Thinking about Life Sciences: KKR Buys First Data: On Private Equity, P... http://blog.aesisgroup.com//2007/04/02/kkr-buys-first-data-on-private-equ...

Thinking about Life Sciences

http://blog.aesisgroup.com

Monday, April 02, 2007

KKR Buys First Data: On Private Equity, Pipelines, Development

It was announced on Monday that First Data, which is one the nation’s major credit-card processing
companies, agreed to be bought out by the huge private equity firm, Kohlberg Kravis Roberts & Co (KKR)
for $29 billion. As the New York Times reported:
“The deal ranks among the 10 largest buyouts ever and signals the continued might of private equity firms, aided by
a flood of cheap debt and eager institutional investors like pension funds.”
What does this and other such mega-deals have to do with pharmaceutical drug pipelines?
The Rise of Private Equity
As many know, we are currently “basking” in an era of low interest rates. Many would regard this as a
good thing. Indeed, I don’t mind the relatively low mortgage rates now; certainly as compared to the 70’s
and 80’s. But, as with everything, there is no free lunch and there is a price to low interest rates.
There are the usual macroeconomic theories that point to overheated economies leading to higher
inflation. Some would also say that the current housing meltdown is related to easier money policies. And
while not necessarily a “price to be paid” one implication of the low cost of debt financing is the current
boom in private equity – as evidenced by today’s KKR - First Data deal.
But there is also another price to be paid for an economy that is tilted in favor of debt rather than equity.
Roughly speaking, debt is a conservative financing instrument. While not inimical to innovation it is
generally not the currency that lubricates revolutions. While private equity firms can provide great value to
the economy they, too, would acknowledge their efforts essentially make incremental improvements to an
existing company’s operations.
Impact on Innovation
To be sure, this can sometimes create stupendous value and certainly why else would pension funds risk
their capital otherwise. Private equity, though, exacts value through mechanisms such as management
changes, business process improvements, new market developments, etc. While this adds value it is not
innovation in any substantial sense.
One can counter by saying that innovation is the job of universities and venture capital. However, despite
high levels of liquidity, the world does not have unlimited money. The $29 billion for First Data means
that much money that doesn’t go to venture capital or other forms of more equity-based innovation
financing. Let’s say it costs $1 billion to bring a new drug to market (more on this later). That means we
could have 29 new drugs being financed instead of having your Visa or Mastercard processed with slightly
more efficiency. I am simplifying, of course, but the same argument has been held for growing
government debt crowding out private investment. Within the private sector, there are also such
“crowding out” phenomena and this is one of them.
Note that these points do not constitute a value judgment. I have nothing against private equity and truly
believe that value creation is a good thing. Even the much maligned Gordon Gekko – glaring out at the
top-heavy phalanx of vice presidents at the Teldar Paper shareholder’s meeting – had a valid point. We as

1 of 2 11/17/2008 12:47 AM
Thinking about Life Sciences: KKR Buys First Data: On Private Equity, P... http://blog.aesisgroup.com//2007/04/02/kkr-buys-first-data-on-private-equ...

a society though should not kid ourselves that these debt-financed investments will be directed towards
fostering innovation. It would be irresponsible of KKR and of its investors to think otherwise. [Here's
the YouTube video of that famous "Greed is Good" speech.]
So why doesn’t this money go towards more research and development – in particular to medical
technology or pharmaceutical discovery? As many have noted (including the Economist this past March),
corporate R&D has decidedly shifted more towards the “Development” side and indeed largely away from
R&D in general. To many firms, the returns on capital from R&D (especially in the context of this bias
towards debt financing) have simply not been great enough to justify more effort. The KKR – First Data
deal is simply an acknowledgement of that on a grand scale.
The Problem with Pharmaceutical Pipelines
With respect to pharmaceutical discovery, one cannot simply blame investors or management for such
decisions, since frankly the underlying paradigms of drug design seem to be fatally flawed. This may be a
surprise to some, but basically we know very little about how drugs bind to or act upon their targets.
The genomic revolution promised thousands of new targets – and a brave new world in medicine – but
relatively little has come of that. This past week, the American Chemical Society held its annual meeting
in Chicago where renowned Harvard chemisty George Whitesides was awarded the Priestley Medal which
is the industry’s highest honor. In his acceptance speech, he commented on this problem as follows:
The binding of a small molecule – a drug, ligand, substrate, or transition state – to a protein is arguably the most
fundamental molecular process in biology … the idea of rational design of drugs … was an objective we all
understood … but we have made mostly a kind of negative progress over the … years. We do understand better now
than we did then what we don’t understand and why the problem remains so difficult, but we still cannot design
ligands. How do reactants in any process, especially those in molecular recognition, interact with solvent and
especially with water? … we find that our current theories – of complex, tightly coupled kinetic networks, of
protein-ligand binding … of noncovalent interactions and so on simply do not work [bold face added].
While in college, I attended several of Prof. Whitesides’ lectures and I can truly say he is an optimist at
heart. His comments here are thus especially sobering. In this regard, I would agree with KKR and most
investors that throwing $29 billion at pharmaceutical drug development using the current paradigms
would likely not return as much value as investing in better credit card processing. Scary as that sounds;
that’s what the market is telling us.
Like the famous Indian legend of the blind men and the elephant, we have glimpses of the fundamental
process of molecular interaction but by no means a full view. There has been much turmoil in the
pharmaceutical industry. Fellow columnist Michael Rosen has commented on this subject and many of us
(myself included) have proposed various improved business models and R+D processes in order to help
solve the sparse pharmaceutical pipeline problem.
Ultimately, however, in the absence of a more complete understanding of protein-ligand interactions, the
sparse drug pipeline will largely remain a wasteland – which despite the great benefits to society from
improved medicines – investors will continue to avoid.
Ogan Gurel, MD MPhil
gurel@aesisgroup.com
http://blog.aesisgroup.com/

Private equity innovation venture capital pharmaceutical drug pipeline research Aesis Research Group Ogan Gurel MD

2 of 2 11/17/2008 12:47 AM