Bill Ackman has a reputation for being one of the smartest guys on Wall Street and for making a lot of money for his clients through his Pershing Square hedge fund. After graduating from Harvard Business School, Ackman entered the investment management business in 1992. Since that time his successful trades have included a short of mortgage insurer MBIA before the financial crisis began and heavily investing in the restructured mall owner General Growth Properties.
One trade that did not go Ackman’s way was his bet on Valeant Pharmaceuticals in 2015. Ackman has now finally sold out of his entire position at an enormous loss of about $4 billion. What went wrong and how could such a smart investor make such a poor investment?
Valeant is a pharmaceutical company with roots that stretch back to the 1960s, but which for years did not have a compelling amount of profits. The foundation for a corporate transition was laid in 2006 when hedge fund Value Act purchased $200 million worth of the company’s stock. A year later, it was influential in installing Michael Pearson, a McKinsey consultant, as the new CEO.
Pearson set to transform Valeant by running the company in a more business-like manner than he thought other pharmaceutical companies were typically run. Pearson often criticized the large research and development budgets at other places as not being well-thought out to maximize shareholder value. Rather than try to churn out drugs from internal research, Valeant would acquire other companies and their drugs after their prospects could be more easily ascertained.
Pearson made other shareholder friendly moves as well. Among the first was purchasing Biovail, a Canadian corporation, and reincorporating all of Valeant post-transaction in Canada. The move let Valeant funnel a substantial amount of profits through off-shore entities and reduced its effective tax rate to less than 5%. The purchase also set the stage for the Valeant’s modus operandi in integrating acquisitions – cut costs to the bone, including research and development and thereby boost short-term income.
As the pressure intensified to continue driving up the stock price, Valeant began expanding into other forms of financial engineering. This included buying individual off-patent drugs without competition and then taking enormous price increases. Since the drugs were generic, theoretically the higher prices would attract more competition, but since the generic approval process at the FDA can be length, Valeant knew that they had a window to charge virtually any price it wished – and it did.
The unwinding of Valeant may have occurred when it set it sights on Allergan – a large pharmaceutical company that makes products such as Botox. Allergan resisted Valeant’s advances, which sparked the entering of Bill Ackman into the story. The company and the hedge fund manager teamed up to pressure Allergan to sell and Ackman’s fund purchased large amounts of Allergan stock. When the deal fell through, Ackman was so impressed with Pearson that he re-invested the proceeds from selling his Allergan stock into Valeant at a price of about $170 per share.
Almost immediately, things started going very bad for Valeant. They were criticized sharply for the price increases and tax shelters and company executives were hauled before Congress to testify. But, the smoking gun that really altered the direction of the company was revelations about its relationship to a mail-order pharmacy named Philidor. Valeant had purchased Philidor, but kept the acquisition of its books and gave the appearance of an arms-length relationship by carefully crafting the acquisition. Valeant used the pharmacy to steer patients to expensive, branded products primarily in its dermatology business.
What cannot go on forever, always ends. And Valeant’s strategy of constantly acquiring and then slashing expenses at companies could only go on for as long as they had companies to purchase and access to the capital markets to purchase them. Once that cycle ended, Valeant was left with $30 billion in debt and a weak pipeline from neglecting R&D expenses.
Valeant has been trying to sell assets to work down the debt load and Ackman has said he still thinks the stock could double, but was too much of a distraction for his firm. While that strikes many as an odd statement, the lessons from Ackman’s trade are numerous. Investors should carefully consider the business model of a company they invest in and determine its sustainability as well as scrutinize the incentive structure employed by the company.
As for Ackman, after a bruising trade, he will for sure be back and unlikely to make the same mistake again.