The global pharma industry is evolving. Following high profile failures of mergers the pharma sector is choosing strategic alliances and focussing on specific fields to counter challenges of rising costs of new drug development and patent expiry.
Our definition of good corporate governance is holistic, as regular readers will know. Hence we aren’t primarily concerned by the shenanigans of boardroom goings on, or compliance with relevant regulations, important though this may be. To us, the critical judgement is whether the organisation is fulfilling the aims of its key stakeholders and doing so in an ethical and effective manner with due transparency and accountability.
So we thought we would take a brief look this year at corporate governance in the pharmaceutical industry which has been undergoing dramatic changes in recent years. We’ve written about some of the events which have seemed to us to be leading to board decisions which were at odds with good corporate governance and the long term interests of all the key stakeholders.
Recent examples of poor corporate governance
One example was the attempt by Pfizer to acquire AstraZeneca for reasons which boiled down to saving tax (albeit rather a lot of tax) and had little to do with the long term future of the business of AstraZeneca and its employees. This was defeated largely because the tax element was so blatant and the political dimension (UK jobs and expertise) became a significant factor. More recently, the even bigger agreed merger of Pfizer with Allergan, based openly on an inversion deal, was aborted when the US Treasury proposed a rule change which would radically reduce the tax benefits of the scheme.
Another example was AbbVie’s bid for Shire which was about furthering the strategic goals of the acquirer but which we judged to offer upside only for the shareholders in Shire and purely downside for the company and its employees. This approach was withdrawn when the tax saving element was judged to be so politically unacceptable that it would probably not be approved.
In a different field, GlaxoSmithKline (GSK) was hit hard by the authorities in China for marketing its products through a raft of incentives which the authorities deemed to be corrupt practices. It was perhaps unfair that GSK was singled out where this appeared to be not just standard practice, but the only way to market the products in a culture where the medical professional buyers were significantly underpaid. However, it could hardly complain when these practices were brought into the light of day.
Are things changing, and if so, for the better or worse?
To take the ethical issue first, it was encouraging that GSK announced that it had now implemented the policy it announced in December 2013 to cease payments to outside healthcare consultants to speak on behalf of their medicines and vaccines. GSK’s head of respiratory medicines was quoted as saying that “it’s like smoking on aeroplanes. People will look back and say “did we really do that?” ” Let’s hope he’s right and a transparent, ethical approach will be rolled out worldwide by GSK and followed by all their competitors. However, the only way we’ll ever know for sure is by independent surveys, as we never tire of saying. Further prosecutions would be too late.
What about the bigger strategic issues of corporate governance facing Big Pharma?
The major strategic issues facing the industry are the increased costs of technology and increasing regulation which have been driving up the costs of developing new drugs in recent years. The result has been a bulking up to create huge companies which possess the scale and resources both to develop ground-breaking new products over the very long timescale needed to bring them to market, and a global reach to sell these new drugs to world-wide markets. There is also the perennial problem of the progressive expiry of the patents covering their most successful products and the need to plan for their replacement by new drugs under test. This is coupled with the uncertainty as to whether these will be approved, let alone whether they will become the new “blockbusters” required to avoid a dramatic drop in revenues.
The approach up till recently has been to rationalise multiple research facilities and cut administration costs, then look for a merger so that the same process can be applied to the combined entity. The justification to the acquired company is that the premium paid will generate an immediate profit for the institutions that own the shares and save them the delay and uncertainty of waiting for the optimistic forecasts of management to be realised. We have criticised this as poor corporate governance in that it favours one stakeholder (the shareholders) in the acquired company while cannibalising it for the benefit of the acquirer.
Strategy is changing and governance with it
However, it seems as if industry views are evolving to change strategic assessments. Firstly, it seems that small independent labs are better at producing new drugs than those of the pharma giants, which has led to the giants gobbling up these independents as soon as they show signs of getting approval for their new inventions. And secondly, it has led to the swapping of whole facilities between the big pharma corporations rather than major corporate mergers and acquisitions. The declared new purpose is for these giants to focus their resources and hence build strong positions in selected fields.
