Entidades empresariales

By the summer of 2011, both Pharmasset and Gilead faced a strategic decision over hepatitis C: should they proceed independently or pursue a ‘combination’? If they were to undertake a combination with each other, what would be the right price? Each company approached these questions from a different vantage. As I described at the end of section 5.1, Pharmasset plotted the potential for bringing PSI-7977 to patients as a stand-alone company, but recognized the need to scale-up their capabilities in regulatory approval as well as in setting up a global manufacturing and distribution infrastructure. From Pharmasset’s vantage, any suitor pursuing an acquisition would need to appropriately value the potential earnings stream that PSI- 7977 could bring. Gilead, on the other hand, had few promising avenues other than an

acquisition to gain a significant share of the hepatitis C market. To explore this acquisition avenue, Gilead joined with Barclays Capital in ‘Project Harry’, the internal name given to their joint effort to model the financial value of PSI-7977.152 The compound, combined with Gilead’s long-standing experience in Phase III trials for anti-virals as well existing global manufacturing and distribution channels, could yield the new revenue the company needed to kick-start

slumping growth. To make this happen, however, Gilead would need to determine whether and at what price to make such a bet.

Interviews 1, 3, 12, 15, 38 contributed insights into the capitalization process.

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In Project Harry, Gilead was ‘Gryyfyndor’, Pharmasset was ‘Harry’, with PSI-7977 the ‘golden snitch’ – the most potent hepatitis C compound that could serve as the backbone to a curative therapy (United States Senate, Committee on Finance 2015).

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As Gilead and Pharmasset weighed these positions and potential strategies, both companies conducted capitalization exercises in order to assess the value of sofosbuvir (still named PSI-7977 at the time) to each of their businesses. Described simply by Muniesa (2011:31), capitalization can be conceived of as the reduction of a stream of future earnings to their present value through the use of a calculative device (a discount rate) which signals how much money a capitalist would be prepared to pay now for a future flow of money. Gilead would use this calculation to identify how much it would be willing to pay now for the future flow of earnings from sofosbuvir. Pharmasset, by contrast, would need to determine how much it would need to receive now in order give up the potential to accrue earnings from PSI-7977 in the future as a stand-alone company. Rather than understand these exercises in capitalization through the sole lens of a technical device, however, dissecting the assumptions of the calculation reveals the relations of power that are stake in drug pricing and innovation. I focus on two major

assumptions here, drawing primarily on data from ‘Project Harry’, Gilead’s joint valuation exercise with Barclays Capital.

The first assumption was the potential price that PSI-7977 could demand upon approval. Gilead, for example, assumed a price of $65,000 per patient through most of its modeling exercise while also testing a sensitivity range of prices $10,000 below and above that point (United States Senate, Committee on Finance 2015:792). They chose this figure for sofosbuvir’s future price based on the price of the existing standards of care for hepatitis C which was about ~$50,000 in 2011, and the anticipation that not only would it likely rise by the year of the drug’s approval (estimated to be 2014 in the model), but that buyers would pay more for a superior clinical outcome (United States Senate, Committee on Finance 2015:792). This continued the promise of pricing escalator that had mobilized the chain of speculative capital through the innovation process. In making this pricing assumption, Gilead pointed to its anticipation of its relationship with a central actor: the state, and specifically, its public health delivery systems.153 Particularly in the US, the largest market for pharmaceuticals, Gilead forecasted their ability to set the price and gain monopoly returns, with a high level certainty about the limited countervailing powers of the state.154 This relatively open pricing horizon, protected from competition via the patents for PSI-7977, would

I discuss the dynamics of drug pricing and the ‘health delivery state’ in the following chapter.

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Even in other high-income settings (such as Europe and Japan), which would purchase hepatitis C medicines with greater regulatory and negotiating power, Gilead anticipated being able to charge prices in the range of the existing therapies, at a discount to their US launch prices.

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shape the valuation that Gilead placed on the compound and the amount they would be willing to bet.

The second assumption was what Muniesa earlier referred to as the ‘calculative device’ – the discount rate (Muniesa 2011). The discount rate is used by business managers, in this case the senior leadership teams of both Gilead and Pharmasset, to identify the rate of return (or ‘return on investment’) which must be exceeded to justify an investment. This discount rate is based on a core assumption in financial accounting: a hundred dollars tomorrow is worth less than a

hundred dollars today. This discount rate is based on a company’s weighted cost of capital, which is the rate of return expected by investors and debt holders on the capital it has provided to a business. A failure to generate a return greater than the cost of capital – in this case 10% for Gilead – would mean that an investment is not worth pursuing (United States Senate, Committee on Finance 2015:822).155

