Tax reform fears driving Big Pharma mergers

The rumblings that corporate tax reform will close favorable loopholes for pharmaceutical and biotechnology companies are getting louder.

The sector, which benefits from deductions for research and development and international operations, has the most to lose in any shake-up of the corporate tax code. The tax breaks give sector companies significantly lower effective tax rates compared to healthcare services companies such as providers and insurers, whose operations are almost wholly domestic, with small R&D budgets.

The nuances and holes in the tax system helped fuel an explosion of cross-border mergers and acquisition activity last quarter—with price tags to match. Driven largely by the life-sciences sector, and particularly domestic drug companies acquiring overseas companies, the value of year-to-date M&A activity reached new heights.

Modern Healthcare's quarterly Healthcare M&A Watch report tracked $229.8 billion in deal value in the second quarter—more than four times higher than any period since at least 2011.

The 287 transactions also represented a 30.5% increase in deal volume over the second quarter of 2013 and 22.1% over the previous quarter—a sure sign that momentum is picking up again after a lull that persisted throughout last year. But it was the prices paid for those transactions that lifted eyebrows about the rejuvenation of M&A activity by pointing to potential tax changes being discussed in Washington.

For companies that already enjoy a low effective tax rate, the benefits of moving their headquarters overseas include being able to move cash back into the U.S. without a tax penalty. About $2 trillion is held offshore by U.S. companies, and the portion held by pharmaceutical and medical-device companies is in the “hundreds of billions,” said Martin Sullivan, chief economist at Tax Analysts. “They want to unlock their trapped foreign profits,” he said. “This gives them a platform for future growth for their own M&A and they also become a target themselves.”

To get the benefits of a “tax inversion” deal, a U.S. company's shareholders must own less than 80% of the combined entity. The string of deals came after President Barack Obama's March budget proposal suggested tightening that threshold to 50%.

Pfizer in April set the tone when it launched a record-setting bid for London-based competitor Astra-Zeneca. The initial $101 billion offer topped even the $90 billion the New York-based drug giant paid to buy Warner-Lambert in 2000.

The deal was notable not only for its size, but because it would allow Pfizer to shift its headquarters to the U.K., where it could take advantage of lower tax rates. AstraZeneca fought off the unsolicited advance.

Pfizer bumped up its offer to $119 billion, but ultimately had to abandon the deal after it failed to convince AstraZeneca of its merits. British law now mandates a three-month cooling-off period before Pfizer can try again. Because the deal is no longer on the table, the $226.5 billion in M&A value tracked in the report does not include Pfizer's bid.

Still, other drug and technology companies quickly followed Pfizer's lead, driving up the total.

Two other tax-driven deals—where a U.S.-based company went shopping across the Atlantic—followed weeks later. Minneapolis-based Medtronic will pay $42.9 billion to buy Dublin-based Covidien and shift its headquarters abroad. And AbbVie, in North Chicago, Ill., this month increased its unsolicited offer for Shire, also based in Dublin, to $53.7 billion, prompting Shire to finally enter takeover talks after rejecting lower offers.

Rumors also have swirled around whether London-based Smith & Nephew could be next in line for a takeover—though at least one potential bidder, Kalamazoo, Mich.-based Stryker, has denied that it is eyeing the acquisition.

As legislators in Washington rush to usher in legislation that would make it harder for U.S. companies to move their headquarters abroad, other opportunistic bidders are realizing they may have only a small window for action.

Most of the deal value in the second quarter—$159.1 billion or about 69% of the total—came out of the pharmaceutical, life sciences and biotechnology sector, according to the Healthcare M&A Watch report. And $109.5 billion was concentrated in deals involving an overseas target company.

Acquirers also showed greater willingness to pursue a hostile takeover, or one where the target company is resisting the deal. The largest still-active deal tracked in the report is Valeant Pharmaceuticals' play for Botox-maker Allergan, which has been bumped up to $52.7 billion in an effort to win over the resistant company.

In total, pharmaceutical, life sciences and biotechnology companies forged 79 deals, a 71.7% increase in activity over the same period last year and 36.2% higher than last quarter.

