The Drug-Company Ripoff

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How McKinsey Helped Turn Big Pharma into a Rent Extraction Business

Posted on March 25, 2016 by 

The pharmaceutical industry has long enjoyed very generous government support, yet over the last two decades has taken to putting profits (meaning CEO and C-level bonuses) over combatting disease. Drug companies in the US benefit from decades of large-scale research and development by the National Institutes and Health and other Federal agencies. They also get R&D tax credits that to a large degree represent an acceleration of tax break for the expected future profits. Yet when those profits actually show up, they shift them offshore to avoid paying taxes in the US.*

And let us remind you that it not the responsibility of corporate executives; the “maximize shareholder value” theory of governance was made up by economists and does not have a legal foundation (see here for a longer discussion). And even if that were the case, actually trying to achieve that goal is counterproductive. As John Kay of the Financial Times explained in a 2004 article, and expanded in his book Obliquity, in complex systems, attempting to chart a straightforward path to a goal typically fails. Why? We don’t understand the system well enough to define an efficient way through it. For instance, a study that paired companies in a series of industries, one that chose complex and aspirational goal versus ones that set out to “maximize shareholder value,” found that in every case, the company with richer and loftier objectives performed better than its counterpart.**

One of the poster children for anti-social conduct by Big Pharma is Valeant, which is basically an up-market version of Martin Shkreli, a patent troll whose main method of “adding value” has been to buy drug businesses and jack up prices. A post yesterday at Business Insider recaps some of the high points of the well-warranted consternation over Valeant’s practices:

Valeant’s stock has fallen over 85% in the last year, in part because of scrutiny over its pricing practices. The House of Representatives is investigating the company for jacking up the prices of two heart medications over 200% and 500% respectively. Hillary Clinton has called out the company in her campaign videos, and the Senate has gone after the company for this practice as well.

This issue, combined with accounting issues, forced the company to say that it would change its business model, and rely on sales volume to generate revenue last December. It also said it would cut some prices — just some.

Either way, the market isn’t convinced, and some analysts say that Valeant will never be what it once was because without the ability to jack up prices of the drugs that it acquires. See, Valeant doesn’t really do its own research and development. It only spends about 3% of revenue on that, while its peers spend average of about 13% on it.**

Business Insider also pointed out:

Valeant Pharmaceuticals doubled the price of a drug called Seconal, which helps terminally ill patients end their lives peacefully, according to a report from KQED News.

Valeant purchased the drug last February, and jacked up the price from $1,500 to $3,000 after the state of California proposed legalizing assisted suicide.

The KQED report states that Seconal is an 80 year old drug.

John Gapper put the spotlight on the connection between the consulting firm McKinesy and Valeant today in McKinsey’s fingerprints are all over Valeant:

Valeant’s downfall is not exactly McKinsey’s fault but its fingerprints are everywhere. Half of its six-person senior executive team formerly worked at McKinsey, including Michael Pearson, its chief executive, and Robert Rosiello, its finance director. So did Ronald Farmer, the director who chairs its “talent and compensation” committee, which temporarily transformed Mr Pearson into a billionaire….

Like Enron’s “asset-light” strategy of trading power rather than owning power plants, Mr Pearson brought a consultant’s clinical eye to pharma. He despised costly research (“Be prudent about investing ahead of need — curse of the industry” was one motto), preferring to acquire proven drugs and raise prices.

No one did this more abruptly than Mr Pearson: “Our strategy is basically the education I had through McKinsey,” he said in 2014. He turned Valeant into a hyperactive acquisition vehicle, which not only benefited Wall Street banks but consulting firms for whom post-merger integration work is a labour-intensive, high-margin operation.

But what I find most damning is Gapper’s throwaway observation:

McKinsey provided the intellectual underpinning for pharma companies to rethink radically in the mid-2000s, when drugs pipelines seemed to have dried up and research productivity fell. As the firm’s partners concluded repeatedly in calling for “a bolder, more radical approach to Big Pharma’s operating model”, boards and executives had to alter course and cut costs.

And Pearson put that into place not only at Valeant, but for years before that as the head of its global pharmaceuticals practice. Even though drug companies have very handsome cash flows, they now prefer to leave the hard work of discovering new drugs to smaller players like biotech companies,**** snapping them up if they make a breakthrough.

Roy Poses at The Health Care Renewal blog has written with great energy and detail about the corrosive effect of what he calls generic management, or what could also be described as misrule by MBAs, on the delivery and quality of health care. Not only do they increase the cost of the adminisphere through their lofty pay, but they also make clear that they have little interest in or respect for clinical expertise, and wind up degrading care and demotivating staff.

Given how many MBAs have been churned out, and how they’ve wound up ensconcing themselves in other fields, like higher education, which similar dubious effects, one might argue that Valeant-like strategies would have inevitably have taken hold. But McKinsey operated as a major transmitter and legitimator of extractive practices.
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* Pharmaceutical companies pay so little tax that many top tax professionals believe the companies exaggerate the tax savings they will achieve through inversions in order to assure shareholder approval.

** One could argue that “maximizing shareholder value” has served as an excuse for rent extraction by top executives, so this outcome is a feature rather than a bug.

*** Bear in mind that that 13% figure overstates what laypeople would consider to be R&D by a large degree. For the 15 years, well over 80% of FDA “new drug applications” are for extensions or minor reformulations of existing drugs. In other words, the “new drug application” process as currently practiced is mainly about extending license protection, not invention.

**** “What’s the difference between high tech and biotech? How long it takes you to find out you’ve lost all your money.”

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