How McKinsey Helped Turn Big Pharma into a Rent Extraction Business

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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28 comments

  1. Cry Shop

    Lest we forget Chelsey, who once weaned off the witch’s teat, got her first job at McKinsey? Superb training for her eventual return to the family trust. Training on how to use any monopoly and corruption, whether a patent, or government power, to drive money to the super class** of rent takers. Here in this example the super class are not the shareholders of Valeant (who actually are being punished) but the executive board. It strikes me very likely that Clinton is saying one thing, but really doing something else out of view when it really matters when she critiques pricing, but keeps taking their money. Clinton clearly believes the voters are stupid, and she isn’t far off, a good percent of those backing her evidently are.

    BTW, One assumes that any trust, stock fund or leverage firm holding long positions in these firms are doing so because their own board are being rewarded in some barely legal way for selling out their investors as well. If Morgan Stanley and Goldman Sachs are any guide, it would not surprise me if the management of these investments are themselves actually shorting the same shares through other vehicles, just as MS and GS purchased shorts and options against the mortgage back securities they sold.

  2. divadab

    Flipping seconol isn’t off patent yet? Have patents been made perpetual?

    “Yeah baby I don’t believe you no good at all
    Oh baby I don’t believe you no good at all
    Well woman cause you’ve been drinkin’ too much whisky,
    I believe you’re talkin’ too much seconal”

    Johnny Winter

    Monopoly Capitalism at its most filthy and disreputable and corrupt. Fucking parasites.

    1. Larry

      The Secobarbital patent has long expired. But Valeant is the only distributor of the drug at present. It is thus possible that another generic manufacturer could step in and make and distribute the drug, but I suspect that the ROI would not warrant entry into the generic market. So even without patent protection, it is possible to establish monopoly pricing for drugs.

      https://en.wikipedia.org/wiki/Secobarbital

      This was Shkeli’s game as well. And it seems that every slimy McKinnsey/MBA type is creeping into this game these days. This gouge sick people at any and all cost is eventually going to lead to the golden goose getting slaughtered. I’m not sure how much longer these practices can stand up to rightful public outrage.

      1. none

        Seconal is made by Ranbaxy, an Indian manufacturer with a sordid history of its own. I wonder what Seconal costs in countries other than the US. And for use in assisted suicide, does it really need FDA safety approval?

    2. BradK

      Monopoly and Capitalism are mutually exclusive concepts. What we have here is nothing short of organized crime.

      1. vidimi

        huh? monopoly and “free markets” may be mutually exclusive concepts but monopoly is just the end goal of capitalism.

    3. TomD

      I expect Seconol is no longer patent protected, several of the drugs that Shkreli’s company bought were no longer patent protected. However, the size of the market for the drugs was so small that no one had bothered making a competitor drug or generic.

  3. 2and20

    Raising prices the way they have is a scummy thing to do, but I don’t see the problem with it…any other industry, customers would just walk away if they don’t like the price. Here though, it’s clearly the setup of the healthcare system itself that’s the problem. Hate the game, not the players..

    1. reslez

      Martin Shkreli approves this servile comment.

      > Hate the game, not the players..

      The game did not poof into existence.The players designed the game and pushed for all the rules. This is an industry devoted to price gouging the ill who have no alternatives. In a just world these execs would all be serving life sentences, which is better than what they offer their customers.

  4. washunate

    Patent troll is definitely the operative phrase. The drug companies are doing exactly what public policy tells them to do.

    1) the drug war limits access to other drugs
    2) corporate trade pacts limit access to international drugs
    3) government support for wage inequality in higher education allows MDs, JDs, and MBAs to command outsized compensation packages in the private sector, too (well, at least the subset of them interested in preying on the public…)
    4) Medicare does not negotiate volume discounts
    5) the government does not enforce anti-competitive laws against players in healthcare like hospital chains
    6) which all culminates in IP law that is out of control transferring enormous amounts of wealth to private interests in the drug dealing business

  5. allan

    ” …executives had to alter course and cut costs.”

    In 2013, Valeant purchased Bausch & Lomb, closed its corporate headquarters in Rochester, NY, and slashed local employment. Locals are now hoping that Valeant will be forced to sell off B&L, although whether the headquarters will ever return to Rochester is dubious.

    Yet another price paid by the little people for QE ∞, which helped fuel Valeant’s binge.

  6. dodahman

    I saw this from Mckinsey in early 80’s while at a now defunct pharma company. It has been their mantra for a long time. I asked the lead guy how he slept at night. Sleaziest bunch of consultants I ever came in contact with.