Yet the use of this cost of capital in investment and valuation assessments reveals a crucial relationship of power: between shareholders and business managers. In this configuration, any capital that cannot be used to generate growth greater than the cost of capital would be deemed to be wasteful, and would thus be better directed towards shareholders who could, as argued under the frame of ‘maximizing shareholder value’, more efficiently allocate capital to other firms and sectors in the economy. In this case, the acquisition of PSI-7977 was forecast to generate growth greater than the cost of capital (at the price points cited above). However, I follow its role in this capitalization exercise because it reveals how the growth expectations of shareholders structure every capital allocation decision by Gilead’s senior leadership into a simple imperative: either grow greater than the cost of capital within a near-term time horizon, or distribute the capital to shareholders.156 Though Gilead’s shareholders expected growth to exceed the cost of capital, I later show that shareholders did not actually risk any capital into the innovation process behind sofosbuvir.157

See the explainer box for a more detailed primer on these financial accounting methods.

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Michael Jensen, one of the leading proponents of ‘maximizing shareholder value’, summed this

imperative up when he argued, “The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies” (Jensen 1986:23).

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In fact, through the mechanisms of share buy backs, Gilead had reduced its share count over the prior decade (Seeking Alpha 2015). Yet the high levels of stock-based pay for Gilead’s senior executives tied the strategic interests of shareholders and the managers making these capital allocation decisions. I review both mechanisms later in this chapter, in section 4.4.

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Using these two core assumptions, about the future pricing of PSI-7977 as well as the discount rate, Gilead assessed the potential value of a Pharmasset acquisition. Gilead capitalized PSI-7977 through the net present value calculation (see Muniesa’s earlier definition of

capitalization): future cash flows were translated to a present value using a discount rate, with the cost of the possible acquisition then subtracted (United States Senate, Committee on Finance 2015:824). By Gilead’s modeling, an acquisition of Pharmasset translated to a net present value for Gilead of $25.5 billion (after a $10 billion acquisition price), indicating the vast economic potential of the opportunity (United States Senate, Committee on Finance 2015:810).158 Furthermore, Gilead believed that it could create greater economic value with PSI-7977 than Pharmasset could alone: though Gilead’s internal drug development program had not yielded a backbone compound as promising as PSI-7977, they anticipated that several of their secondary compounds could be used in combination with PSI-7977 to generate a single daily pill regimen that could gain a dominant market position (United States Senate, Committee on Finance 2015:861-862). Paired with their global manufacturing and distribution infrastructure that had previously specialized in anti-viral therapies (with its HIV products), Gilead’s modeling encouraged an aggressive posture towards acquiring PSI-7977.

Yet reviewing Gilead’s posture reveals the dynamics of a third relationship of power beyond Gilead and its shareholders and Gilead and the health delivery state: its position of power vis a vis Pharmasset and other small companies with pharmaceutical assets. Similar to Gilead, Pharmasset had undertaken its own valuation exercise to assess the value of PSI-7977 if it were to develop it as a standalone company. They arrived at a net present value of $11 billion, indicating a potentially lucrative economic future for the compound if it were to make it through final Phase III trials (United States Senate, Committee on Finance 2015:888).159 But Pharmasset forecasted two major barriers to this future as a stand-alone company.

First, unlike Gilead, Pharmasset did not have an existing organizational apparatus for engaging regulatory agencies around the world nor the manufacturing and distribution

capabilities required for hepatitis C (United States Senate, Committee on Finance 2015:498-505,

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The company’s senior leadership placed a high degree of certainty in the compound’s effectiveness in Phase III clinical trials, using 100% and 75% as its ‘possibility of success’ parameters in its sensitivity tests for PSI-7977’s value (United States Senate, Committee on Finance 2015:810, 824).

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Pharmasset’s valuation of PSI-7977 was lower than Gilead’s because Pharmasset believed they would need to pair the compound with a secondary compound from another company, thereby splitting the revenue; furthermore, Pharmasset used more conservative assumptions than Gilead based on their lack of existing experience in global regulatory, manufacturing, and distribution capabilities.

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507-510). Incumbent firms like Gilead, Merck, and Bristol Myers Squibb already had well-

established infrastructure globally; if any of them beat Pharmasset to the market with a hepatitis C treatment (by acquiring another small company with a hepatitis C asset, for example),

Pharmasset stood to lose major market share for its lone stream of revenue. Second, Pharmasset, also unlike Gilead with its HIV earnings stream, had no other potential revenue possibilities beyond PSI-7977. Even if it were to build global capabilities in regulatory process, manufacturing, and distribution, Pharmasset would have to quickly diversify to other disease areas and products in order to generate the kind of growth that shareholders would expect (United States Senate, Committee on Finance 2015:501). As I described in the previous chapter, Pharmasset’s executives had examined the landscape and deemed that generating such growth from internal research and development would not be possible in the tight frame of 3-5 years, or the time by which growth from hepatitis C revenues was set to plateau and even decline (United States Senate, Committee on Finance 2015:501).

