If you ever wonder, as many have during this election cycle, what’s wrong with our system of market capitalism—how far removed Wall Street is from Main Street—take a look at Valeant Pharmaceuticals.
I hesitate to write that second word of the company’s name, because Valeant looks much less like a drug research and development company than a private equity firm—the kind that comes in, buys up other firms, strips their assets, then uses dodgy accounting methods to make the whole process look appealing to investors (on paper at least).
Valeant has been in the news since last fall, when it shares fell sharply on claims that it was not only jacking up its drug prices in egregious ways (something that Hillary Clinton complained loudly and threateningly about) but also booking phantom sales via a now defunct distribution company called Philidor.
After ferociously denying all this, Valeant announced yesterday that it would actually have to restate its earnings for the last two years because $58 million worth of sales to Philidor were wrongly booked when drugs were delivered to the vendor, not to patients, as they should have been.
Amazingly, the stock actually rallied on this news.
Why does this company and this story matter so much? Because it illustrates so many things that are broken in our capital markets—the things that have created the kind of populist rage that have resulted in Donald Trump becoming the likely Republican nominee for President, not to mention Democratic socialist Bernie Sanders giving Hillary Clinton a real run for her money.
Nothing has changed, really, since the financial crisis of 2008. The capital markets are supposed to serve business, and more importantly, the public at large, not the other way around—that’s what Adam Smith, the founding father of modern capitalism, envisioned. They are supposed to let wealth flow to the companies and people that deserve it, in order to help them create real economic growth.
Valeant shows that our system is no longer doing that. The company’s crazy style of accounting is amazingly becoming the rule rather than the exception at many companies, as Gretchen Morgenson explained so well, but its basic business model of “buy not build” isn’t uncommon in the pharmaceutical field either.
For years now, many large and important drug “research” companies have been decreasing the amount of money they spend on actually inventing new drugs and instead going deep into debt to buy other firms, preferably ones with established, branded drugs and few competitors, and then hiking up their prices, which is easy in this country since the government can’t, as in European nations, negotiate directly with such companies to keep prices (and profit margins) at a reasonable level.
One resonant 2010 Morgan Stanley report called for the pharmaceutical industry to “exit research [meaning the search for new drugs] and create value,” by throwing cash back to shareholders or buying up companies that could create short-term revenue streams, if not longer-term profits. Of course, the term value has a different meaning for shareholders than for patients.
Drug company CEOs will say that they need 100%-plus price hikes (which more than 200 drugs, and not just those owned by Valeant, experienced in 2014) to “innovate.” But the truth is that innovation hasn’t been their business models for years now. While the decoding of the human genome has presented incredible new opportunities for breakthrough drugs and therapies in everything from cancer to dementia, investment into early-stage biotech and pharmaceutical research and development has been decreasing for many years now. The number of new firms being started is declining. And the number of venture capitalists investing on the area is going down, too—from 201 firms in 2008 to a mere 137 by 2013. Investors and drug company CEOs alike know it's hard, risky work to come up with a new blockbuster drug, so they choose to bolster their stock prices buy purchasing something already on the market, or to sit on the cash altogether. The result? “The really innovative stuff doesn’t get funded,” says Andrew Lo, an MIT finance professor that has studied the dysfunctional business model of pharma.
So why does our market system – which, remember, is in theory supposed to send capital where it deserves to go, where it can create the most economic value – allow this? Because of 40 years of small changes to the system that favor financiers and shell game firms like Valeant rather than true innovators — not only accounting standards that led to firms like Enron and clearly haven’t been cleaned up since, but also a model of shareholder “value” that says a stock price is the best reflection of corporate value, and a tax code that favors debt rather than equity. Valeant currently has $30 billion in debt on its balance sheet, but a good chunk of that is tax-deductible, so hey, why not?
Of course, all that debt will ultimately make the company’s risk of default much higher, as Wells Fargo pharma analyst and former whistle blower David Maris pointed out in a scathing 40-page research report on Valeant recently. As he put it, “we believe that Valeant’s self-proclaimed “new business model” for pharma has been reliant upon low-cost debt for deals, cost cutting for acquired companies, price increases, and based on recent press reports, specialty pharmacy practices that are now under scrutiny. We believe that following recent intense scrutiny of its practices, Valeant’s growth may be impeded.”
I’ll say. Of course, the big investors like Bill Ackman who’ve helped buoy the stock over recent years will likely have taken their profits by the time the company goes bust. It will be Main Street investors left holding the bag—again.