MAY 2015 VOL. 33 / NO. 5 CAPITAL ALLOCATION IN THE AGE OF ... · 'Growth Pharma'" — "The Pink Sheet" DAILY, November 17, 2014.) Fireworks aside, Valeant Pharmaceuticals and Pershing

MAY 2015 VOL. 33 / NO. 5www.PharmaMedtechBI.com

OrthOpedics

Arthroplasty Physicians Trade Views If Not Blows At World Congress BY AshleY Yeo

BiOpharma Q&a

Rossetti Sets A High Bar At Merck Serono BY Chris Morrison

intellectual prOperty

The Patent Is Dead; Long Live The Royalties! BY BAsAM nABulsi And erik PAul Belt

Venture capital

New NEA Fund Could Bring $1 Billion To Health Care BY toM sAleMi

INSIDE

▼ ONLINE ExcLusIvE

AAOS 2015: Hey Big Spender – Spend A Little More Time On EBM

CAPITAL ALLOCATIONIN THE AGE OF

SHAREHOLDER ACTIVISMBY JEFFREY GREENE AND ELLEN LICKING

Maybe no company is safe from activists, but there are protective measures that managers and boards can take. What biopharmas can learn from Valeant Pharmaceuticals

and Pershing Square’s pursuit of Allergan.

2 | May 2015 | IN VIVO: THE BUSINESS & MEDICINE REPORT | www.PharmaMedtechBI.com

BIOPHARMA STRATEGIES

• Valeant and Pershing Square’s pursuit of Allergan represents an important case study in the changing face of biopharma shareholder activism – size and performance no longer offer the protection they once did.

• The bigger the difference between a company’s market value and its intrinsic value, the greater the risk of activism.

• To protect themselves, compa-nies should continually reassess their capital allocation priorities, cost structures, and balance sheets via an integrated ap-proach that minimizes the po-tential difference between mar-ket value and intrinsic value.

• The authors recommend five steps for companies to build into their ongoing strategic planning initiatives.

BY JEFFREY GREENE AND ELLEN LICKING

CAPITAL ALLOCATIONIN THE AGE OF

SHAREHOLDER ACTIVISM Maybe no company is safe from activists, but

there are protective measures that managers and boards can take. What biopharmas can learn from Valeant Pharmaceuticals and Pershing Square’s pursuit of Allergan.



April 21, 2014 started out like any other beautiful day in Southern Califor-nia. Despite a Monday packed with meetings, Allergan Inc.’s longtime

chairman and chief executive officer, David Pyott, took a break around noon to stop by the employee cafeteria and grab lunch.

It was the quiet before the storm.Approximately one hour later, Pyott and

his senior team learned of two SEC filings that put Allergan in the crosshairs of both a shareholder activist, Pershing Square Capi-tal Management LP, and a hostile acquirer, Valeant Pharmaceuticals International Inc. On April 22, Valeant, which had previously expressed interest in buying Allergan, went public with a $47 billion offer for the Irvine, CA-based specialty pharma company.

“It felt a bit like December 1941,” Pyott recalled in an interview nearly one year later.

The war of words, fought largely via attack-style PowerPoint decks, press releases, and lawsuits, would last roughly seven months. Along the way, Valeant Pharmaceu-ticals raised its offer price three times to a high of roughly $60 billion, complained to US and Canadian regulators about Allergan’s “misleading” statements, and filed a lawsuit demanding a special shareholder meeting to vote on the proposed merger.

Allergan waged its own campaign to win the hearts and minds of investors. Thanks to a cost-cutting campaign named Project En-durance, and ramped-up guidance, it vowed to more than double its adjusted 2013 earn-ings per share by 2016. Allergan also filed a lawsuit alleging Valeant and Pershing Square committed securities fraud, and it ultimately orchestrated a successful white knight bid by Ireland-based Actavis PLC. (See "Actavis To Pay $66 Billion For Allergan, Establishing A 'Growth Pharma'" — "The Pink Sheet" DAILY, November 17, 2014.)

