According to analysts, merger and acquisition activity in the biopharmaceutical industry will continue to be hectic this year in the wake of last year’s record breaker, in which deals totaling $300 billion were concluded. An increasing number of these transactions are driven by activist investors urging boards to allocate capital more efficiently. In May 2016, the annual Life Science and Health Care Forum featured a panel of experts discussing the role of M&A in this dynamic investment landscape, the changing nature of investor activism, and its impact on the health care and biopharmaceutical industries.
The panel was moderated by Mergermarket and Dealreporter Senior Editor Takashi Toyokawa. The panelists included:
Managing Director at FTI Consulting’s Strategic Communications practice. Over the past 20 years Steven Balet has advised public companies and hedge funds on contested proxy campaigns, corporate-governance issues, and M&A. Today, Balet drives messaging, strategic planning, and influencer engagement to help his clients deal most effectively with proxy threats.
Ruth De Backer
Expert Principal in McKinsey & Company’s Strategy & Corporate Finance practice where she leads a joint venture of McKinsey’s Pharmaceuticals and Medical Products and Strategy and Corporate Finance, Ruth De Backer specializes in Corporate Strategy, Resource Allocation, Transactions, and Activist Investors. She works closely with senior management in the health care sector, advising on a range of matters from organization and governance, to portfolio management, to activist investor defense.
Jeffrey R. Jay
Dr. Jeffrey Ray is the Co-Founder and Senior Managing Partner of Great Point Partners, LLC. Dr. Jay has led private equity investments, and sat on the boards of numerous companies and completed dozens of structure financings for publicly traded companies. He is on the Health Care Initiative Advisory Board of the Harvard Business School, and the Dean’s Board of Advisors at the Boston University School of Medicine.
J. Daniel Plants
J. Daniel Plants is the Founder and Chief Investment Officer of Voce Capital Management, LLC. Prior to Voce, he held executive positions in the M&A groups at Goldman, Sachs & Co., and JPMorgan. Since Voce’s inception in 2011, it has employed public activism in 11 investments. J. Daniel Plants is an expert on corporate governance, having led the corporate defense advisory business at JPMorgan. He is a member of the Council of Institutional Investors, and the National Association of Corporate Directors.
TAKASHI TOYOKAWA: Let me begin by asking why there is so much M&A activity in health care right now, and why so much investor activism?
J. DANIEL PLANTS: If you had asked me when we began back in 2011, I would have told you that I liked the fact that health care had a very defensible business model. I liked the fact that there were a lot of strong balance sheets in health care. I liked the fact that there was a lot of M&A, and I would have told you that the valuations were really reasonable. I think that last factor has changed a little bit. I wouldn't say they're unreasonable, but they don't jump off the page like they did two, three, or four years ago. So it doesn't surprise me that there's been a lot of activism in M&A, and it's drawing people into health care.
JEFFREY JAY: When we're providing capital to a company, either to complete an acquisition, or to restructure their balance sheet, there are conditions we negotiate in advance. We will do due diligence, and we'll decide, "Hey, look, we want you to drop these particular programs. We think they’ve got a low ROI, and we want to see certain expense cuts in return for our investment.” We may want them to change the composition of the board. In some situations, we've asked for board seats, either directly, or we put someone on, independently, that we think is going to be a great fit. So the way we think about activism is more than a proxy fight; it can encompass a variety of levers. I expect we'll see more activism, because, bottom line, it works. Active investors can add a lot of value to a company, provide guidance, and enhance long term shareholder returns.
The New Rules of Engagement
TAKASHI TOYOKAWA: JPMorgan reported in 2015 that the activist asset class went to more than $112 billion from just $12 billion just in 2003. So what are companies doing to pre-empt this and to try not to be an activist target?
RUTH DE BACKER: McKinsey is always on the corporate side, so we're working with management. Sometimes we role-play. Are we allocating capitals correctly? If we go back to 2009, I think bigger companies felt immune to activists. Now even the largest health care companies don't feel that way. So we are having lots of conversations with very large companies.
STEVE BALET: I'd like to build on what Ruth said. Size and performance are no longer a defense against an activist. Activist funds have gotten large enough to challenge virtually any company in the world. I head our activism and shareholder engagement practice at FTI Consulting, and shareholder engagement prior to any activist entering the stock is a company's best means of pre-empting being targeted. If your shareholders understand what your strategies are, what you've considered and looked at in formulating those strategies, and if they have faith in the processes that occur in the boardroom, then they're less likely to be supportive of an activist plan because they understand that the board has gone through a good process to arrive at the strategy currently in place. And we help companies communicate with their shareholders and stakeholders in making sure that message comes through.