The high activity level also was seen in the vendor space, particularly for medical technology and device companies. The 99 vendor deals represented an increase of 52.3% year over year and 8.8% quarter over quarter. But those solid gains in deal volume were dwarfed by the increase in deal value, which soared to $60.2 billion, or 2.8 times higher than the second quarter of 2013, and 4.3 times higher than the first quarter of this year.

“There is a little bit of a herd mentality,” said Ellen Federman, senior consultant for global M&A services at Towers Watson.

Healthcare M&A experts said the sudden boom in deal prices is hardly surprising in the context of the current financing environment. Stock prices have rallied and lenders are more willing to offer favorable terms to borrowers. Companies are taking that opportunity to evaluate their portfolios and diversify into new business areas.

“What we're seeing that's different in the second quarter is that this isn't just organizations looking to take out weaker players to gain some cost synergies,” Federman said.

The tax-driven frenzy in the life-sciences sector stood apart from activity in the provider segment of the industry, where deal-making slowed, even as year-over-year transaction values continued to rise. In 2013, the provider space was the lone sector that continued to put up a higher number of deals despite the broader slowdown in healthcare M&A.

Two of the largest hospital groups—Community Health Systems in Franklin, Tenn., and Dallas-based Tenet Healthcare Corp.—are now busy integrating their respective blockbuster mergers from last year, said Brian Tanquilut, an analyst at Jefferies & Co. Other acquirers are facing roadblocks, including fewer targets and higher valuations.

Another major hurdle appears to be the threat that antitrust regulators might block in-market transactions.

In total, providers forged 100 deals with a total disclosed value of $9.8 billion. Deal volume fell about 5.7% compared with the same period last year, even as deal value increased about 7.7%.

But the numbers did show a significant bump over last quarter, with volume increasing 29.9% and value doubling. “You're starting to hit a stride where sellers that were holding out for a higher multiple are willing to sell,” said Angela Humphreys, a healthcare M&A attorney at Bass, Berry & Sims. “Now you're hitting a potential sweet spot.”

Many of the provider deals showed a quest to diversify, she said, pointing to one of the sector's largest transactions, Amsurg Corp.'s $2.35 billion bid for Sheridan Healthcare.

The M&A Watch report found that compared with last year, the number of deals for hospitals and post-acute-care providers declined in the second quarter while a greater number of deals were signed for clinicians and outpatient services.

Outpatient services were at the center of two other large provider deals in the second quarter. In the sector's third-largest deal, private-equity firm Clayton Dubilier & Rice committed $910 million to acquire Healogics, which operates about 500 wound-care centers. And Surgery Center Holdings, which manages ambulatory surgery centers, forged a $792 million deal to buy Symbion Holdings Corp., which runs short-stay surgical facilities.

While tax considerations didn't motivate providers, there was interest in international deals. Acadia Healthcare, an operator of psychiatric hospitals, made a $660 million play for U.K.-based Partnerships in Care, also a behavioral-health provider. And hospital giant HCA, which in April was ordered to divest two of its central London hospitals, was rumored to be looking at a bid for Australia's Healthscope, a large private equity-backed chain that ultimately decided to pursue an initial public offering.

The sector also saw its own hostile takeover battle as Kindred Healthcare made its $573 million case for Gentiva Health Services, a home-health and hospice operator that is still fighting for its independence.

As large companies get even larger, the next wave of transactions may be a spate of divestitures. The second quarter already saw two dozen companies pruning their portfolios. Two of the period's largest transactions involved Novartis buying GlaxoSmithKline's oncology portfolio for $16 billion, while GSK bought Novartis' global vaccine business for $7.1 billion.

The two drugmakers also plan to join hands to launch a new consumer healthcare business.

The outlook for deal activity, therefore, remains robust.

“No one has a crystal ball, but I think there's a fair amount of momentum around the transactions,” Federman said. But while she saw volume increasing throughout the rest of the year, it's less clear whether deal values have hit their peak. “That's the big concern—that the prices will continue to rise above where they make sense and there will be buyers' remorse,” she said.

Follow Beth Kutscher on Twitter: @MHbkutscher