Fireworks aside, Valeant Pharmaceuticals and Pershing Square’s pursuit of Allergan represents an important case study in the changing face of biopharma shareholder activism. In an environment where activists can attract passive institutional investors and join forces with would-be strategic ac-quirers, size and performance no longer offer

the protection they once did. “Five years ago, people considered Big Pharmas too large for real activism. That sentiment feels less true now,” notes Alex Denner, PhD, founder and chief investment officer of the activist fund Sarissa Capital Management.

Indeed, the Allergan saga underscores how vital it is for companies to optimize their capital allocation strategies and operational performance before underperformance trig-gers activist involvement. Simply put, “good enough” capital management is less relevant if shareholders believe more could be done. One way to think about it: the bigger the difference between a company’s market value and its intrinsic value, the greater the risk of activism.

We believe the following five questions provide a helpful framework as companies proactively assess their capital allocation and business performance:

1. Does the company have the right overall cost structure?

2. Are portfolio businesses worth more together than they are apart?

3. Are current capital allocation decisions financially and strategically aligned with the company’s mission?

4. Given the close linkage between R&D and long-term value creation, are R&D investment decisions rigorous, consis-tent, and well-articulated?

5. How open are communications with shareholders, especially the institutional investors that vote shares?

By asking these questions, management teams can preemptively challenge internal assumptions about value creation with an external perspective. They can also ensure the company’s overall strategic priorities are closely linked to its financial capabilities, driving a return on invested capital.

Such a worldview may seem quaint in a time of high valuations, cheap debt, and rapid growth. But even during these good times, many of the biggest companies in the sector are experiencing a slowdown in revenue growth relative to the industry over-all. (See "Biopharma M&A In An Era Of Elusive Growth, Capital Triage, and New Competitors" — IN VIVO, June 2013.) Moreover, execution risks have grown with the emergence of new competitors and reimbursement pres-

sures, even as flush balance sheets make it easier for companies to be less disciplined in their deployment of capital. For companies that successfully acquired other biopharma firms in the past 18 months, there is also increasing pressure to deliver on promised synergy targets.

Companies should recognize that share-holders are now demanding greater trans-parency on a range of issues, from growth prospects to drug pricing policies. In such an environment, it’s not hyperbole to suggest that one significant managerial misstep can open the door to activism.

WHAT’S DRIVING LIFE SCIENCES ACTIVISTS?It isn’t difficult to understand why David Pyott was “very surprised” to find Allergan the target of an activist. Revenues in 2013 grew nearly 12% year-over-year, while the company’s total shareholder return jumped nearly 93%. Based on those metrics, not many would have labeled Allergan an “un-derperformer” in April 2014.

True, the drug company may have been overly dependent on its flagship product, Botox (onabotulinumtoxinA), which ac-counted for 32% of its 2013 total sales. Still, the injectable was growing at double-digit rates due to regulatory approvals in new indications. Moreover, the firm had recently divested its underperforming obesity in-tervention business, freeing up resources for its other businesses, as well as for M&A opportunities.

Were there things Allergan could have done better? Undoubtedly. But as one hedge fund investor notes, “It wasn’t a terrible situation.” Still, a closer analysis of recent biopharma activism cases suggests that although Allergan may not have mis-stepped per se, it did overlook opportunities that ultimately made it an acquisition target.

Using Capital IQ's and FactSet’s Shark Repellent databases, we identified 265 cases of life sciences activism between January 1, 2006 and December 31, 2014. We further analyzed these campaigns, categorizing the target companies by market capitaliza-tion and the motives of the activist(s). (See sidebar, "Methodology," for search parameters and definitions.)



Not surprisingly, a majority (75%) of the 2006–14 activist campaigns involved com-panies with market caps less than $1 billion. However, as time progressed, activists were more willing to target larger entities as demonstrated by median and mean annual market cap data. In 2009, for example, share-holder activists set their sights on just three life sciences firms with market caps greater than $1 billion; in 2013, that number swelled to 11. Similarly, our analysis shows that the mean market cap of activist targets increased from $5.8 billion in 2006 to $31 billion in 2014, while the median jumped more than five-fold from $2.4 billion to $12.3 billion. (See Exhibit 1.)

