Rhyming or Repeating?

M&A volume is up substantially in 1H14. Some are worried the market may be overheating just as it did prior to financial crisis in 2006 and 2007. My view is this market is in a different stage than the 2006-2007 period. M&A has been depressed following the crisis. Current activity appears more like a return to normal than overheating. Keep in mind, the stock market increased over 30% last year while M&A was flat. The two are usually correlated.

Especially interesting is the increased activity of activist and hostile bids. In fact we are seeing a potentially new development of a combined activist-hostile bid with the Pershing Square-Valeant-Allergan Drama. Shareholders are putting increased pressure on management to do something. You survived the crisis-now do something beyond share repurchases with our excess cash. Thus,they are positively reacting to many announced deals. This factor plus an improving economy, cheap debt and a rising stock market are contributing factors.

Additional observations include:

1)   Deal Quality: deal quality is high. It is primarily larger consolidating and synergistic industrial transactions like 1990s versus the 2006-2007 private equity going private transactions. The deals are concentrated in the telecom and healthcare industries which are undergoing structural changes.

2)   Financial Structure: although debt remains plentiful and cheap strategic acquirers are primarily funding transactions with equity. The percentage of debt financed cash deals has fallen from over 65% in 2006-2007 to around 45%. This helps lower deal risk as sellers are participating in the future prospects of the new entity, and leverage levels remain modest. Sellers are willing to accept buyer stock given increased confidence in markets. They see the potential for a double dip price increase for an appreciating buyer stock post close.

3)   Private Equity (PE): LBO activity remains far below its 25% pre crisis percentage of total M&A. This reflects current high M&A prices and stiff competition from strategic buyers who have better synergy prospects than PE. PE has responded by using increased leverage to help offset higher purchase prices.

Of course, things can change quickly. The impact of the unwinding of the Fed’s quantitative easing program remains an issue. PE, with its large level of dry powder, could become more aggressive and drive up prices and debt levels. Thus, caution is warranted and disciplined bidding is needed by both strategic and PE acquirers. Nevertheless, the current market feels like it is in the early growth phase-not the later overheated stage. History appears to be rhyming - not repeating the overheated 2006-2007 period at this time.

j

Build or Buy: Deconstructing the Big Pharma Value Chain Thru M&A

Industry changes drive M&A. Currently, we are seeing a plethora of deals in the big pharma industry. Traditionally, the industry utilized a Vertically Integrated business model. The model combines the various links in the Value Chain within each firm including early stage R&D, sales and marketing, manufacturing, and distribution. Early stage R&D is high risk and expensive (more than 15% of annual revenues in some firms). The search for blockbuster drugs to justify such investment has become difficult given many former winners going off patent and weak development pipelines. Consequently, big pharma margins have suffered.

Early stage R&D relied on a big firm’s ability to fund the needed large expenditures. This has become more problematic given the weak governance and incentive structures in large bureaucratic firms. Consequently, firms have been considering alternative funding arrangements. Instead of developing drugs internally, they buy the new drugs from better suited smaller entities thru licensing, joint ventures or acquisitions. These early stage Incubator type firms would be funded by Venture Capital, Private Equity or Hedge Funds. This would allow big pharma to focus on its core competencies. Thus, the question or bet is what is the most efficient structure to undertake early R&D- in house or buy?

This question is at the heart of the recently announced $40B+ Valeant-Pershing Square  hostile joint venture buy-in for Allergan. Valeant's business model is based on buying versus developing new drugs-primarily thru acquisitions with Allergan being the largest by far. Valeant’s R&D expenses to revenues ratio is only 3%. Their stock price has increased 9 fold since the current CEO arrived in 2008 and embarked upon a serial acquisition program. The current bid despite being over 20X EBITDA promises to be minimally dilutive based on the large amount of R&D and SG&A cost savings planned.

Allergan uses the traditional integrated model. Its R&D to revenues ratio is 17% (almost $1B LTM). It also has a top heavy $2B+ SG&A cost structure characteristic of vertically integrated firms. Its stock had stagnated over the past years. The Valeant bid equals a price Allergan has not seen since 2008. It reflects the large strategic value gap inherent in Allergan based on its current strategy and asset combinations.

Allergan is expected to resist the offer. It has a Poison Pill, and is expected to seek possible white knights like Johnson and Johnson. If those fail, then it may embark an acquisition campaign of its own to make itself too big and ugly to buy like Jos A Bank tried. Valeant and Pershing established a significant 9.7% Toehold to cover the downside of losing he bid. How they accomplished this is an interesting application of good Lawyering.

Industry disruptors like Valeant are employing new business models to rapidly reconfigure industries undergoing structural change. They accept the change while targets resist change. Ultimately, history is on the side of change not resistance. Early stage drug R&D will continue. The questions is how and who will perform it.

 J