The humbling of Valeant’s Michael Pearson

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How humbling this whole escapade must be for Michael Pearson, to have his fall from pharmaceutical grace propelled by Martin Shkreli.

Yep, that guy – the smug "entrepreneur" blasted for raising the price of specialty drug Daraprim by more than 55 times, and later charged with fraud by the U.S. Securities and Exchange Commission for other woes. Until Mr. Shkreli's business practices came to light last fall, barely anyone noticed Mr. Pearson was up to the same sharp price hikes at Valeant Pharmaceuticals.

The chain reaction since has been swift. Only six months after Mr. Shkreli was put under the spotlight, Valeant is in shatters, plagued by a moribund stock price, untrustworthy financial statements and criminal and regulatory investigations.

So, too, is Mr. Pearson. By Christmas, Valeant's CEO had been hospitalized for pneumonia; now he's gone from the company altogether, pushed out by the same board that welcomed him back from sick leave three weeks ago. It is the end of an era, and a horrible stamp of failure. Seven years into the CEO's game plan to resurrect the struggling company, his strategy has fallen on its face in epic fashion.

What we're left with: A "Canadian" company we should happily disown, and critical reminders that certain business rules should never be broken. Chief among them: Debt is never a problem until, suddenly, it is; markets will love you until, suddenly, they don't; and the roll-up game, driven by endless acquisitions, is nearly impossible to sustain.

To blame this all on Mr. Shkreli would be silly. Valeant's business model pushed boundaries in almost unimaginable ways. Nearly anything that boosted earnings was on the table.

By slashing research and development spending costs, Mr. Pearson freed up cash flow to buy more companies – whose R&D departments were then gutted to repeat the same trick. To juice earnings, he acquired Ottawa-based Biovail in 2010, which came with a Barbados-based subsidiary. Valeant started ushering U.S. profits to offshore tax domiciles – marking the first-ever pharmaceutical tax inversion and sending its corporate tax rate to the mid-single digits.

To fuel acquisitions, Mr. Pearson borrowed tens of billions of dollars of incredibly cheap debt. By mid-2015, Valeant had $31-billion (U.S.) in debt and paid over $1-billion a year in interest.

There were warning signs these bold acts would backfire. Last March, Warren Buffett's inner circle started to inflict damage. At an investor meeting, Charlie Munger, one of the value investor's best friends, said he was "holding his nose" by looking at Valeant, adding that the company "wasn't moral."

That cautionary message did little to deter two of Valeant's top investors: the Sequoia Fund – which has ties to Mr. Buffett – and Bill Ackman's Pershing Square Capital Management. Whatever criticisms were hurled at the drug maker, they stood by it, repeatedly stressing that they believed in Mr. Pearson. Their faith in him seemed nearly biblical. And because they showed resolve, hedge funds kept piling in – momentum investing at its very worst. By the end of June, nearly 100 of them had stakes in the drug maker.

Then came the September news that Mr. Shkreli jacked up a drug price, and later invoked capitalism in his defence. Hillary Clinton quickly turned the issue political by tweeting "price gouging like this in the specialty drug market is outrageous." The U.S. Senate called hearings, and both Valeant and Turing, Mr. Shrkeli's company, were forced to explain themselves.

What's happened since should never be forgotten by any board director or corporate executive. Even though Mr. Shkreli was a side show at a separate company, he morphed into a black swan for the entire industry. Suddenly every company was under scrutiny, and confidence in Valeant cracked. Within a month, Mr. Ackman had turned on the CEO, publicly reprimanding Mr. Pearson for seemingly scripted responses during an investor call in October when investors wanted real talk.

One of the best lessons from the global financial crisis was that everything became correlated when the U.S. housing market crashed. The same is true for Valeant. Investigations into its pricing policy made investors worry about revenue; worries about the income statement morphed into fears about balance-sheet debt; leverage woes prevented Valeant from borrowing more to fund future acquisitions.

The cynicism turned investors' momentum strategy on its head. The fervour that sent Valeant's shares soaring above $300 (Canadian) capitulated because few of those buyers were looking to invest for the long term – they were simply riding a wave. Short sellers, then, were able to inflict the exact opposite effect on the way down, only with much more force.

We may never know why investors were so eager to follow Mr. Pearson. Maybe it was his pedigree – having graduated from Duke and then leading McKinsey & Co.'s pharmaceutical consulting practice. Perhaps it was his early success turning money-losing Valeant into a star. Possibly, it was plain old greed.

Whatever the reason, they put far too much faith in him. However smart the strategy seemed, basic finance rules eventually ring true. Never, ever forget: Debt has a drowning effect.