M&A in the pharmaceutical sector

December 2014  |  COVER STORY  |  MERGERS & ACQUISITIONS

Financier Worldwide Magazine

For the pharmaceutical sector, 2014 has been a landmark year in terms of M&A activity. While deal values may have rocketed across a variety of sectors, it was in the pharmaceutical industry that M&A really took off. In the first half of the year a record $317.4bn worth of pharma transactions were announced, mainly focused on Western markets where inversion deals and declining product pipelines have been the main drivers of activity.

Although many pharma companies have been focused on acquisitions in the West, an increasing number of international life sciences firms are beginning to turn their attention toward growth in emerging markets in the Far East, notably in China where the pharma sector has seen considerable recent activity.

High profile deals have caught the imagination of investors and regulators worldwide. Among these was Novartis International AG’s $19bn unit swap with GlaxoSmithKline. Novartis also sold its animal health unit to Lilly for $5.4bn as the firm moved to a non-core, non-pharma business. Elsewhere, Bayer AG agreed to purchase the over the counter business of Merck & Co for $14.2bn, although at the time of writing the deal has yet to complete. Mylan Inc’s acquisition of Abbott generic products for $5.3bn was another significant deal. Given that deal volumes and values in the pharma sector have picked up pace throughout the year, what factors have been driving transactions?

Intense activity

Many firms within the sector, rather than concentrating on short-term gains over 2-3 years, have begun to look to the future in a more meaningful way. Acquisitions are being used to improve market positioning in pursuit of this long-term strategy. Since the pharmaceutical industry has particularly long product lifecycles, firms can often give off an air of inactivity – yet there is an increasing awareness of the sector’s need to generate momentum. Today’s pharma companies realise the dangers of remaining idle as product pipelines mature; increasingly, they are looking to generate growth and unlock shareholder value by tapping into expanding emerging markets. They also appear to be specialising their product offerings and divesting non-core business units, focusing attention on a number of central functions, such as vaccines or generics. Many of these specialised sub-categories will provide companies with growth opportunities going forward. The global vaccine market currently accounts for around 2-3 percent of the global pharmaceutical industry, but in the coming years the World Health Organisation expects this market to grow in the region of 9-10 percent. Other analysts have predicted that vaccines will see 10-15 percent growth per annum. Irrespective of a company’s ultimate goal, M&A is a strong mechanism that allows a firm to remould itself.

Conditions for dealmaking have improved markedly over the last 12 months. Deal-starved companies are finally utilising their cash-rich balance sheets to chase inorganic growth. Furthermore, favourable debt financing, low interest rates and good credit supply for leveraged buyouts have all contributed to the upswing in deal activity. “M&A activity has been quite intense over the past year,” agrees Marek Petecki, a partner at Bristows LLP. “Confidence levels have continued to improve, and companies in the pharma and other life sciences sectors seem to be making the most of this positive climate to reinforce and reshape their businesses in response to some of the pressures they face. Key drivers include changes in regulatory environments, significant pricing and cost pressures from government organisations and other stakeholders, developments in technology, and the continuing need to replenish product pipelines.”

Diminishing product pipelines have certainly played a role in fuelling M&A activity this year. Research and development (R&D) spending by the industry’s larger players has not yielded the anticipated returns in recent years. According to some analysts, companies have used acquisitions and divestitures as a way to reduce their R&D expenditure. Bigger pharma groups are less likely to fund giant research facilities in order to replenish their deal pipelines. Impending patent cliffs have also played a major role in promoting M&A activity throughout the sector in 2014.

The private equity (PE) industry has started to take a keen interest in the pharma industry, as it offers the opportunity to create excellent returns in the right markets. In early 2014, the Carlyle Group announced a $4bn acquisition of Johnson and Johnson’s blood testing business. PE’s interest in pharma is likely to be particularly pronounced for companies whose products and pipelines are well positioned to service ageing populations around the world. PE groups have also been interested in acquiring a number of low-growth, mature drug portfolios from large pharma firms. Although many of these portfolios have faced declining sales of late, some of the PE industry’s biggest players – namely the Carlyle Group and Blackstone Group – believe that they can make a profit from these products, provided they are able to acquire the businesses cheaply.

Emerging markets

Over the last 12 months, competition for deals has increased. Many pharma groups are targeting emerging markets as their next growth areas. China is already the third largest global pharmaceutical market and likely to see increased growth in the years to come. Developing social and economic conditions in China should provide fertile conditions for pharma products. Not only is the country’s population ageing, it is also becoming more urbanised and middle class. As in other emerging markets, this middle class has a higher level of disposable income today than at any other point in history. Dietary changes have also been the catalyst for an explosion of ‘Western’ diseases throughout China. A number of hitherto rare conditions, such as type 2 diabetes, cardiovascular disease and neurological disorders, are now more commonplace, which will further power the Chinese pharma market. The government has pledged to increase its investment in healthcare, announcing a program of major healthcare reform which will extend to providing insurance to rural areas. Chinese authorities hope to have universal health insurance coverage by 2020. According to estimates from the IMS Institute for Healthcare Informatics, China is forecast to provide more than a third of global growth in pharmaceuticals spending between 2012 and 2017. Should the country implement universal coverage, this would increase China’s share of global sales from 8 to 15 percent over the same period. That makes the Chinese market an attractive prospect for Western firms.