DANIEL PLANTS: But sometimes you get the feeling the companies are going through the motions, right? They've been given advice that they need to engage, but it really boils down to whether they’re open-minded. If everything's going well, the stock price probably reflects that, and it's not going to be fertile ground for activism. But when someone like us shows up, chances are we're onto something. We could be wrong, but it's likely that there are issues, and it's therefore likely that there's going to be change. That doesn’t mean we have to get everything we want, but there has got to be constructive change. If not, it's going to be imposed. And so smart boards and management teams get in front of that, and they listen. Most activist managers have the majority of their own personal network tied up in their funds, so they're focused on trying to generate value. And so, when someone like that shows up at your door, see if there's a way you can work with them. They're probably not going to go away easily, and they may have some good ideas.
STEVE BALET: That's a change as to how boards were advised years ago: Give activists the Heisman and push them away. And then that changed to engagement, but engagement was, as Dan said, a tactic. It wasn't substantive. But I think we're seeing that change. Boards are truly engaging with activists, and that's the right path to take for the shareholders. That doesn’t necessarily mean that everything will end well. There may just be a genuine difference in strategy that should be taken to the shareholders. But it leads to more productive results most of the time.
Why the Best Defense Is Not Defensive
TAKASHI TOYOKAWA: Jeff, what's been your experience in dealing with some of the companies you've gone after?
JEFFREY JAY: We're looking for companies that are undervalued. And there's a reason why the stock is undervalued. These companies generally have goofed up in some material way, and alienated a bunch of shareholders who've left the stock. And the stock’s been pounded as a consequence.
We typically will offer operational, structural, capital allocation, governance, and M&A suggestions. Operationally, it may be abandoning a futile R&D program. A lot of biopharmaceutical companies are founder-led, and sometimes, when the founder has a Ph.D. in cardiovascular, he'll try to advance a cardiology program whether or not it has a chance of being successful. A structural suggestion might be selling off a division. We see this all the time. Some health care companies have non-core subsidiaries, and those are a distraction. Sometimes they're a source of cash but, if you can sell them off, you can redeploy that cash in a higher return on investment sector. In terms of capital allocation, a lot of health care companies have 20 percent, 25 percent EBITDA margin. A lot of these companies have a lot of cash sitting idle on their balance sheet. We’d like to see some of that cash come back to the shareholders, who can reinvest it elsewhere. As for governance, there are a lot of companies that have poor boards. When we see a weak board, we want that board strengthened with individuals that can help drive long term value creation. Finally, in terms of M&A, this is not just forcing a company to put itself up for sale. We see companies that want to do highly diluted acquisitions that inevitably are going to lead to the destruction of shareholder value and, obviously, we try to stand in the way. We do have companies that can be more successful as a part of something larger. And there we want to see the businesses sold. These needn’t be contentious issues. If we get a company to engage with us, it can be a win-win for the management teams and for everybody.
STEVE BALET: Yes. It’s important for companies not to think of it as an activist defense strategy. It’s an engagement strategy, putting yourself in a position to tell the Street the best story you can. If you are an underperforming company, then you have to make sure the Street understands your program to turn the company around, and why you believe in it. That’s the best way, and you should be thinking about it even when you're performing well. I'm representing a company right now that's had a 66 percent total shareholder return over three years, and they're being targeted by an activist. So you can do great, but a lot of activists may believe you could do better. So you should be preparing because that first meeting with an activist can make or break the engagement. You should be planning on how that meeting should go to make sure it goes as well as possible, and to keep things out of the public eye. It gets expensive if it gets in the public eye. So thinking about that engagement as early as possible is just par for the course nowadays.
RUTH DE BACKER: Absolutely. Once an activist comes knocking, you want to make sure that the right people are there to answer, and you want everyone to be well-versed in your strategy, especially if it could go into the press. You want to make sure that you don’t distract your employees. So having that communication with your employees, your board, and with other investors is critical. Who are the regular investors that you want to call upon before the activists actually come knocking? We've seen many companies starting to do this even if they don't think they're on anyone's radar.
To M&A or Not to M&A
TAKASHI TOYOKAWA: There seems to be debate in the health care community between growth through R&D versus growth through acquisitions. How do you come out on this topic?
JEFFREY JAY: When we look at an R&D pipeline – analyzing drugs and drug development programs, looking at pathways, the competitive landscape, and the probability of success – we can make some pretty clear recommendations. There can be successful R&D programs and lousy ones. There can be great M&A strategies and poor ones. You have to judge each situation individually.
STEVE BALET: If you are a health care company that has invested a great deal in R&D, and it isn't producing results, then you should understand that you may be a target for activists. And, unless you can explain how your program will produce a benefit for shareholders in the future, you're going to have a difficult time.
RUTH DE BACKER: I think a lot of companies are still relying on both R&D and M&A. But we do see that in many companies the R&D spend is coming down. So we will continue to see spin-offs, or the sale of assets.
DANIEL PLANTS: Two of the companies in our portfolio were acquired by Valeant in the last couple of years. Now the two companies are among the ones being discussed as potential spin-offs to create liquidity. I don't think they'll trade for what they were bought for, but I do think that's a trend.
