Contemporary Analysis of Pharmaceutical Acquisitions Intentions

The pharmaceutical industry is gigantic and accounted for $1.205 trillion dollars in revenue in 2018, with almost $500 billion dollars of it being accounted for within the United States. It is made up of a few large firms and fragmented with several small firms. Originally, there was a huge value in research output and R&D investment, but as the large firms merged or acquired to expand, firm incentives and niche changed, in respect of firm size. There has been significant mergers and acquisitions surrounding the industry as we have seen more interconnectivity and horizontal integration between pharmaceutical companies with other pharmaceutical companies, insurers, retail, and other life science firms. With all this, we still pay attention to the significant activity within the industry itself. M&A activity has been dominant in the industry over the last few decades. From 1988 to 2000, the value of the activity was around $500 billion dollars; the activity has been on the rise since then and we have seen M&A activity in the first half of 2018 alone equate to $200 billion dollars. We have seen individual transactions of tremendous value occur over time; at the end of 2018, Takeda bought out Shire for $62 billion dollars. 

Firms seek to create value in their actions. And the vast increase in acquisitions in the pharmaceutical industry are initiatives to create value within the acquirer and the target firm. The main driver of value today is innovation. Firms seek a competitive edge to attain a leg up in new drug development and production. Firms also acquire in order to complete or enhance their product pipelines. Lastly, as patents near their expiry dates before which they can be manufactured generically, firms are under pressure to consistently have new projects on hand and in the works. This environment is competitive and the pursuit of innovation has distinctly incentivized small and large firms to operate differently, but also complement one another for a mutually beneficial acquisition. 

Pharmaceutical companies depend on a few blockbuster drugs for much of their revenue. Developing and transitioning a drug through clinical trials is costly and timely, but the protected production (against generic manufacturing) and sales of the product is the main profit driver in the elite firms of the industry. With this, the drug patents have short lives before the equilibrium point of prices and profits will have to fall eventually due to the impending threat of generic production or a more efficacious drug (which can occur during the life of the drug’s patent). Thus, firms must always keep their pipelines filled with pending projects. 

In the current state of the industry, large firms have transitioned from excess R&D investment and have traded it off in order to outsource. They have found that their main competition are firms of relatively similar size and advantages arise from new drug development and premier product pipelines. Furthermore, R&D investment in large firms cannot prevent smaller firms from running their operations and investments. Thus, they scope out and compete to purchase small firms who effectively innovate as it is more profitable. Often, these larger firms hold diverse patent portfolios with low R&D expenses. On the other end, small firms compete with one another on their marketability of showcasing innovation in drug development. They ramp up R&D investment to increase their value and become attractive to potential acquirers; from this, they reap massive payouts for high valuation. In addition, the process of transitioning a drug through the three clinical testing stages is costly and target firms sell off knowing that a larger firm is more capable of funding and succeeding the process. We see that small and large firms – targets and acquirers alike – see benefits and value during an active acquisition market. 

Based on the momentum of demand that small firms face during active acquisition markets, they try to build up bargaining power. They optimize the return on the buyout when they drive up R&D investment with the incentive to increase acquisition surplus. It is important to note here that R&D is intangible and an off-balance sheet asset. It isn’t a direct profit driver, but it is complicated to value between two parties during a deal. Target firms make significant wealth here. 

Knowing this, acquiring firms need to figure out how the acquisition becomes worth it to them as they typically overpay for target firms. Beyond the pursuit for innovation and product pipeline enhancement, acquirers seek to increase market power. After approval to procure protection against competition in the manufacturing, production, and selling of a new drug, the acquiring firms increase the equilibrium point between prices and profits. Even though an acquirer’s cash flows may take years to break even after an acquisition, the resulting competitive advantage in the industry provides competitive longevity and future operation synergy.

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