With competition heating up, acquirers need to consider a number of unique issues when negotiating and structuring a pharma sector deal. “The particular challenges that face acquirers of pharma assets are perhaps most evident when you look at deals in emerging markets,” says Mr Petecki. “Pursuing assets and opportunities in these markets will often throw up a whole host of risks, but particularly in relation to ownership of intellectual property, regulatory matters and integrity issues. It can be challenging for large pharma companies to get to the bottom of these issues through due diligence, and to find acceptable solutions which can be implemented effectively, but there can be huge rewards for doing so successfully.” He adds that integration risks are frequently overlooked or underestimated. To be effective, integration planning needs to begin much earlier in the transaction timetable than is often assumed. Poor integration planning can threaten the bright future of a transaction, so companies need to devote time and resources to evaluating potential hurdles and laying the groundwork for a smooth combination. A pre-determined vision and strategy which all employees can embrace is a basic prerequisite of sound integration.

Tax reforms

There is no question that the pharmaceutical sector is at the forefront of the M&A playing field. Following years of relatively modest activity, the size and frequency of announced and completed deals has been encouraging. For US firms in particular, the inversion tactic has seen deal activity skyrocket over the last 18 months or so. Across the board, inversion deals accounted for over $315bn in the first three quarters of the year, up from $71.7bn during the same period in 2013.

But the tide of inversion deals may be turning. In late September, the US Treasury Department issued a new set of guidelines with the express aim of curtailing tax inversions. Although the guidelines are yet to be finalised, and may be overturned in the future, they have created uncertainty around this practice. The planned changes will help to bring the US tax code more in line with its neighbour Canada, as well as European nations such as the UK, Ireland and the Netherlands. A number of firms were spooked by the announced guidelines and have withdrawn from pending inversion deals. In mid-October, the board of drugs manufacturer AbbVie Inc recommended that the company’s shareholders reject the firm’s $52bn acquisition of Irish rival Shire Plc. Richard Gonzalez, AbbVie’s chairman and chief executive, said “Although the strategic rationale of combining our two companies remains strong, the agreed upon valuation is no longer supported as a result of the changes to the tax rules and we did not believe it was in the best interests of our stockholders to proceed.” Responses to the changing regulatory environment are varied. While some companies have been forced to abandon their deals, others have vowed to move forward regardless.

In addition, the tax regime in inversion-hotspot Ireland may also be changing. The Irish government has proposed closing the tax loophole known as the ‘Double Irish’. This loophole allows companies to send royalty payments for intellectual property from one subsidiary registered in Ireland to another, which resides for tax purposes in a country with no corporate income tax. So, rather than paying the standard Irish corporate tax rate of 12.5 percent, which is already comparatively low, companies that exploit the loophole pay significantly less. Although the change would undoubtedly affect the pharma industry, the revision is unlikely to come into force for at least another six years. The delay would provide firms with ample time to adapt, and many companies are monitoring the situation.

The months ahead

2014 has been an exciting year for the pharma industry. Transaction volume and values are way up as mega-deals have one again become a prominent feature of the acquisition landscape. Many pharma companies have utilised M&A to diversify their businesses or refocus corporate strategy. According to Mr Petecki, the outlook appears promising. “We are optimistic that M&A will continue to be quite strong through to the end of 2014,” he says. “Confidence levels still appear to be good, though tempered by the ongoing challenges that the sector faces. We do, however, expect that pharma companies will continue to pursue strategic alliances and joint ventures, as well as more innovative structures, as less risky alternatives to outright M&A deals – particularly as the pool of attractive acquisition targets diminishes. We also expect to see a continued growth in the pharma sector’s interest in deals involving digital technologies, and in IT-related investments more generally,” he adds.

Clearly, the pharma sector is in a transitional period. More firms are choosing to specialise and are using M&A to achieve their goals. As firms continue to prioritise core businesses and divest weaker units, the industry will be in a period of rearrangement.

The bulk of deal activity is likely to remain focused on the Western market. But China and other emerging markets will have an important role to play in future M&A. Activity in the Chinese life sciences sector, an area which already constitutes the third largest pharma market in the world, has remained strong, and is likely to continue to do so moving forward.

Tax inversions have also played a major role in defining the narrative of the pharma sector over the last 12 months. The propensity of US pharma companies to complete inversion deals has not only driven significant transactions, it may also have a transformative effect on the US tax regime. Although there has been a political and public backlash against the tactic, firms will continue to build shareholder value through whatever legal means are available. While some have questioned the moral compass of firms that pursue inversions, and labelled them ‘corporate deserters’, inversion deals will likely be around for some time to come, and will play an important part of redefining the pharma sector. In the short term, attempts to stop inversions are more likely to slow the practice.

© Financier Worldwide

BY

Richard Summerfield