ValueAct Pays a Price for Its Supporting Role at Valeant

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Bill Ackman gets a lot of ink and a lot of criticism as one of the largest investors behind the crisis-ridden Valeant Pharmaceuticals.

But another activist investment firm with a much larger role in Valeant’s activities has largely gone unquestioned: ValueAct, a San Francisco based investor that also has a large stake and board seat on Microsoft.

ValueAct, founded by Jeffrey Ubben, deserves credit — and perhaps a large dose of disapproval — for virtually everything that’s happened to the company over nearly the last decade, both good and bad.

ValueAct has been a longtime investor in Valeant, dating to 2006. The company has held at least one seat on the company’s board since 2007, and more recently held two seats. It helped install Valeant’s now-dethroned chief executive, J. Michael Pearson. It oversaw the design of the company’s compensation policies that some critics now suggest created incentives to use aggressive accounting practices. It also backed Valeant’s controversial strategy to cut research and development and to significantly increase the price of its drugs.

For years, Valeant’s success was ValueAct’s success. It was a home run. At one point last summer, when Valeant’s stock was trading at $250 a share, ValueAct’s return on its stake was a whopping 2,100 percent. And it was proud of Valeant’s deal-driven, slash-and-burn strategy: “We believed extraordinary value could be created not from a traditional strategy of high-risk R&D bets but rather from a focus on operational excellence, cost control and asset divestitures,” ValueAct said in glowing support of the company back in 2009.

But that was then.

Today, Valeant’s shares are down about 88 percent from their high of last summer in the face of questions about the company’s accounting, the ouster of Mr. Pearson and a scuffle inside the boardroom that led to a director being asked to resign, a request the director refused. Oh, and the company is being investigated by Congress and the Securities and Exchange Commission.

ValueAct, amazingly, is still in the black, having bought much of its stake in Valeant at an average share price of $11.

Last June, ValueAct sold about $1 billion worth of Valeant shares only months before the company’s troubles surfaced. Under securities laws, insiders are held to a very strict policy about when they can sell since they are privy to the company’s internal records and plans. No one has accused ValueAct of selling its shares with knowledge of the company’s impending downfall, and there is no reason to believe that was the case.

ValueAct described the sale of shares last summer as a standard portfolio transaction.“We have owned Valeant shares for over nine years and have sold shares on three previous occasions for the same portfolio management purposes,’’ it said in a statement at the time. “After this sale, our investment in Valeant will continue to be well in excess of $3 billion and will be one of the largest investments in our funds.”

But ValueAct, given its presence on the board and long relationship with Valeant, had to be aware of the company’s use of a mail-order pharmacy, Philidor, as a way around the efforts of pharmacies and insurance companies to sell lower-priced generic drugs instead of Valeant’s high-priced brand-name drugs. That practice has come under scrutiny and led, in large part, to Valeant’s current crisis.

Valeant declined to make Mr. Ubben available to comment. In fairness to him, he is at a disadvantage as far as defending himself publicly because most company lawyers prevent insiders from speaking out.

It is hard to see how ValueAct wouldn’t have been aware of some of Valeant’s more aggressive strategies, unless it intended to claim that it was duped by management, a claim it has yet to make. Indeed, even though ValueAct’s representative, Mason Morfit, had stepped down from the board (before returning after the crisis hit), Mr. Pearson said in a statement last fall: “Although Mason has not officially been a part of the Valeant Board for more than a year, I have continued to value his vision and guidance, and I believe his insights will be invaluable during this time.”

It was Mr. Morfit, among others on the board, who helped put in place a compensation plan for Mr. Pearson and other managers that some governance experts say may have led to Valeant’s aggressive approach, both with its use of Philidor and with its accounting practices, which have now come under scrutiny.

Mr. Pearson’s compensation plan, once heralded as a model for paying for performance, was tied directly to the success of the company’s stock price. Mr. Pearson needed to reach certain thresholds of performance to be paid or he would get nothing beyond his salary. And last year, Mr. Pearson’s salary was slashed to zero to make him even more dependent on the performance model, so he was completely focused on his incentive bonus.

The stock needed to go up at least 15 percent annually over at least three years for his bonus shares to vest. If the stock went up 45 percent, Mr. Pearson would be paid three times as much. By last summer, Mr. Pearson was worth about $3 billion on paper.

“We richly reward for outstanding T.S.R. performance,’’ the company said in a filing, referring to total shareholder return, “but pay significantly less for below-average T.S.R. performance.” It acknowledged that its formula meant “the company’s executives could be among the best-paid in the industry.”

That might have sounded good in theory. Who doesn’t want their executives’ pay directly tied to the company’s performance? Unlike those in so many companies, Valeant’s compensation structure meant that Mr. Pearson would do well only if the shareholders did too. None of the “heads you win, tails you win too’’ chicanery that has led to such skepticism about compensation at public companies.

But it meant that Mr. Pearson and his team needed the stock to keep going up. And that may have led to a culture that was too aggressive.

All along, ValueAct was there. The firm’s managers may not have been operating the company day to day, nor making some of the decisions that led to the current crisis of confidence. But it happened on their watch, under a chief executive they championed. At a minimum, ValueAct tacitly endorsed Valeant’s strategy. And now, ValueAct is stuck holding the shares, unable to sell them given its insider status and all the continuing investigations.

While ValueAct’s investors may still look at Valeant as a profitable trade, they might want to give the company the kind of scrutiny ValueAct failed to give Valeant.

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