By Barbara Ryan, consulting managing director in healthcare capital markets and strategic communications, FTI Consulting
Last year marked an extraordinary time in the global life sciences market — record setting, in fact — and 2014 is already off to a roaring start. There were 60 mergers and acquisitions (with the average deal size 49 percent larger than the previous year’s).
And, almost 60 percent of investors responding to FTI Consulting’s fourth annual “Life Sciences Investment Survey” said they expect to see a significant to moderately significant increase in M&As in 2014.
What’s driving this urge to merge and acquire? In a recent panel discussion hosted by FTI Consulting, the action in the M&A space last year (and going forward) was largely driven by companies and their investors in the specialty pharma/generic category looking for their portfolio companies to grow and diversify.
For example, one of the more significant deals last year was Perrigo’s $8.6 billion acquisition of Ireland-based drug manufacturer Elan. Perrigo, a $22 billion company, is the largest manufacturer of OTC pharmaceuticals in the U.S., and Elan has a pipeline of experimental drugs for serious conditions, with its most notable success the multiple sclerosis drug Tysabri.
As Perrigo Executive VP and CFO Judy Brown told the FTI panel, the Elan acquisition was driven partly by the company’s desire to expand outside the U.S., giving its “booming” generics business a global platform to bring “quality, affordable healthcare to more markets” and partly to build a balance sheet that would allow the company “to do more and larger transactions than we would have been able to do in the past.”
As part of the transaction, Perrigo is reincorporating the combined company in Ireland, taking advantage of Ireland’s corporate tax rate of 12.5 percent, as opposed to the U.S.’s 35 percent. “By having a footprint in Ireland, by now being an Irish company,” Brown said, “we have more flexibility in our cash flow utilization, where we’re going to deploy cash, and how we’re going to be able to invest effectively globally.”
But switching domiciles to take advantage of lower corporate tax rates is not without its risks. Indeed, as FTI Senior Managing Director Tom Crawford told the panel, the practice, often called inversion, is “like Voldemort [in the Harry Potter books]. It’s not something we like to say out loud.”
The Elephant in the Room
Apple has done it. Starbucks has done it. Google has done it. Many multinational corporations have taken advantage of lower tax rates in foreign jurisdictions through a variety of strategies, including inversions, transfer pricing (charging prices for goods and services between divisions in a company for the purpose of either lowering profits in high-tax jurisdictions or raising them in low ones), and intellectual property (IP) migration (in which IP developed in a high-tax jurisdiction is moved to a low-tax one, enabling a company to recognize its revenue in the low-tax jurisdiction even if its sales take place in the high-tax one). IP migration particularly is common in the pharmaceutical industry, which has made large investments and built large facilities offshore.
Apple, Starbucks, and Google, among others, have been taken to task publicly for these strategies which, although legal, are viewed by consumers — rocked by the 2008 financial meltdown and still adversely affected by the slow economic recovery — as less-than-ethical business practices. As Crawford said, “You pick up the paper and you read every day some outrage about how much money is pooled offshore, avoiding taxation somewhere, and people want to do something about that.” (The headline for the Boston Globe’s June 17, 2014, story on the purchase of Dublin-based medical device manufacturer Covidien by Massachusetts-based Medtronic, another device manufacturer, read: “Address in Ireland may be Covidien’s sweetest asset.”)
Governments, responding to their disgruntled citizens, increasingly are prone to viewing these corporate financial arrangements skeptically and often as mere tax avoidance schemes and consequently pondering regulatory remedies. Right now, the Organization of Economic Co-Operation and Development (OECD), the European Union, and the G20 are all working on rule changes that would require companies to maintain significant facilities, management, or personnel in the offshore location in order to be able to report the revenue there. The U.S. is also saying that if a company is not managed and controlled in the jurisdiction where it’s reporting revenue, it will be disqualified from taking tax deferments.
As Crawford told the panel, if a company wants to be in a jurisdiction, “You have to demonstrate that it’s not solely for the purpose of avoiding or paying low tax.” There have to be “boots on the ground, or facilities, or some sort of management in control of operations for the overall business,” said Crawford.
Given the competitive demands on pharmaceutical companies and the benefits that accrue to corporate cash flow and the bottom line by the mitigation of tax liabilities, how can companies stay within the letter and spirit of these new and forthcoming regulations without risk of being placed at a disadvantage? The answer, both Brown and Crawford agreed, is understanding, openness, and engagement.
Shrinking the Elephant
Brown stressed the importance of keeping a company’s management team briefed both on current and proposed regulatory shifts. Management, she said, is making long-term investment decisions that will, of necessity, be affected not only by U.S. but also by foreign policy makers. When a company’s leadership is properly informed, it can make strategic investment decisions without running the risk of being surprised by events down the road. Furthermore, informed leadership can create a narrative that it can communicate to regulators that positions a company on the side of the angels.
Crawford worked with Perrigo to create and communicate that narrative. “The key for us in differentiating what Perrigo did from the standard tax avoidance, tax structure game that’s going on with inversions was that we made the business case for what Perrigo was doing,” he said. “We didn’t start at the point that we decided we wanted to acquire Elan. We started two years before the acquisition talking about the need for U.S. tax reform. We started telling the story about Perrigo’s contributions to the healthcare system. We talked about how what we do could be exported around the globe and the benefits of what we do in the U.S. That allowed us to go into the merits of the deal instead of talking about inversions.”
Brown testified before the U.S. Ways and Means Committee, engaged with its members, and argued that the U.S. needed lower tax rates to become more competitive globally. She pointed out that in order to continue adding jobs in the U.S. and to grow the company, Perrigo needed to compete with firms taking advantage of lower tax rates abroad. However, while Brown acknowledged that tax was a component of Perrigo’s acquisition of Elan, it was not the driver for the business decision. That, she told the committee, was growth.
Perrigo’s narrative and engagement strategy, said Crawford, has become “something of the white hat example of a U.S. company that is struggling to remain competitive for share outside the U.S.” Ultimately, instead of opposition or blowback when the acquisition was announced, according to Crawford, the Chairman of the Ways and Means Committee said, “I don’t blame you for what you did. You’ve been up here for two years telling us we need to do something. You can’t wait for us to go and do your business.”
The lesson from the Perrigo-Elan acquisition, Crawford said, is that “Policy makers are not looking to crucify people who explain themselves and who have a rationale for what they’re doing. I think they’re looking at people who try to arbitrage the system in a way that doesn’t appear to be about anything more than getting a tax benefit.”
The Tax Future
It’s becoming clear that governments are going to get tougher on companies that appear to be gaming the system to avoid taxes. Crawford recounted a meeting with the Finance Minister of Ireland who told him, “I’m going to keep our Irish rate – we’re not going to give that up – but I’m going to call the bad guys in and tell them you’ve got to get right or you’re getting out.”
That attitude is something new, and companies that don’t “get right,” that don’t implement controls and management in the jurisdictions in which they recognize revenue, risk alienating both governments and investors. At the FTI panel, Alan Hartman, a partner in Centerview Partners, an investment banking and advisory firm, said that investors “should just not be around those companies that have inverted or those that are otherwise in offshore jurisdictions. This issue is a big one for all Pharma.”
If, Hartman posited, pharmaceutical companies suddenly, without planning for it, find themselves paying 30 percent tax instead of a rate in the low twenties, “The math of those companies looks very, very different.” And the multiples at which they’ve been trading will look very, very different, too.
It behooves pharma leadership to begin planning for this future now. That means making sure their tax policies align with their corporate values and that they’re engaging thoughtfully with the investors and regulators who hold their financial futures in their hands.