The Perfect Storm For M&A Shows No Signs Of Abating
This article was originally published in Scrip
AstraZeneca plc's deal to buy ZS Pharma is the latest in a record wave of deal making and consolidation in the pharmaceutical sector that has lasted more than 18 months, with the value of mergers and acquisitions since the start of last year running into the hundreds of billions of pounds. From household names and global giants right through to up-and-coming young companies, the wave has swept every part of the sector and – even as some investors are beginning to portray signs of skepticism – shows no sign of abating just yet. This is because the sector is in the middle of a "perfect storm" for deal making – a rare combination of four key factors that make acquisitions attractive for a range of businesses in the sector. This combination is not going away.
First and foremost, borrowing costs remain at historically low levels. Near-zero interest rates mean lower capital costs, ensuring that the return on investment from buying assets is much higher than has previously been the case. Equally importantly, there is a growing awareness that the cost of debt will not be as low as it is currently for very much longer, and therefore the opportunities that exist now should be grasped while they can be.
There is more to low cost of capital than low interest rates, however. There is expertise at play as well. During the financial downturn, a large number of M&A bankers moved out of finance and into industry – including into pharmaceutical companies. As a result, the sector has more in-house acquisitions expertise than ever before, analyzing deals and securing the best possible funding options to support them.
Neither of these factors, however, is unique to pharmaceuticals. So why is this sector seeing more activity than others?
The ongoing consolidation of the pharma customer base, coupled with the increased scrutiny on public healthcare spending and an ever lower number of blockbuster products based on small molecular entities, is leading to a disruption in the traditional generics industry. As a result, generics firms have used acquisitions to move towards providing higher-value, branded products, while the large drug makers whose patents have expired in large numbers have sidestepped years of research and development investment by buying young biotech specialists. Just as interest rates won't stay low forever, there won't always be a pool of available companies with proven new drugs, or established branded drugs, to buy.
The third factor in the perfect storm is tax. The most obvious example is Pfizer. Chief executive Ian Read has said publicly, on more than one occasion, that tax is a competitive challenge for his company in the US, and only last year his firm tried to use a merger – in that case with UK-based AstraZeneca – to create a tax inversion.
Its latest interest in Ireland-based Allergan has been seen by some in a similar light and, despite repeated claims by governments that they want to crack down on tax inversions, tax arbitrage has never been more of a prominent motivation to acquire than it is now. Part of that is due to the fact that inversion deals are difficult to carry out, often so much so that the protracted process can often outweigh any potential benefit. The difficulty has undoubtedly increased in recent years following the Obama administration's moves last year to tighten five different pieces of the US tax code to make inversions less profitable.
Ultimately, while difficult to execute, inversion deals are equally tough to prevent entirely. For as long as they allow shareholders to receive higher earnings per share, the motivation will be there to pursue them.
Finally, and perhaps most interestingly, acquisitions can be a useful distraction for financial markets that are attracted to big, exciting moves like mergers – and by contrast, are not enthused by less glamorous moves such as becoming incrementally more profitable by addressing weaknesses in other areas. For a senior management team, it can be hard to get shareholders to buy into a programme of addressing a shortcoming in operations, for example, almost regardless of how badly needed that is.
Tackling traditional problem areas is often also much harder to achieve and may require senior skillsets that the company does not currently have. They also require lots of hard work and investment to achieve small percentages here and there.
Even in this sector, where M&A activity has become almost commonplace, striking an exciting new deal still catches the eye of investors, who are more than happy to give boards the time, space and funding to prioritize them. The result is that there are businesses out there that still have a quagmire of management structures, or a plethora of different sites duplicating work in numerous locations. These weaknesses may prevent those firms from achieving their full potential, and will at some point need addressing. But for as long as the other three factors mentioned above mean that there are opportunities to be had, those businesses will continue to be on the acquisition trail, making hay while the sun shines.
Not all four factors are at play in each and every deal, of course. For as long as all four conditions remain as they do at the moment, however, the current wave of deals will continue. Investors hungry for transactions will continue to ask boards what their M&A strategy is, and management teams will in turn keep pursuing them.
Only when liquidity is withdrawn, or when the pool of targets reduces to such a size as to make even an inversion deal unaffordably expensive, will the feeding frenzy stop. So far, that point still seems a long way away.
Philipp Gutzwiller is the global head of healthcare for Lloyds Bank Global Corporates