BENCHMARKING TOTAL SHAREHOLDER RETURNTotal shareholder return, which measures the value created for an investor via share price in-creases and dividends over time, offers a good proxy for relative performance. We therefore calculated the cumulative total shareholder return for 31 biopharma company bellwethers. (See online-only Appendix for a complete list of companies included in the analysis.) One-third of these were Big Biotechs, one-third were specialty pharma/generics firms, and the re-maining were Big Pharmas. To establish bench-marks for these companies, we computed the median cumulative total shareholder return, as well as yearly medians for the companies in both the bottom and top halves of the group. In this way we stratified the population into quartiles: significantly underperforming, underperforming, overperforming, and signifi-cantly overperforming.

Note that four of the 31 companies in this data set were targets of activism in either 2013 or 2014. When we further analyzed the total shareholder returns posted by compa-nies in this subset, we discovered something striking: the median total shareholder return generated by the four activist targets tracks closely with the median total shareholder return associated with the companies in the bottom quartile.

Interestingly, the shareholder returns for the activist subsector were initially higher than the lowest-performing quartile. In 2011, before activists became publicly involved in any of the four companies, total shareholder returns for this subgroup dropped by 17 percentage points, from 34% to 17%. In comparison, total shareholder returns for the bottom quartile of companies for that

year were 21%. Based on these results, we believe the bottom quartile of companies in our analysis, which includes six Big Pharmas, is at elevated risk for shareholder activism. (See Exhibit 2.)

SHIFTING TRIGGERSHistorically, shareholder activists have tar-geted biopharmas for two reasons: 1) for the opportunity to sell the company to a stra-tegic buyer; 2) to improve governance and create more shareholder-friendly policies (e.g., the elimination of either poison pills or lavish severance packages for manage-ment). (See "Activist Shareholders Complicate Buyout Math" — IN VIVO, June 2007.)

Our analysis suggests that regardless of market cap, transaction-motivated activism started to wane in 2012. In 2006, 37% of the

life sciences activist cases were triggered by a desire to sell the company; in 2014, this was true in 26% of cases. This tail-off makes sense given the strengthening public market. As valuations began to climb in 2012 and then skyrocketed for much of 2013–14, we believe the gap between market value and intrinsic value winnowed, making M&A activism a riskier proposition.

Moreover, although governance remains a critical issue overall, other triggers, par-ticularly business portfolio restructuring and operational performance, have grown in im-portance since 2006. This is particularly true for companies with market caps greater than $1 billion. Our analysis shows 15% of the activism campaigns waged during 2006–08 were triggered by either operational or busi-ness portfolio concerns. In contrast, during

Researchers at EY (formerly Ernst & Young) conducted a compre-hensive analysis of all life sciences

activism cases between January 1, 2006 and December 31, 2014. This universe of companies included biopharmaceuti-cal companies, medical technology and device manufacturers, and nutritional product developers. We collected data using Capital IQ’s and FactSet’s Shark Repellent databases. Additional details were confirmed via researching company-specific filings using the US Securities and Exchange Commission’s EDGAR database.

In defining shareholder activism, we excluded certain activities from our data set as not representative: 1. 13-D filings with no publicly disclosed activism; 2. activist short-selling campaigns; 3. hostile M&A (e.g., Sanofi’s bid in 2010 for Gen-zyme or Roche’s 2008 overture to buy the outstanding shares of Genentech that it didn’t already own). In certain cases, dif-ferent investor groups launched related campaigns within the time frame of an ongoing campaign. In such instances, we considered the activities as part of a single campaign unless the investors’ underlying motives were different. For consistency, we used the earliest 13-D filing date on record as the official start of an activist campaign.

To understand if the drivers of activism were changing over time, we assessed

motives based on five parameters:Capital structure: The allocation of cash toward share repurchases or dividends

Operational performance: Activism trig-gered by R&D investment choices, SG&A spend, or tax structures

Sale of the company: Activism that blocks or promotes the sale of a company to a strategic investor

Business portfolio restructuring: Activism that pushes for spin-offs and/or divestitures

Governance: Activism related to board in-dependence, executive compensation and incentive alignment and strategic direction.