  7. grayslady

    Back in the 1970s, certain senior managers in the large bank that I worked for wanted to restructure the organization in order to more effectively pursue certain markets on a global basis. McKinsey was brought in to perform a study. A friend of mine, who was a member of the team meeting with McKinsey, told me that, in the initial meetings, McKinsey came right out and asked what objective the managers wanted the study to reach. Lo and behold, when McKinsey completed its report, a restructuring was recommended that was exactly in line with what the senior managers wanted. McKinsey was merely used for window dressing. As the late Mayor Richard Daley said, when asked by reporters why so many of his political appointees were close friends: “Do you expect me to appoint my enemies?”

    1. MikeNY

      Yeah, when I was on ‘the Street’, I heard pretty open talk about hiring consultants to ‘prove out’ or validate management’s decisions. Cart before horse.

      There’s no question in my mind that Big Pharma is a rent extraction business. Just look at their profit margins which are at least double the S&P average. And that’s after R&D.

  8. Joel

    What McKinsey has really done – in pharma and every other industry they touch – is to radically empower financial engineering as the dominant managerial theory. The two biggest pharmaceutical companies have been run by a McDonald’s lawyer and a ketchup guy known for “operational efficiency”, both utterly out of their depth. Their boards figured their lack of understanding of the industry gave them sufficient distance to kill drug development programs, close labs, close plants, etc. that someone with more connection to drug development couldn’t do. Pfizer must have destroyed more than 100,000 jobs through is wave of acquisitions and post-merger integrations. The lack of connectivity of their leaders to the endeavor of drug discovery and development also makes them comfortable pissing away $billions and $billions on stock repurchases – which should be recognized as another huge scandal that transcends pharma. Its not just McKinsey – Bain and BCG preach similar self-serving obscenity, and the ranks of ex-consultants from all three of these firms dominate the private equity death stars that cruise around destroying US companies industry-by-industry, town-by-town in the name of creating monopoly pricing power and deb-laden potemkin shells they can flip to dumber buyers.

  9. Montana

    The economics profession has created a monster by the original research and creation of tools that are taught to MBAs without economists’s sense of the overriding goal of maximizing social welfare. MBAs are taught to micro maximize profits (“shareholder value”) without regard to externalities or impacts on society. And they are good at it. The MBA curriculum should be reformed by requiring each newly minted MBA to serve a year’s hard time in jail, just to get it out of the way.

    1. Malcolm MacLeod, MD

      Monta: I fully agree. I was a partner physician in Northern California Kaiser-Permanente
      Medical Group (1960’s-90’s) when Permanente went from physician control to less expensive
      MBA’s and it was a disastrous decision, as working conditions for staff physicians became
      more difficult and happiness at work became less. I retired early, and I’m glad I did, as the
      bureaucracy became a heavier burden. However, I loved my job until I retired.

  10. Steve H.

    I followed a trail from Kay to ‘Problem Driven Iterative Adaptation,’ which seems Harvard affiliated.

    It seems this may be a better way to cope with the issues inherent in the Lipsey Lancaster Theorem than, for example, a Kelly strategy that requires perfect knowledge.

    “But the geneticist Professor Steve Jones describes how Unilever actually did solve this problem — trial and error, variation and selection. You take a nozzle and you create 10 random variations on the nozzle. You try out all 10; you keep the one that works best. You create 10 variations on that one. You try out all 10. You keep the one that works best. You try out 10 variations on that one. You see how this works, right? And after 45 generations, you have this incredible nozzle. It looks a bit like a chess piece — functions absolutely brilliantly. We have no idea why it works, no idea at all.” – Harford.

  11. petal

    Big pharma and VC’s are also getting into agreements with universities (not just small biotechs) in order to get an even bigger jump on the market. They will license at a super early stage in the research to try to catch up with or beat their competitors. Sometimes they leave/pay for the first 2-3 years of development to the original groups (or spinoffs) and then pick up a lot more of the heavy lifting when it’s time to go into clinical trial.

  12. MikeW

    In the 1980s my father was the COO of one of the five largest life insurers in the US (think Des Moines). He loathed McKinsey and for good reason.

    McKinsey hit on the following and were actively promoting it in the industry. During the period of high interest rates they realized that owners of whole life policies could borrow against them at much lower rates. They convinced one of the most well known and respected life insurers to promote this to their policyholders as a means of making some money. Low and behold interest rates started moving against them and created a cash crunch for the lending insurer. It was viewed by the in-the-know within the industry as a crisis as should this company’s problems become public knowledge it would ripple through the industry with negative consequences (in those days it seems senior management cared about their reputations much more than they currently seem to). Quietly my father was part of a very select group of executives from 4 or 5 major insurers that banded together to provide the troubled company the cash they needed to get through the period. I do not believe this story has ever been made public. Needless to say McKinsey’s role in all of this went unpunished.

