Zero Hedge
All posts from Zero Hedge
Zero Hedge in Zero Hedge,

Tying The Valeant Roll-Up Together: Presenting The Goldman "Missing Link"

While the Valeant soap opera has had constant, heart-pounding drama for weeks and following yesterday's report that it allegedly fabricated prescriptions, even an element of career-ending (and prison-time launching) criminality, so far one thing had been missing: an antagonist tied to Goldman Sachs.

Thanks to a profile by Bloomberg, we are delighted to reveal the "missing link", one which ties everything together. Its name is Howard Schiller.


Schiller was, between December 2011 and June 2015, the CFO of Valeant, and is currently on its board of directors.

More importantly, prior to joining Valeant, he worked for 24 years at Goldman Sachs as chief operating officer for the Investment Banking Division of Goldman Sachs, responsible for the management and strategy of the business.

How and why did Schiller end up at Valeant? Jeff Ubben, of the hedge fund ValueAct Capital, helped bring in J. Michael Pearson from McKinsey to run Valeant. Pearson then helped lure Schiller from Goldman Sachs.

And, as Bloomberg notes, "Goldman Sachs and other banks brought in investors, making many millions in fees in the process."

All thanks to the "roll-up" strategy that blossomed and ballooned under Schiller.

Because much more important than using Valeant as a Wall Street fee piggybank, which in turn resulted in a circular loop whereby virtually every analyst covering the company had a "buy" recommendation as we showed two weeks ago...


.... which then pushed its price ever higher, making it even easier to acquire smaller (or larger) companies using the stock as currency, and creating the impression of virtually perpetual growth (simply due to the lack of any purely organic growth comps), and even more important than the company's current fiasco involving Philidor (which may or may not involve a criminal investigation before too long), was that Valeant was nothing more than a massively indebted serial acquirer, or a "roll-up", taking advantage of the recent euphoria for specialty pharma exposure, and with Ackman on board, a sterling activist investor to provide his stamp of approval (recall the surge of Weight Watchers stock just because Oprah Winfrey came on board).

That aggressive roll up strategy was the brainchild of Schiller (and Pearson) which in turn was developed with Wall Street's help in one massive monetary synergy, whereby everyone profited, as long as the stock kept going up.

With the price crashing, the entire business model of the Valeant "roll-up" has now come undone.

So now that the time to count bodies has begun, let's meet the architect who was the brain behind Valeant aggressive expansion spree.

Schiller ran Goldman Sachs’ health-care practice until 2009, when he became the chief operating officer of Goldman’s investment bank. The next year, the bank advised Valeant on its breakout purchase of Biovail Corp.


After Schiller arrived at Valeant, in late 2011, the drug company orchestrated some of its most controversial deals. In the process, Valeant enriched its shareholders. Its market value soared from $14 billion to $70 billion during Schiller’s tenure as CFO, as one Wall Street analyst after another placed “buy” on its stock.

It also enriched Wall Street:

Under Pearson and Schiller, Valeant became a lucrative client for Wall Street. Goldman Sachs, for instance, was entitled to more than $15 million in fees for the Biovail deal. The firm also earned about $55 million for helping the drug maker raise $9.3 billion in debt and equity financing for the 2013 acquisition of Bausch & Lomb Inc., including its role as sole underwriter of a $2 billion stock sale, regulatory filings show.

... Goldman at this point, of course, was Schiller's former employer. Surely there was no conflict of interest there.

Goldman Sachs Lending Partners served as the lead lender among a group of banks that provided a credit line and term loans to Valeant. Later, the same banking group agreed to raise as much as $8 billion in financing for Valeant’s proposed acquisition of Allergan Inc. Goldman Sachs didn’t participate in that group offering financing and stepped down as the banking group’s administrative agent because it was involved in defending Allergan against the deal.

We don't understand: why would that stop the bank that was just fined a whopping $50 million for wilfully and criminally stealing inside information (which helped it make who knows how many billions in profits) from the New York Fed?

And then, just as abruptly as when Hank Paulson quit Goldman to join the Treasury just so he could cash out of his GS stock tax free, Schiller announced his resignation one short month after Valeant's failed attempt to acquire Allergan (in collusion with Bill Ackman who made hundreds of millions buying calls on Allergan having material non-public information that a hybrid strategic/financial bid was coming) fell appart after it was outbid by Actavis Plc.

As Bloomberg observes, "it was an opportune exit." Under the terms of his departure, he stands to continue vesting in a stock and options package that made up the bulk of his $46 million in pay through 2014, according to company filings.

It gets better: before stepping down, he sold $24 million of Valeant stock to pay taxes, including a portion when the shares were trading above $200, company filings show.

Call him lucky, just don't call him a criminal.

But while he is no longer CFO, he most certainly has present this past Monday on a conference call in which Valeant defended its relationship with Philidor: "Valeant turned to him, rather than to a company officer, to walk investors through a big part of Valeant’s presentation about its ties to Philidor."

Schiller told listeners that Valeant had launched a pilot prescription-fulfillment program through Philidor, and based on its success decided to strengthen its relationship with the specialty pharmacy. Then, last December, Valeant "acquired the option to acquire Philidor," he said.