In many cases, activists sought to make governance changes to further different, primary objectives, such as the sale of the company or the divestiture of a particular business that was underperforming. In such cases, we categorized the campaign motive as M&A or business portfolio restructuring, not governance. In cases where there were multiple drivers of activ-ism, we assessed each trigger individually so that we could develop a more complete picture for the causes of activism. In addi-tion, lacking specific information about ob-jectives, we classified campaigns that were “driven by an increase in shareholder value” in the operational performance category.

SHAREHOLDER ACTIVISM METHODOLOGY



2012–14, 40% of the campaigns were due to underperformance in those categories.

That finding doesn’t surprise long-time investor Dennis Purcell, a senior advisor to Aisling Capital. As a result of the recent bull market, “it’s so easy to raise money that the temptation might be to not save it for a rainy day,” he says. “There’s a tendency to be less disciplined about the allocation of capital.” Sarissa’s Denner is equally frank in his assessment of the situation: “We see plenty of companies where the stock has done rea-sonably well, but, boy, they are not run well.”

In today’s rapidly changing and competi-tive environment, it is difficult for diversified companies to manage multiple business units optimally. Therefore, in recent years, critical mass in a disease indication or busi-ness specialty has emerged as a strategic imperative. “We think there is some appro-priateness to sticking to your knitting,” says Paul Clancy, EVP and chief financial officer of Biogen Inc., which weathered an activist campaign by Carl Icahn in 2009. “Over the

long term, this focus results in being able to develop therapies that are commercially more attractive.” (See "Biogen Idec Charts A New Course" — IN VIVO, January 2011.)

Based on data from EY’s Global Divest-ment Study, life sciences companies are beginning to rebalance their portfolios in order to reinvest in growth areas. Indeed, the complicated three-part deal between GlaxoSmithKline PLC and Novartis AG to create respective vaccine and oncology powerhouses is an important example of this trend. (See "After A Gargantuan Year For Pharma M&A, More To Come In 2015" — "The Pink Sheet," January 12, 2015.)

This emphasis on focus has created cred-ible valuation benchmarks – via transactions or publicly traded comparables – for animal health, consumer health, oncology, and vaccines businesses, among others. As a result, investors can more easily assess the performance of individual business units or product lines within other diversified biopharmas. Pending their sum-of-the-parts

analyses, investors may believe more value can be realized by spinning or selling off underperforming or lower-growth assets. In such situations, there is a disconnect between how the market values the assets as part of the conglomerate configuration versus as individual entities. It is a scenario ripe for activism.

FOCUSING ON OPERATIONAL PERFORMANCE AND THE BALANCE SHEETTransaction-motivated activism may be off the boil, but as the case against Aller-gan shows, it is still a distinct possibility, particularly if strategic buyers align with shareholder activists. In today’s heated life sciences M&A climate, deals are at least partially driven by access to cheap debt financing and the ability, based on the earn-ings of the target company, for the acquirer to show Wall Street the deal will be accretive.

Drill down into Allergan’s income state-ment and it’s not hard to see how an

Exhibit 1Activists' Targets

Note: Only life sciences companies with market caps greater than $1 billion were included in the analysis (n = 59).

SOURCES: EY; Capital IQ; Shark Repellent; company filings

0

2

4

6

8

10

12

0

5

10

15

20

25

30

35

2006 2007 2008 2009 2010 2011 2012 2013 2014

Num

ber O

f Act

ivis

t Cam

paig

ns

Mar

ket C

apit

aliz

atio

n ($

B)

Mean Median Total Number Of Campaigns



arbitrageur could develop a rationale for why the Irvine, CA-based company was a suitable target. In 2013, Allergan allocated 17% of its total revenue to R&D and 38% to selling, general, and administrative ex-penses. To put those numbers in context, as a subsector, specialty pharma companies spent on average 7% of their sales on R&D and 25% on SG&A. In addition, Allergan also had a significantly higher tax burden than most of its peers. With 85% of the leading specialty pharma/generics players now domiciled overseas, the average effective tax rate for the group was 18%. Allergan’s effective tax rate in 2014, however, was 26.5%. (See Exhibit 3.)

Allergan’s above-average expenses were balanced by expectations of strong future earnings, particularly for its medical aesthet-ics and eye care franchises. Moreover, with roughly $1.6 billion in cash on its balance sheet and a low debt-to-equity ratio, Al-lergan had a stockpile of financial firepower waiting to be deployed.