    1. Ishmael

      I joined the troubled subsidiary of a Fortune 500 company which paid McKinsey a million dollars to tell them to buy it. The CEO wanted to do this strategy so the only purpose McKinsey served was to deliver a report which he could take to the board and say see what McKinsey proposed. McKinsey later came in and was paid a million dollars to say they should sell the subsidiary I was with. We met with top management saying we could turn this around but their mind was made up. The paid $1.5 billion for the subsidiary and sold it to management for $50 million. Eighteen months later we sold it for $1.8 billion after returning it to profitability. See what a few mil gets you.

      The only reason that many of these M&A strategies are taking place is the Federal Reserve has pushed down interest rates so low that it invites these strategies and encourage the sale of high yield bonds where most people are going to lose a big chunk of their money.

  13. duffolonious

    I work for a medical device company and its the same thing. R&D farmed out to startups that are then acquired. The main part we do is integration.

    Same with IBM, same with an large business that gets cheap funding.

    I also think in medical devices there is some regulatory arbitrage. The startups being fast and loose. And then we (the teams I work with) play cleanup.

  14. Lord Koos

    There was a piece about Valeant on Zerohedge a few days ago, the gist I got was that the writer expected the company to collapse, as apparently they are leveraged way out there.

  15. Wade Riddick

    When asked why he raised prices, Shkreli said in one of his interviews he had a “price inelastic” product, meaning he could charge whatever he wanted and demand wouldn’t fall because his customers were in a life-or-death situation. We used to call this extortion. His entire pricing calculus revolves around how he can extort people. His justification was insurance companies would bear the cost – so I suppose you can add insurance fraud to his ambitions.

    They also caught the outfit altering doctors’ scripts at Philidor to redirect business to Valeant. Isn’t that a felony? Valeant is like the Enron of drugs.

    What they didn’t tell you is that the entire industry works this way now – which is why they’re so mad at Shkreli for being so blatant about how the golden goose works. There is a massive price-fixing ring centered around the Pharmacy Benefit Managers/Purchasing Managers Organizations. Pharmacies are paid a kickback on every drug they stock, creating an incentive to stock the expensive ones and dump the cheap ones. As with the 19th Century railroad cartels when they squeezed the food supply, both the producer and consumer suffer loses. It’s classic middleman fraud like you’ve seen today with investment banks in the copper and aluminum markets.

    Suppliers are also buying up generics and shut down factories until only one or two remain. The end result is all the shortages involve cheap, effective drugs. The expensive ones are all available. This is the opposite of what classical economics says should happen in an efficient market: expensive goods should be in short supply and cheap ones should be plentiful.

    In the last five years, I’ve had three different prescriptions go on and off the market – some of them repeatedly. 2ml vials of magnesium are totally unavailable, which makes it impossible for small practices to stock drugs for in-office use – and I think this is part of the goal to force independent professionals to close up shop and head to hospitals. Many of the changes in compounded medicine only make sense from this perspective. (Why limit compounded medication to 10% by volume of the business to sales in hospitals and doctors’ offices? Since when has rigging market share been a quality control procedure?)

    These shortages have killed hundreds, if not thousands, of patients – especially in oncology – and the MBA-run hospitals sit there perfectly quiet about it, directing their oncologists to tell patients they received “the best available drugs” for their conditions. They’re more terrified of the legal liability than they are their patients deaths.

    So it’s not just a matter of price and the rent-seekers in pharma and driving drugs off the market that don’t even have more expensive competition.

    Also take a look at the recent stories on “upselling” – packing more dose into a vial than can be used, thus leading to billions of dollars in waste every years (which Europe also manages to avoid).

    Blame _Citizens United_. Maybe if we didn’t make patients pay for corporate donations to political campaigns whenever they buy drugs, regulators wouldn’t push prices this high through a myriad of methods.

    For-profit war with military contractors has brought us the two longest, most expensive and indeterminate wars ever. Why would a military contractor win or lose a war when that meant no more profit? Why would a politician want anything other than permanent war since that brings in the donations from the contractors?

    Likewise, for-profit prisons means kidnapping for profit and for-profit healthcare means sickness for profit.

    Why hasn’t a progressive state stepped forward to open up its own non-profit co-op to manufacture basics like insulin? They would create local jobs by selling to other states and they could drive down their medical costs.

    1. For The Win

      Thank you for the thoughtful and informative comment.

      The pressure to join big practices can lead to other headaches as well. It seems big pharma likes large practices because it degrades the human connection between the doctor and his patient, making it easier to prod the doctors to over-prescribe.

      My best friend from high school quit his 20+ years ER practice at a hospital to set up an Immediate Care Clinic. He was being pressured to use drugs that were sub-optimal for the patient, because they were profitable for the hospital. Probably the hospital management might have been getting direct perks from big pharma as well.

  16. Rajesh

    Wonderful article. The Shkreli comparison was spot on…but other pharma companies aren’t exactly Angels. GSK in China for instance. And they keep ever greening patents that are about to expire.

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