Watch Out for the Hangover
Acquisition binges often lead to hangovers; here’s what to watch out for.
Merger and acquisition (M&A) activity remains robust across all industries, including contract pharmaceutical services, as low interest rates and slow organic growth create both the opportunity and the rationale for doing deals. Recent events suggest that the world may have reached the boundaries of what is doable, however, as some large deals, such as the proposed combination of Pfizer and Allergan in pharma and Halliburton and Baker-Hughes in petroleum, have fallen apart over issues of tax policy, antitrust, and global commodity prices. Volatility in the world’s stock markets is also making it more difficult to do deals where payment is to be made in shares rather than cash.
Deals in the contract manufacturing organization (CMO) world aren’t likely to be affected by those macro-economy issues because of their relatively small size and scope, and it is expected that a number of them will be announced in the later part of 2016. A number of factors will continue to drive M&A in the CMO sector including a difficult initial public offering (IPO) market, the scramble for strategic assets, facility divestments by global bio/pharma companies, and a number of private equity-owned companies reaching the point, typically five years or so after their initial acquisition, when the owners are looking to sell.
However, flurries of acquisition activity, such as those seen in the past few years, invariably lead to hangovers that can impact the operations and even the viability of the buyers. In times of strong end-market demand, such as the contract services industry has been enjoying, there is intense desire to close deals to broaden capabilities and build market share. In the rush to do deals while financial markets are accommodating, companies can outrun their operating and financial capabilities. The following are some potential pitfalls that bio/pharma companies need to watch out for when doing their due diligence on service providers that have been active acquirers.
Integration challenges. Putting manufacturing, sales, human resources, and accounting operations on the same platform is a big, expensive undertaking that companies may fail to anticipate. Integration often requires investments in new software platforms, additional senior executive leadership, intensive staffing retraining, and ultimately the creation of a new corporate culture that can take years and a lot of cash. Companies pushed to show profits that justify the deal may not be willing or able to make the investments necessary for successful integration. The resulting complexity can have negative implications ranging from delayed financial reports (which can violate loan covenants) to high staff turnover to, in extreme cases, compliance issues because facilities operate under different quality and standard operating procedure (SOP) regimes.
Sustaining capex. Some acquirers are piling on debt in order to fund their acquisitions. In the current financial environment, interest rates are low, but interest, principal repayment, and loan covenants may limit cash available for investment in new plant and equipment. Further, as noted above, integration may require investment in new information technology and other capabilities that compete with the need for new or replacement manufacturing equipment. Customers can be persuaded to pay for some new investment, but that is usually for specialized dedicated equipment, not basic capabilities.
Strategic effectiveness. Acquisition-driven companies can be susceptible when the underlying strategy proves to be inappropriate or difficult to execute. For instance, the full service CMO model looks to be an appropriate response to the efforts by bio/pharma companies to consolidate their supplier base. But just as a chain is only as strong as its weakest link, a CMO’s reputation can suffer badly if any part of the full service offering falls below acceptable standards of performance.
Adverse market changes. Given the high prices paid for acquisitions and the use of debt to fund them, acquirers may be especially susceptible to any downturns in demand for contract services. Especially in a fixed-cost business such as manufacturing, small declines in demand can lead to disproportionately large declines in profitability, and any profit declines put debt servicing and loan covenant compliance at risk.
External funding for early stage bio/pharma companies has always been cyclical, and there was a sharp drop-off in external funding in the first quarter of 2016 as valuations of early stage bio/pharma companies came down sharply. While there may not be an immediate negative impact on the CMO industry, the funding slowdown could impact the industry in 2017–2018 if it continues.
While acquisitions are an important and legitimate avenue for companies to broaden their capabilities and gain market share, it’s important to remember that such strategic considerations aren’t always what is driving deal activity. Often acquisitions are sought as a remedy for slow organic growth (i.e., the inability of the current core business to grow as quickly as the owners would like). Also, it should be noted that private equity firms are paid to put capital to work and may be driven to do deals in part to demonstrate to investors that they are doing just that.
While Valeant Pharmaceuticals is not a CMO, its recent travails are a close-to-home illustration of what can happen when the assumptions underlying an acquisition-driven strategy prove to be unrealistic. Contract development and manufacturing organization (CDMO) industry veterans may also recall what happened to AAIPharma 10 years ago when it tried to transition from a CDMO to a pharmaceutical company. Corporate executives may challenge the boundaries of ethical and legal practices when their market and business assumptions prove unrealistic.
Most of the major players in the CDMO industry are well-managed and conduct careful due diligence when carrying out their acquisition strategies. But bio/pharma companies that depend on CDMOs for product development and in-market supply owe it to themselves to be especially diligent when qualifying suppliers that have been actively acquiring new businesses. Inquiring about integration activities and capital structure may not be part of the usual due diligence questionnaire but the answers could be crucial to the success of the relationship. Even if the survival of the supplier is not immediately threatened, clients need to be aware of potential disruptions to the business.
This article is reprinted from the June 2016 issue of Pharmaceutical Technology magazine.