This scenario, coupled with Allergan’s

higher than average effective tax rate, created an attractive opportunity for a strategic buyer with a lean R&D development model and an imprimatur to grow by serial acquisition. Valeant Pharmaceuticals fit the description.

Following its 2010 merger with Biovail Corp. and reincorporation in Canada, Vale-ant Pharmaceuticals acquired more than a dozen companies or business units, build-ing a specialty drug firm with expertise in ophthalmology and dermatology. As such, there was obvious strategic overlap with Allergan. In his 65-page April presentation to investors, Michael Pearson, Valeant’s CEO, outlined the “financially compelling” results he believed would come from a merger, including $2.7 billion in cost savings as a result of cuts to Allergan’s R&D and com-mercial operations.

But with a market capitalization roughly equivalent to Allergan’s, a balance sheet that was already heavily leveraged, and a target that wasn’t interested in selling itself, Valeant needed help. Enter Pershing Square, which had $13 billion under management, but

had thus far avoided investing in traditional drug companies. In a separate presentation to investors, Pershing Square’s Bill Ackman estimated a combined Valeant-Allergan would only need to trade at 7.4 times its 2014 pro-forma cash earnings-per-share to eclipse Allergan’s unaffected share price. In other words, the likely return was worth the associated risks of an activist campaign.

Allergan’s Pyott acknowledges that inves-tors might have viewed its high SG&A-to-revenue ratio as a weak point. However, he counters Allergan had “cogent arguments” for its decisions. “We had to create not only sales forces but market competencies,” he says. “You don’t build markets with water. You need gasoline to fuel the engine.”

However, as the activist campaign wore on, priorities within Allergan shifted from en-abling longer-term growth to demonstrating nearer-term earnings. In July 2014, Allergan cut 13% of its workforce and optimized capi-tal allocation via its Project Endurance plan, which was designed to boost earnings per share from $4.77 in 2013 to $10.25 in 2016.

Exhibit 2Who's At Risk?

Note: Company financials were calculated through December 31, 2014. The sum of the return in market capitalization plus issued dividends equaled total shareholder

return. Four companies that were activist targets in 2013 and/or 2014 provided the median data for the activist subset. See the online-only Appendix for a complete

list of companies included in the analysis.

SOURCES: EY; Capital IQ

0%

50%

100%

150%

200%

250%

300%

2009 2010 2011 2012 2013 2014

Cum

ulat

ive

Tota

l Sha

reho

lder

Ret

urn

Median Bottom Tier Top Tier Activist Targets

Companies with total shareholder returns in this range are at increased risk}



Exhibit 3Benchmarking Biopharma Expenses, 2014

Note: R&D and SG&A were calculated as a percentage of sales using adjusted non-GAAP data from 2014 year-end company reports. Median data shown in orange.

SOURCES: EY; Capital IQ; company filings

0% 10% 20% 30% 40% 50% 60%

Perrigo

Valeant Pharmaceuticals

Mylan

Endo International

Actavis

Gilead Sciences

TEVA Pharmaceutical Industries

Alexion Pharmaceuticals

Jazz Pharmaceuticals

Bayer Healthcare

Sanofi

Zoetis

Biogen

Johnson & Johnson

Median

Pfizer

Roche

Merck & Co.

Amgen

Celgene

GlaxoSmithKline

Novartis

Shire

Bristol-Myers Squibb

Allergan

Eli Lilly & Co.

AstraZeneca

� SG&A

� R&D

Pyott also admits the company should have looked harder at M&A opportunities prior to the spring of 2014. “With hindsight, we should have used the balance sheet more aggressively. We were trying to be disciplined,”

he says. Indeed, had Allergan used some of its balance sheet to acquire a competitor – a move it attempted once Valeant’s bid became public – it likely would have been out of Vale-ant’s reach as an acquisition target.

The activist case against Allergan illus-trates how even well-run companies can fall victim to their own strategic choices, not because they are inherently incorrect, but because an activist group can develop



Exhibit 4Engaging With Activists Requires An Integrated Approach

To help management and boards better align with their shareholders, EY has created an integrated approach to understand the business considerations of greatest interest to activists.

