The Valeant saga is probably a long way from a resolution. Anyone that says they know how it will end is either delusional or looking to influence the stock. That being said, there are a few lessons to be gleaned:
- Organic growth is superior to growth by acquisitions—especially when growth by acquisitions is financed with large amounts of debt and even more especially when that debt is fueled by Wall Street bond offerings.
- In industries that rely on intellectual property, research and development spending is critical for survival.
- Accounting transparency is a big deal. I’m not saying that Valeant is Enron Part II, but I will say that unscrupulous behavior is a lot harder to detect when its wrapped up in complicated financial arrangements.
- The more a company works to highlight non-GAAP (AKA crap) results, the more investors should focus on GAAP results instead. As Gretchen Morgenson pointed out last week in the New York Times, Valeant earned $912 million in 2014 GAAP profits, while its non-GAAP reported cash earnings were $2.85 billion.
None of these lessons are new. They’re commonsense, investing 101, which leads one to wonder why so many successful money managers have risked huge amounts on such an inherently sketchy business. Sequoia Fund’s stake in Valeant is a staggering 34 million shares. Bill Ackman’s Pershing Square Capital owns 20 million; SF-based ValueAct, 15 million; NYC-based Paulson & Co, 9 million; NYC-based Lone Pine, 5 million; and Greenwich-based Viking Capital, 5 million. New York’s Brave Warrior Advisors (managed by Glenn Greenberg, son of legendary baseball player Hank Greenberg) has reportedly tied up more than a third of its assets in Valeant. These are massive investments from some of the biggest, best-known funds in the world—and that is exactly where the problem lies.
These outsized bets are a side effect of liquidity. As assets under management grow, liquidity constraints reduce the number of potential stocks and bonds where a manager might make a meaningful investment. Everybody in money management knows this, but few discuss or acknowledge it. The optimum asset size—if maximizing performance potential is a firm’s primary goal as opposed to maximizing the amount it can earn in fees—is almost always less than $1 billion. But a sub-billion fund usually doesn’t bring its managers fame or notoriety—and it certainly won’t earn them enough to pay for record-breaking apartments overlooking Central Park—so a combination of ego, greed and amorality seduces fund managers to bring in as many investors as they can. As AUM balloon, it gets harder and harder to produce great risk-adjusted returns. The only way to do so without engaging in insider trading or other illegal practices is to lever up or beta up. That increases the risk of a performance blowup. Years ago, a famous Bay Area money manager friend summed the issue up succinctly: “Almost everyone who manages over $500M is someone who checks his ethics at the front door every morning.”
The Valeant story shouldn’t just raise questions about the fund managers who placed giant wagers on the company. We should also examine the people who gave those managers the capital to do so. Why would any asset allocator trust a multi-billion dollar fund that continues to solicit new investors? The sad truth is that many large endowments and pension funds are overseen by political hacks with a minimal understanding of the investment landscape. Some endowments invest in funds solely because the manager is an alum and/or significant donor, and the investment comes with the unspoken understanding that the manager will keep his or her donations flowing. It’s a corrupt system, so I guess we shouldn’t be terribly surprised when it results in the funding of (allegedly) corrupt companies like Valeant
What really makes my blood boil is the fact that nobody questions why the realized gains from university endowments are tax-exempt. Or why donations to those endowments are tax deductible. Or why, unlike every other tax-exempt organization in the country, university endowments are not required to give away five percent or more of their assets each year. Or why tax-exempt organizations supposedly devoted to education have been raising the costs of tuition at an astronomical rate—often at schools that educate no more students than they educated 30 or 40 years ago. Forget one pharmaceutical company and its (allegedly) suspicious accounting practices. These are the real scandals that deserve our attention, and our outrage.