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Is Valeant the wrong partner for Bill Ackman’s bid for Allergan?

Sanjay Sanghoee is a political and business commentator.

Pershing Square Management CEO Bill Ackman is at it again. The activist investor, who owns almost 10% of Allergan stock, has repeatedly tried to buy the $50 billion maker of Botox. Now Ackman and Valeant, a Canadian drugmaker he partnered with earlier this year to acquire Allergan, seem prepared to raise the bid even higher.

However the deal goes, Ackman makes money. Not only does his stake in Allergan enable him to pressure the company’s board to accept Valeant’s bid, although so far Allergan hasn’t budged, but it also allows him to block other suitors. What’s more, if a bidder emerges that puts a big premium on Allergan, Ackman could accept the deal and walk away with a hefty return on his shares. From Valeant’s perspective, the company would reportedly get a 15% cut from any such outside deal from Ackman, so it has little to lose by playing the game.

The only problem is that Valeant(VRX) may be the wrong partner for Allergan, and even Ackman.

Valeant increased its sales by 66% last year to reach $5.8 billion, largely through multiple acquisitions of health care companies, including Bausch + Lomb. While it appears the company is doing well, critics argue that once Valeant buys companies, executives slash their investments in research and development — an unsustainable business model that hampers future growth. Allergan (AGN)has pointed out that its R&D expenditures were 17% of sales in 2013 while Valeant’s was a meager 2%.

If critics are right that Valeant is cutting R&D investments too deeply, that means it is essentially a seller of existing products from acquired companies. For health care and pharmaceutical companies, particularly, that’s problematic since their businesses thrive on constant innovation and new products. For drug companies, the average cost of development can reach a staggering $1 billion or more, according to an estimate by Tufts University and Eli Lilly. Since Allergan plays in this arena, it explains why the company has so far rejected a buyout by Valeant, which would likely cut Allergan’s R&D budget and hurt its future pipeline of products.

More importantly, the only way for Valeant to keep making money from this business model would be to keep acquiring more companies since its older portfolio of products could eventually run out of steam in a competitive marketplace. You can almost view it as an M&A version of borrowing from Peter to pay Paul. In order to keep showing growth to its shareholders, Valeant would have to buy new companies continuously, using profits from each new company (combined with debt and financial partners like Pershing Square) to finance the acquisition of the next one – until it runs out of opportunities, financing options, or the market catches on.

Obviously, this all depends on who you believe – the critics or the supporters. On the face of it, at least, Valeant is on shaky ground, and Ackman should be smart enough to know that. Especially since he has been the most vocal critic of another company that he accuses of having a questionable business model – Herbalife.

Herbalife (HLF) is the global nutrition company that Bill Ackman famously ‘shorted’ for $1 billion, saying that it is a pyramid scheme that makes money not by selling products to consumers but from sales to middlemen. So long as it can keep recruiting new sales people, and those sales people recruit others and so on, selling its products to the end market becomes inconsequential.

But if Ackman is so bearish about Herbalife, then why is he betting long on Valeant by partnering with it on a takeover? He seems convinced thatHerbalife is a surefire loser while the other is a guaranteed winner.

It’s possible, of course, that he is being purely opportunistic and will exit Valeant after making money on the Allergan deal before anything bad happens. That, however, also conflicts with the moral high ground he has adopted on Herbalife. Ackman has criticized Herbalife for what he considers the unethical exploitation of poor people by recruiting them to sell products in a pyramid scheme, yet if you consider the implications of Valeant cutting critical R&D for health care, the situation doesn’t look much better for the ‘people’ that Ackman is championing.

Unlike, say, an automaker, companies in the medical industry have the capacity to create new products that can save or improve people’s lives – but only through robust R&D. The business model of a major company that is based on sharp cost cutting can therefore have a significant negative impact on the state of healthcare in the U.S.

That, along with the possibility that Valeant could flounder in the future if its roll-up strategy stops working, is why Allergan is wary of accepting a buyout, and why Ackman should think carefully about whether his partnership with Valeant is in anyone’s best interests except Valeant’s.

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein, as well as at hedge fund Ramius. He does not own shares of Valeant, Herbalife or Allergan.