SOURCE: EY

equally cogent arguments for an alternate approach. Because of Allergan’s high tax rate and SG&A-to-revenue ratio, there was a big enough gap between its market value and its intrinsic value to attract a strategic buyer – and a shareholder activist.

In such an environment, some of the firms at greatest risk of disruption by activists are the industry’s bellwethers. “As firms grow, it’s hard to run things with optimal efficiency,” observes C. Fritz Foley, a professor of finance at Harvard Business School. “Some activist funds have the wherewithal to take signifi-cant positions in even the biggest players," he says.” Allergan’s Pyott is more blunt in his assessment of the current hazards facing many biopharmas: “No one is safe,” he says.

MIND THE VALUE GAPMaybe no company is safe from activists, but there are steps management teams and boards can take to innoculate themselves. Bare minimum, we believe management teams and their boards of directors should continually reassess their capital allocation priorities, cost structures, and balance sheets via an integrated approach that minimizes the potential difference between market value and intrinsic value. (See Exhibit 4.)

This sounds very basic, but it’s not neces-sarily a core focus for management teams. According to a recent study by Dominic Barton and Mark Wiseman published in the January-February 2015 issue of Harvard

Business Review, (“Where Boards Fall Short”), “the whole activist industry exists because public boards are often seen as inadequately equipped to meet shareholder interests.” EY’s own analysis suggests that at 14 of the largest US and European biopharmas, up to $37 billion in cash is unnecessarily tied up in working capital.

As Harvard’s Foley notes, “Companies can remain fixated on growth and developing new products at a time when outside inves-tors view those capital allocation decisions as money not well spent.” He differentiates “good growth” that creates shareholder value from “bad growth” that destroys value. When activists identify a company pursuing bad growth with significant value destruc-

E VOLVING IMPORTANCE AS AN AC TIVISM TRIGGER

ACTIVIST AGENDA

KEY CONSIDERATIONS WHO IS AT GREATEST RISK?

Operational performance

Effective tax rates Operating margins Revenue growth

Big pharmas that have not fully rationalized their cost structures Specialty pharmas with high R&D budgets and high tax rates

R&D R&D spend as a percentage of sales Estimated return on invested

capital associated with pipeline

Commercial-stage companies with slowing revenue growth and high R&D costs Growth companies investing in therapeutic areas outside their

core expertise

Business portfolio restructuring

Sum of the parts analysis for individual business units Critical mass in a particular

business or therapeutic area

Diversified biopharmas that must manage different rates of return and associated cost-structures for portfolio businesses Biotechs that use on-market drugs to subsidize inefficient R&D

Sale of the company

Estimated value based on comparable trading and transaction multiples versus current market value

Small biotechs whose market values have dropped below their cash balances Specialty pharma companies and big biotechs that are overly

reliant on a single product and have weak pipelines

Capital structure

Current available cash balance Excess working capital Leverage

Companies with significant cash on their balance sheets, especially if they have not recently issued dividends or repurchased shares. Companies with inefficient capital structures, e.g., too little debt

Governance

Board independence and qualifications Executive compensation and

incentive alignment Strategic direction

Smaller, less mature biotechs Biopharmas with unfriendly shareholder policies Underperforming companies because changing governance is often

the first step to addressing operational and portfolio matters



tion, simply stopping those initiatives can benefit shareholders.

By focusing on maximizing long-term in-trinsic value and making sure the stock price reflects it, companies and their boards adopt the scales their investors use to judge them. To help teams remain focused on return on invested capital across the entire value chain, we recommend companies build the following five steps into their ongoing strategic planning initiatives:

• Review cost structures to determine if they are optimized: Even companies with superior shareholder returns and strong revenue growth need to carefully benchmark expense ratios such as SG&A spend, R&D costs, and tax rates. Indeed, companies should expect that activists will prod them to be as aggressive as pos-sible when it comes to cost reductions and capital efficiency. Third Point LLC’s recently launched case against Amgen is an example of the trend.