Thus in 2014, Novartis sold its vaccines business to GSK in a swap for GSK’s oncology business and in the same year Novartis sold its animal health to Eli Lilly. Other leading corporations engaged in building strong positions in particular fields of medicine are Sanofi, AstraZeneca and most recently Shire which, having retained its independence, succeeded in getting agreement to its offer for Baxalta, and is now aiming to build a world leading position in treatments for rare diseases. The aims of these transactions would appear to make good corporate governance sense since the expertise being acquired is being used to grow business in that field and the interests of all key stakeholders in both acquirer and acquired would seem to be aligned.
Conversely, look at what has happened to Valeant, that aggressive Canadian acquirer of other pharma companies using debt-fuelled financing. Its business model of continual acquisition, cutting costs, particularly research, and raising prices dramatically, which we would regard as an example of poor corporate governance when judged holistically, seems to be coming apart. After US Presidential candidate Hillary Clinton made a strong attack on pharma companies which indulged in price gouging and promised to attack this practice when/if she was elected, the wheels started to come off. Short sellers attacked Valeant for what they called fraudulent business practices and the share price has gone south ever since. The CEO was hospitalised with pneumonia and his interim successor promised to stop doing deals and concentrate on its core business. Essentially though, this was to cut its large debt before shareholders panicked. Within a short while of the sick CEO returning to his desk, he announced his resignation and the share price collapsed further amid stories of imminent default over its $30bn of debt. We would have to hear something about reductions in excessive prices to give them marks for improved corporate governance. But debt reduction and price cutting don’t usually go together.
Conclusion: corporate governance in pharma is improving
So overall we can probably say that outside political forces and the natural evolution of the pharma market seem to have changed general strategies in ways which may produce a beneficial effect on corporate governance. Thus boards are approving strategies of their managements which appear to favour the long term health of their companies and acquisition strategies aim to grow the respective divisions of the businesses. This is clearly in the interests of the employees concerned as well as the owners and all the direct suppliers and local neighbourhoods dependent on these big employers. Management incentives presumably are encouraging these decisions and can therefore be commended.
Not for investing institutions though
The other aspect which we addressed earlier was that of incentive misalignment in relation to the quality of stewardship exercised by institutional investors. Here the evidence of improvement is much more questionable. In its approach to Shire, AbbVie tried to pressure the board into a deal by publicly emphasising the support for the deal from a group of shareholders. In the short term the tactic worked and the board accepted a deal which we felt favoured only that group of investors who would benefit by selling at that point. In the event the deal fell through and the company seems to be going from strength to strength since.
During the deal process, the FT newspaper ran an article which appeared to give support to the idea that shareholders should put their own interests more strongly as the deciding factor in the board’s decision regarding a bid approach. This favours the short-term trader’s position where, as between buyer and seller, neither side will be around if it all goes wrong, and both benefit from incentive plans which favour a deal. Stewardship, by comparison, is supposed to be about looking at the long term future health of the company in which they are investors.
Stewardship has some way to go
Activist investors get involved with companies’ boards and their strategies, to the extent of getting their representatives elected as directors, though essentially for their own short term benefit. Institutional investors rarely put their heads above the parapet, and when they do it is seldom to take the long term position of a Warren Buffett.
So, notwithstanding a relatively positive assessment of compliance with the UK Stewardship Code by the authorities in their last review, it doesn’t appear to us that much has changed regarding the deficient performance of institutional investors generally in upholding good corporate governance.
Perhaps the biggest game-changer coming over the horizon is the emergence of drug-resistant so-called super bugs and the response of governments. It has been suggested that there should be a global initiative to harness the research capabilities of big pharma to produce new drugs before isolated cases of resistance turn into epidemics of catastrophic proportions. A British government minister has even proposed what he describes as a “pay and play” scheme to tackle the problem of the lack of motivation of big pharmaceutical companies to make major research investments with small probabilities of coming up with block-buster new drugs. Ex-Goldman Sachs banker, Jim O’Neill has recently published a report in which he outlines a scheme whereby a levy on all industry players would help fund development of new drugs by those companies which chose to tackle the complex and expensive process of seeking new anti-biotics.
It will be interesting to see the response of the investing institutions to the short-term threat to the profitability of their investments in big pharma and whether their stewardship embraces the challenge of the threat to global health before governments impose their own solutions.