Given these factors, Pharmasset positioned itself for a potential acquisition, realizing that if an established company like Gilead could value its PSI-7977 compound at the threshold ($11 billion) that Pharmasset itself did, then being acquired would be a strategically sound move. The company’s shareholders would thereby be assured to make an immediate gain at the level of its anticipated long-term value while forgoing the downstream risks associated with overcoming the barriers to entry I highlighted above. With this determination, Pharmasset’s senior leadership aimed to answer the lingering question that they had raised in recent years. Rather than building a durable business, they would instead actualize the very meaning contained in their name: serve a larger pharmaceutical company like Gilead with a promising asset, thereafter making

themselves disposable (Berkrot 2011).

In this section, I have provided an extensive account of Gilead and Pharmasset’s valuation of PSI-7977 within the context of each of their own businesses, and unpacked a set of

relationships of power within which the capitalization process is embedded. First, Gilead

anticipated a favorable pricing position with regards to a public health delivery state with limited downstream countervailing power. Second, Gilead’s managers had to account for the expectation of growth that its shareholders expected. Finally, through Pharmasset’s vantage, Gilead was a better potential suitor than a potential competitor, given Gilead’s comparative advantage as an incumbent firm. Taken together, these factors demonstrate Gilead’s position of power within the innovation process to gain control over potential earnings streams via betting on late-stage assets

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and anticipating pricing power with the state – thereby enabling its shareholders to extract value generated through near-term growth.160 We now turn to whether Gilead would be able to execute on this speculative bet.

Box 4.2 Cost of capital, the discount rate, and net present value: a primer

*Adapted from Gallo (2014) in Harvard Business Review

160 _{I elucidate this extraction in section 4.4, particularly through the distribution of hepatitis C revenues to}

shareholders via buybacks.

Cost of capital: the return expected by those who provide capital for the business

- Two types of actors may put up capital for a business: investors who purchase equity, and debt holders who buy bonds or issue loans to a company

- Cost of capital and discount rate (see below) are often confused. While related, they are arrived at in different ways and for different purposes.

o A company’s financial team typically calculates cost of capital; investors use it to assess the risk of a company’s equity.

o The management team typically takes the cost of capital calculation and then translates that number to a ‘discount rate’ that must be exceeded to justify an investment.

- The cost of capital is calculated by weighting the cost of a company’s debt and equity.

o To calculate the cost of debt, take all money the company has borrowed and average the interest rates being paid.

o The cost of equity is a more theoretical number, and measures a stock’s volatility (a beta figure) as well as the market rate of expected return on the stock market (typically 10-12%). - To arrive at the weighted cost of capital (WACC), take the cost of debt and equity and weight them

according to their relative proportions/percentages within the company. For example, if a company has 25% debt at a 4% rate, and 75% debt at a 8 percent rate, the WACC = .25(4%) + .75(8%) = 7% Discount rate: the rate that must be exceeded to justify an investment (also ‘hurdle rate’)

- Used to calculate the value of future cash flows in terms of prevent value, based on the idea that money tomorrow is less valuable then money today (time value of money).

- Typically set by business managers evaluating a potential investment, using the financial team’s cost of capital as a reference point

- Companies will set the discount rate higher than the cost of capital if they are risk-averse and desire a higher rate of return in order to make an investment.

Net present value (NPV): the present value of an investment’s expected cash flows minus the costs of

making/acquiring the investment

- Business managers use this calculation to assess whether an investment should be pursued or made: if the NPV is negative, the project is not a good one, whereas a positive NPV the project might be worth pursuing, with the larger the NPV, the greater the benefit.

- Net present value is calculated using a discount rate (above), which is set based on a business’s cost of capital, and management’s risk appetite.

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Table 4.5: Key figures used in Gilead and Pharmasset capitalization exercises

Gilead’s Project Harry model (with Barclays Capital)

Pharmasset’s Project Knight model (with Morgan

Stanley) Anticipated price for PSI-7977 $65,000 $36,000161

Cost of capital 10% 8%

Years of sales (from approval year to patent expiry)

2012-2030 2014-2030 NET PRESENT VALUE* $25.5 billion $11 billion NPV translated to Pharmasset

share price

$250 per share $136 per share

Market price of Pharmasset as of July 2011

$70 per share, or $4.8 billion Mean target price for

Pharmasset forecasted by 16 Wall Street analysts

$100 per share, or ~$8 billion

Final acquisition value $137 per share, or $11.2 billion

Note: Each of these figures were tested with different assumptions to develop sensitivity ranges, but I am communicating the most relevant numbers here to keep the focus on the core political-economy dynamics. Source: United States Senate, Committee on Finance, 2015