Canada: Megamergers In The Pharma Sub-Sector: All Systems Go

Our April 29, 2014 blog post, M&A in the pharma sector: big deals are on the uptick, spoke to the significant increase in deal activity in Q1 2014 within the Pharma, Medical & Biotech sector and, most notably, within the pharmaceutical sub-sector. While there are critics who rely on conventional wisdom to question not only the trend towards pharma M&A this year but also the overall viability of pharma megamergers generally — suggesting that large M&A deals destroy value, disrupt critical programs, and subvert R&D initiatives — a recent report published by McKinsey & Company titled Why pharma megamergers work explains that such criticisms are short-sighted. In fact, McKinsey points out that, historically, pharma megamergers have been critical for the long-term sustainability of acquirors, suggesting that any short-term disruptions caused by a megamerger are greatly outweighed by its future benefits.

As the basis for its report, McKinsey analyzed pharma "megamergers" occurring between 1995 and 2011; i.e. deals which exceeded $10 billion in which the target company boasted at least 10% of the acquirer's sales and 20% of the acquirer's market capitalization. McKinsey's analysis focused on 17 deals during this period, and considered not only the acquiring company's total shareholder returns in the two to five year window post-merger, but also post-merger revenue, margins, new-product introductions, and product pipeline.

McKinsey's study lead to the following three principal conclusions:

1. Pharma megamergers create value.

The results of McKinsey's study reveal that, two years following a transaction's announcement, median excess returns for a pharma megamerger were 5% above industry index. Five years after a deal's announcement, the median acquired company contributed approximately 37% of the combined company's total revenue and 10% of its new-product revenue. Further, within two years of the closing of the megamerger, the combined company's economic profit increased by an average of more than 50%, mainly due to a larger revenue base and leaner cost structure.

2. Consolidation deals generate the most economic profit

McKinsey's study classified the megamergers it analyzed into 2 distinct groups: (1) consolidation deals which combine companies with existing market overlap, and (2) growth-oriented deals which seek to either create a new company or expand into a previously untapped market.

McKinsey's report explains that, historically, consolidation deals have tended to generate superior economic profit for acquirers, largely due to cost synergies and accelerated revenue growth. Although consolidation deals were very popular in the early to mid-90s, however, the current trend has reflected a move towards megamergers aimed at creating growth platforms. Given that the companies involved in most growth-oriented deals have limited operational overlap and lack many of the synergies prevalent in consolidation transactions, it is not surprising that growth-oriented megamergers tend to be more costly for acquirors — at least in the short term.

3. Growth-oriented deals may be preferable in the longer-term

Despite that consolidation deals tend to facilitate greater economic profit in years immediately following a megamerger, McKinsey's data suggests that growth-oriented deals may be preferable in the long haul. Unlike consolidation transactions which typically neglect to consider long-term business issues, growth-oriented deals are often rooted in future strategic business planning. This difference in approach is reflected, says McKinsey, in the total return to shareholders (TRS). In the context of a consolidation transaction, TRS is significant and is positive for the first three years post-megamerger, but then turns south and becomes negative near the five-year post-merger mark. In the context of a growth-platform transaction, however, while TRS for consolidation deals are lesser in the short term (albeit still positive), TRS remains consistently positive through the five-year mark.

McKinsey concludes its report by noting that, in spite of the recent trend to move away from consolidation transactions in the phama sub-sector, consolidation deals should not be written off entirely: both consolidation deals and growth-oriented megamergers have a proven track record of generating economic profit. This is likely welcomed news for big pharma which, as noted in the Globe and Mail's recent article Corporate confidence is back – and so is the mega-merger, is in the midst of a deal-making frenzy. While the Globe article predominantly speaks to the mega-merger phenomena which is so pervasive in the corporate world these days, it also gives a nod to the considerable increase in M&A activity in the pharmaceutical space, noting that megamergers have played — and will likely continue to play — a vital role in framing the pharmaceutical landscape.

Norton Rose Fulbright Canada LLP

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