• Perform “virtual carve-outs” to assess the value of potential divestment op-portunities: With scale being the operative word, it’s increasingly difficult to build size-able end-to-end solutions across multiple therapeutic areas or types of businesses. To maximize value creation, companies should track the individual performance of each business unit and perform virtual carve-outs to understand the potential impact of a di-vestiture. This do-it-yourself sum-of-the-part analysis also means modeling the potential economic returns, and stranded costs, that could come from a sale, a spin-out, or the creation of a joint venture with a third party.

• Examine whether capital allocation deci-sions enable optimal use of the balance sheet: Management teams should regularly assess whether there are potential benefits to altering dividends or share repurchase policies. Establishing a track record of returning cash to shareholders can help build credibility with investors, notes Peter Kolchinsky, PhD, a managing director at RA Capital. In such instances, “investors will give the management team the benefit of the doubt regarding R&D decisions,” he says.

• Use milestones and/or “gating” mecha-nisms to improve R&D investment decisions: As compounds move from the laboratory to the clinic, not only do the development dol-

lars grow, but analysts start to build future earnings expectations into their cash flow models. Add in the fact that management teams are typically rewarded for advancing, not killing, pipeline programs and it’s not hard to see why R&D groups have a tough time shuttering programs when the data are inconclusive. To build credibility with inves-tors, biopharmas should establish return-on-investment metrics for individual R&D programs. It’s not necessary to strictly adhere to these ROI criteria, especially for early-stage assets. What’s important is that companies perform the analysis up front to help ground their pipeline decisions at logical milestones (e.g., the Phase II to Phase III transition).

• Communicate relentlessly with investors about strategic decisions: Finally, compa-nies shouldn’t underestimate the impor-tance of proactive communication. At the management and board levels, firms need to be able to anticipate the hard questions shareholders will ask and provide credible answers that counter underlying concerns.

FORTUNE SMILES ON THE WELL PREPAREDAs the Allergan case demonstrates, even companies with strong, profitable growth can become activist targets. Had Allergan used its balance sheet for a strategic transac-tion of its own, it might not have found itself an attractive takeover candidate. Instead, as a result of its high tax rate and SG&A-to-revenue ratio, there was a big enough gap between its market value and its intrinsic value to attract a strategic buyer – and a shareholder activist. That Valeant didn’t succeed in its bid to purchase Allergan ultimately matters less than the fact that Pershing Square did. By putting Allergan into play, Pershing Square ensured the drugmaker’s days as an independent entity were numbered – and earned an estimated $2.6 billion in the process.

Allergan may have lost its autonomy, but in the end, David Pyott won two impor-tant victories for his shareholders and his employees. First, more than $30 billion of value was created as a result of the activ-ist campaign; second, the Allergan brand lives on. In mid-February, Brent Saunders, CEO of Actavis, announced that, subject to shareholder approval, the merged entity will take the Botox maker’s name.

On March 17, 2015, shareholders finalized the Actavis-Allergan merger.

In the aftermath of the bruising experi-ence, David Pyott sums up the lessons he learned as follows: “Companies and their boards should discuss strategic weaknesses. They must ask themselves, 'If we were activ-ists, what would we do differently?’”

A#2015800073

The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organization or its member firms.

Jeffrey Greene ([email protected]) is EY's Global Life Sciences Transaction Advisory Ser-vices Leader and Ellen Licking ([email protected]) is a Senior Life Sciences Analyst at EY.

AcknowledgmentsThe authors would like to acknowledge the following individuals for providing assistance with the creation of this article: Andrew For-man, Shyam Gidumal, Glenn Giovannetti, Gautam Jaggi, and Russell Colton provided valuable insights and editorial feedback during the drafting of this article. The research and col-lection of the shareholder activism data were conducted by Manish Sharma, Saurabh Garg, and Rahul Agrawal. They also reviewed all data and analyses presented in the final version of the report. Andrew Forman and Jimmy Zhong developed the financial metrics presented in Exhibits 2 and 3.

IV

Twitter: @EYLifeSciencesey.com/LifeSciences

Documents

MAY 2015 VOL. 33 / NO. 5 CAPITAL ALLOCATION IN THE AGE OF ... · 'Growth Pharma'" — "The Pink Sheet" DAILY, November 17, 2014.) Fireworks aside, Valeant Pharmaceuticals and Pershing