Risk Profiles of Corporate Portfolio Strategies – A Perspective for the Pharmaceutical Executive

The current meltdown of some segments of the global banking system can be seen as a direct result of systemic weaknesses in the way that many financial services companies operated in a largely deregulated financial system during the last three decades.

But are these weaknesses really limited to the financial services industry? Or is the financial melt-down just the tip of the iceberg, revealing a systemic crisis of the economy at large – namely a lop-sided incentive system driving management at all levels and across industries to focus on maximising short-term gain at the expense of sustainability, which requires strong financial and strategic risk management?

Risk is a major challenge for the pharmaceutical industry, which is caught in an ever-repeating cycle of innovation followed by patent expiration. The key characteristic of this industry is that it is much harder to come up with truly novel and useful drugs than to design a new car model, the next-generation electronic consumer device or a new financial derivative.

The inherent output volatility of the pharmaceutical R&D engine is very much at odds with the requirements of public firms to grow EPS on a regular basis. In this environment, being shielded from too much short-term pressure can be a clear advantage as the success of Genentech exemplifies. Genentech laid the foundation to their current portfolio of marketed drugs during the early to mid-nineties, when R&D spending was at 50% of sales and profits were marginal. Roche, as a majority shareholder, provided the stability to stay on course and allowed them to nurture their unique culture and portfolio.

However, the vast majority of companies in this industry have grown through M&A. This dynamic is not likely to change any time soon as the industry will face an unprecedented wave of patent expiration between 2009 and 2013 and the concentration in terms of market share is still small compared with other more mature industries. The situation is further aggravated by an increasingly hostile regulatory and reimbursement environment.

To prepare for the hard times to come, companies such as GlaxoSmithKline, Merck & Co., AstraZeneca and Pfizer have recently embarked on major cost-cutting initiatives, including the revamping or downscaling of their R&D activities and marketing and sales. They also increasingly rely on partnering, expansion into emerging markets and lifecycle management to strengthen their portfolios.

While it is easy to lay the blame for difficulties the industry faces at the door of external constituents such as regulators or payers, it is instructive to review those factors that are within full control of senior management.

We have frequently observed three such factors that stand in the way of dealing with risk appropriately – and thus of an independent long-term growth path:

1. On the strategic level, decisions around diversification, focus and growth are dealt with on the basis of simplified frameworks and metrics that under-appreciate risk
2. R&D-related risks that can make or break a company are not systematically captured and discussed, let alone mitigated – we call it ‘Sleepwalking into phase III failure’
3. At the level of the operating model, incentives, structures and processes have increasingly focused on short-term process productivity at the expense of long-term value creation. In some cases, incentive schemes at the senior level have come to reward behaviour that improves short-term performance but increases long-term risk significantly

These shortcomings in risk management mirror some of the causes underlying the failure of the financial system. In this commentary, we take a closer look at the first factor, i.e. risk management at the strategic level, and show how a thorough understanding of portfolio risk profiles can help companies design more sustainable strategies.

See our website for the full version of this commentary which includes the following topics:

• The Portfolio Challenge – Focus or Diversify?
• The Origin of the Uniquely Focused Pharmaceutical Firm
• Popular Portfolio Decision Tools Can Misguide Management
• Measuring Value and Risk at the Portfolio Level
• To Partner or Not to Partner?
• Using Portfolio Risk and Value Profiles for a Strategy Review
• Is there an Ideal Model?