Daily Times

Few falls in business history have been as sudden and as steep as that of Michael Pearson, the C.E.O. of the drugmaker Valeant. Not long ago, he was heading a company whose stock price had risen more than four thousand per cent during his tenure. A former McKinsey consultant, he had developed a strategy based on acquisitions, cost-cutting, and price hikes. The influential hedge-fund manager Bill Ackman, one of Valeant’s largest shareholders, compared Pearson to Warren Buffett, citing his genius at capital allocation. No one’s calling Pearson a genius anymore. In the past six months, Valeant’s stock price has fallen almost ninety per cent, thanks to a toxic combination of sketchy accounting, political blowback, and slowing growth. Two weeks ago, the company announced terrible fourth-quarter earnings, and said that it wouldn’t be able to file its annual report on time, which drove the stock down fifty per cent in a day. Investors who once saw Pearson as a savior now consider him an albatross: when, last week, Valeant announced that he would step down, the stock price rose.

Valeant used to be a small drugmaker, struggling to stay afloat by doing what pharmaceutical companies typically do: invest heavily in R. & D. in order to discover new drugs. But Pearson, who took over in 2008, scrapped that approach. He argued that returns on R. & D. were too low and too uncertain; it made more sense to buy companies that already had products on the market, then slash costs and raise prices. So Valeant became a serial acquirer, doing more than a hundred transactions between 2008 and 2015. It invested almost nothing in its core business; R. & D. spending fell to just three per cent of sales. It was ruthless about bringing down costs, sometimes laying off more than half the workforce of a company it acquired. And though Martin Shkreli may be the public face of drug-price gouging, Valeant was the real pioneer. A 2015 analysis looked at drugs whose price had risen between three hundred per cent and twelve hundred per cent in the previous two years; of the nineteen whose prices had risen fastest, half belonged to Valeant.

The company also pulled every trick in the financial-engineering handbook. In 2010, it merged with a Canadian company, in order to bring down its tax rate, and it sheltered its intellectual property in tax havens like Luxembourg. It used opaque accounting methods that made it hard for investors to judge how well acquired companies were doing. To ward off competition from generic drugs, Valeant entered into a complicated relationship with a mail-order pharmacy called Philidor. Meanwhile, it paid its executives exceedingly well, and tied their compensation to shareholder returns, thus encouraging a single-minded focus on stock price. Valeant embodied practically everything that people hate about business today. So it’s no surprise that much of Wall Street saw it as a profit-making machine.

If Wall Street was happy, what went wrong? There were a couple of contingent problems: the dubious relationship with Philidor made people wary of Valeant’s accounting (the company just announced that it would have to re-state earnings for 2014 and part of 2015), while the political backlash provoked by Shkreli limited Valeant’s ability to raise prices. But the bigger problem was that Pearson’s buy-and-slash approach hit its inevitable limits. Valeant had become what’s known as a roll-up: a company that buys lots of other companies, trusting that they’ll be much more profitable together than they were apart. The challenge for roll-ups is that they have to keep feeding the beast: if you grow by buying, you have to keep buying to thrive. But, the bigger you get, the fewer deals there are that can truly boost your bottom line. And, because your grim reputation precedes you, you end up paying big premiums, which may mean that you have to start borrowing heavily. (Valeant’s debt is almost three times its annual sales.) Not surprisingly, roll-ups have a terrible track record. A Booz Allen study of the performance of eighty-one roll-ups between 1993 and 2000 found that only eleven did better than the market as a whole. Another study found that more than two-thirds of roll-ups created no value for investors at all. The only roll-ups that succeed are those which find, as one study put it, “a fundamentally superior way to make money.” Valeant’s collapse has shown that it had no such ability.

Valeant now says that its roll-up days are over, and that it’s going to focus on expanding its business “organically.” Yet it’s far from clear that this will be possible. For years, Valeant has been less like a drug company than like a super-aggressive hedge fund that just happened to specialize in pharmaceuticals. It made money not by providing economic value to customers but by financial engineering and by gaming the system. It exemplified a corporate era in which financialization too often eclipsed production. And, in the process, it forgot an important truth about markets; namely, that there are few free lunches. Pearson’s promise to investors was, in effect, that other companies would do the work of researching and developing new drugs, after which Valeant could swoop in and reap the enormous rewards without having taken any risk. But this was a fantasy. The attempt to evade risk turned out to be the riskiest strategy of all.