Just four days later, after news broke that Philidor was fabricating prescriptions, that view changed at 5 am this morning when the company announced that "we have lost confidence in Philidor’s ability to continue to operate in a manner that is acceptable to Valeant and the patients and doctors we serve."

Call it unlucky, just don't call it criminal.

During the Monday call, Umer Raffat, an analyst at Evercore ISI, raised a question on many people’s minds: Why did Schiller leave when he did? “I feel like no one’s satisfied, and I keep getting that question from many investors in many meetings. So, would appreciate all your input there,” Raffat said.

Schiller reiterated that after two careers over 30 years, he wanted to "do some things on my own.”

He continued: “The timing was right. And again, just to be absolutely crystal clear, if I had –- and which I’m guessing, it could be an undertone of the question, if I had any concerns whatsoever about Valeant or Mike I would not have stayed on the board. It’s as simple as that."


Pearson quickly followed up. He said Schiller had called him shortly after the stock-commentary site Citron Research, run by short-seller Andrew Left, sent Valeant’s stock into a tailspin with a report questioning the company’s accounting and its relationship with Philidor, the pharmacy. Pearson has since called for authorities to investigate Citron.

Good, and when those authorities find nothing wrong with Citron, which merely blew the whistle on a rollup that many others had suspected for years, they can focus all their attention on Valeant.

For their benefit, here is a quick primer on the rapid rise and even more rapid collapse of some of the best known (and most infamous) roll-ups yet:

The notion behind roll-ups is to take dozens, hundreds, or even thousands of small businesses and combine them into a large one with increased purchasing power, greater brand recognition, lower capital costs, and more effective advertising. But research shows that more than two-thirds of roll-ups have failed to create any value for investors.


We were interested to find that many roll-ups were afflicted by fraud—among them, MCI WorldCom, Philip Services, Westar Energy, and Tyco—but we won’t focus on those in this article because for the most part the lesson is simply, “Don’t do it.” Instead, let’s look at the fortunes of Loewen Group. Based in Canada, it grew quickly by buying up funeral homes in the U.S. and Canada in the 1970s and 1980s. By 1989, Loewen owned 131 funeral homes; it acquired 135 more the next year. Earnings mounted, and analysts were enthusiastic about the company’s prospects given the coming “golden era of death”—the demise of baby boomers.


Yet there wasn’t much to be gained from achieving scale. Loewen could realize some efficiencies in areas like embalming, hearses, and receptionists, but only within fairly small geographic proximities. The heavy regulation of the funeral industry also limited economies of scale: Knowing how to comply with the rules in Biloxi doesn’t help much in Butte. A national brand has little value, because bereaved customers make choices based on referrals or previous experience, and being perceived as a local neighborhood business is actually an advantage. In fact, Loewen often hid its ownership. And it damaged whatever reputation it did have with its methods of shaming the bereaved into buying more expensive products and services (such as naming its low-end casket the “Welfare Casket”).


Nor did increased size improve the company’s cost of capital. Funeral homes are steady, low-risk businesses, so they already borrow at low rates. The cost of acquiring and integrating the homes far outweighed the slight scale gains. What’s more, the increase in the death rate that Loewen had banked on when buying up companies never happened. Fast-forward several years and the company filed for bankruptcy, after rejecting an attractive bid. (Relaunched under the name Alderwoods, Loewen was sold to the same suitor for about a quarter of the previous offer.)


Often roll-ups cannot sustain their fast rate of acquisition. In the beginning, all that matters is growth—buying a company or two or four a month, with all the cultural and operational issues that accompany a takeover. Investors know that profitability is hard to decipher at this point, so they focus on revenue, and executives know that they don’t have to worry about consistent profitability until the roll-up reaches a relatively steady state. Operating costs frequently balloon as a result. Worse, knowing that the company is in buying mode, sellers demand steeper prices. Loewen overpaid for many of its properties. In another case, as Gillett Holdings and others tried to roll up the market for local television stations in the 1980s, the stations began demanding prices equal to 15 times their cash flow. Gillett, which bought 12 stations in 12 months and then acquired a company that owned six more, filed for bankruptcy protection in 1991.


Finally, roll-up strategies often fail to account for tough times, which are inevitable. A roll-up is a financial high-wire act. If companies are purchased with stock, the share price must stay up to keep the acquisitions going. If they’re purchased with cash, debt piles up. All it took to finish off Loewen was a small decline in the death rate. For Gillett, it was an unexpected TV ad slump. When you go into a roll-up, you need to know exactly how big a hit you can withstand. If you’re financing with debt, what will happen if you have a 10%—or 20% or 50%—decline in cash flow for two years? If you’re buying with stock, what if the stock price drops by 50%?

This is precisely what just happened to junk-rated Valeant (which has leverage of just over 6 times) which - even if found innocent of any Philidor wrongdoing - is essentially finished: the rollup bubble has burst and now it has to show it can be profitable and generate cash.

Judging by its stock price today, few are hanging around to see if it can.