy got tricky due to inadequate due – diligence. Daiichi simply didn’t go deep, and after the acquisition, plants and manufacturing related skeletons started to tumble out.

Figure 5: Pharma companies pursue M&As with less senior people involvement

An analysis by McKinsey highlighted two key points for pharma M&A failures – lack of involvement of senior people, and absence of standardised processes and guidelines (Check Figure 5 and Figure 6).

Figure 6: Pharma companies rely less on standardised process and guidelines

So it’s apparent that in their hurry to do M&As, pharma companies are probably not giving adequate attention to various aspects of mergers and integration, be it sound strategies, focusing on the ‘price of the target’, rather than the ‘fair worth of the target’, or the lack of well laid processes and guidelines for post deal integration, or cultural issues. Hence, the success rate of pharma mergers, in terms of value creation, hasn’t been very good.

It would be interesting to close this article with an old statement by Donald Trump. Though he has been in the news for making some very radical statements in his quest to become the US President, but he was probably spot-on when he said, “Sometimes your best investments are the ones you don’t make”.

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