As an investor, I'm indifferent to how companies grow – acquisitions or R&D. They just need to be disciplined about their risk profile. The vast majority of M&A deals don't work. Management teams get excited about buying something, but then there are integration challenges; teams don’t stay. A lot of things can go wrong. I generally would not be supportive of our portfolio companies doing a lot of M&A, but there are a couple of management teams that have done it well, and I am happy to see them when they’ve bought something because I know they're careful, and use an appropriate discount rate to reflect the risk.
Should the Board Have a Stake in the Company?
JEFFREY JAY: I remember talking to a director and saying we should do this, this, and this. And then there was a pregnant pause, and the person said, "Well, you know, if I take on the CEO, I may be asked to leave the board, and the compensation that I receive is very material to me.” He was being honest; these people are human. Some are getting a lot of money in total compensation, and they just don't want to rock the boat. But that's a real problem when you're trying to get people to do the right thing for the business because they’re not all thinking about the shareholders. They're thinking about what's good for them.
TAKASHI TOYOKAWA: You hear this often from the buy side: They want directors to be owners. Is that the best way to incentivize the board and add value for shareholders?
STEVE BALET: I think the majority of directors are thoughtful, and want to do a good job for their companies. They're not necessarily people that have a lot of money. I don't think we want all of our board members to be extraordinarily wealthy. So it's a little disingenuous to expect them to invest a great deal of personal wealth in the company. Is there a way to compensate them so that it’s tied, much as management's should be, to the performance of the company? Absolutely. But I don't think requiring board members to have a significant stake in the company is realistic.
DANIEL PLANTS: I agree that I don't think that a board member should be expected to own the same amount of stock as an institutional fund. But one of the things that we’ve always done when we run a proxy contest is to require nominees to buy company stock with their personal assets. Nominees ask me, "How much do you want me to buy?" That’s their affair; I just say make an investment that's meaningful to you. I’ve had directors buy $25,000 worth of stock; I've had someone buy a million dollars of stock even before he had been added to the board. I think that's extreme, although I think the other end was extreme, too. But I think some demonstration of personal commitment is important. Almost as important to me is if they’re consistently selling company stock. Independent directors should not sell company stock. Period. If they have a change in life status – a divorce, or they have a health problem, or whatever – and they have to tap into those funds, they should just get off the board.
Management is different. The management team has its whole net worth tied up in company stock. It's therefore reasonable for management teams to prudently take reasonable amounts of their equity off of the table as part of being diversified and balanced. But not independent directors. I'm on two boards, and I’ve never sold a single share of stock. If you see independent directors selling stock, that a red flag. It's not acceptable.
Traditional Investors vs. Activists
TAKASHI TOYOKAWA: Are we seeing traditional investors becoming more supportive of activists?
DANIEL PLANTS: I think smart investors look at activists and see that, essentially, they’re willing to work for free. “I don't have to do anything; I don't have to pay; I just need to vote for these guys if it comes to that.” And I think some large investors have decided they can dabble in activism. But if you're a large institution, you're likely somewhat restricted in terms of your ability to run a proxy contest. Your firm has all sorts of touch points with these corporations: 401Ks, and other kinds of corporate and treasury services that they don't want to lose as a result of pushing too hard. So I think there's a ceiling on how much the institutions can do.
STEVE BALET: On an institutional level, there’s a growing willingness to support activists, even a bias toward activists, although that is probably drifting back a little. I think we're seeing some of the larger institutions taking a look at all sides. There are certainly large institutions that used to say, well, you get ISS [Institutional Shareholder Services], or you get Glass Lewis, and I’ll vote that way. That's not the case anymore. I think ISS and Glass Lewis are useful tools for intuitions in terms of making their decision, but I don’t think (outside of some funds) that they have as large an influence as they used to. Companies are doing okay in voting situations with activists. Activists were winning about two thirds of the time in 2013; now it’s back to 50-50.
RUTH DE BACKER: Institutions are listening to both activists and management. And we have some pension funds investing directly into the activist class. So the institutions are not directly doing the activist campaigns, but they’re providing money for others to go after underperforming corporations.
STEVE BALET: I think it's important to note that we're discussing what I call economic activists. We’re not discussing corporate governance activists, who have a different focus. Economic activists are looking for actions that will produce yield; corporate governance activists may be looking for the company to take actions to produce yield, but within a much lengthier timeframe. That type of activism doesn’t normally result in a proxy contest.
DANIEL PLANTS: I think taking a longer perspective will benefit investors. We've recently settled a proxy contest with a company called Air Methods Corporation, which is the largest operator of medical helicopters in the U.S. We were investors in the company for four years without ever saying anything, publically or privately. And then, in the last year, we became concerned. There were some structural issues. We started pushing them, and ultimately that led to public letters, and we nominated directors. But I told them, “Look, we've been here for four years. We’re not going anywhere. And, even if you beat us, we’ll be back.” We recently settled with them. We put one of our nominees on the board. They also agreed to de-stagger the board. And we haven't sold a share of stock since the settlement. I think if you are a long term investor, you bring perspective, and staying power, that will allow you to make your case over time.
TAKASHI TOYOKAWA: Thank you all for this fascinating discussion.