Do you remember Philidor RX Services, the specialty pharmacy that distributed Valeant Pharmaceuticals(NYSE:BHC) products exclusively? (Valeant would rather you forgot it.) When it finally acknowledged its tight relationship with Philidor in October 2015, it blindsided the market, initiating a sharp decline in the shares that would ultimately erase nearly $80 billion of the company's market value. The Senate Committee on Aging recently released 818 pages of documents pertaining to Valeant that clear up a host of questions about the company's shenanigans.

Philidor had come out of nowhere, as it were, to represent nearly 7% of Valeant's revenues in the third quarter of 2015. Valeant tried desperately to convince investors that the pharmacy company was an independent entity, but its labored explanation of their close relationship in a 90-page presentation raised more questions than it answered (the presentation has since been removed from Valeant's website, as you may have noticed from the first link in this article).

In an eyebrow-raising structure, Valeant had paid $100 million for the option to acquire Philidor... at no further cost. If you have the ability to buy an asset at zero cost, why wouldn't you go ahead and exercise the option? The only reason I can think of is that the asset actually becomes a liability if you own it.

Why didn't Valeant purchase Philidor?

The Senate Committee sent Philidor a list of questions, among them, "Why did Valeant never purchase Philidor?" Philidor's attorney answered:

Philidor concluded that Valeant's conduct was consistent with a concern about the economic impacts of any PBM [pharmacy benefits manager] response if Valeant had purchased Philidor.

Philidor's assumption: Valeant was worried that if it publicly acquired Philidor, it would damage key relationships with the pharmacy benefits managers that were paying for its drugs. That's a logical, consistent explanation.

Valeant thus found a way to structure its acquisition so that it wasn't one under the strict letter of the law -- but the most recently revealed evidence shows that was just a sham.

The published documents also include the full purchase option agreement between Valeant and Philidor, which listed incentive payments that Valeant promised Philidor for specific revenue milestones, according to the following schedule:

Revenue target to be achieved over four consecutive quarters

Milestone payment

$524 million

$25 million

$1.04 billion

$25 million

$1.75 billion

$25 million

$3.50 billion

$25 million

Source: Purchase option agreement

Bloomberg has confirmed that it is completely non-standard for a pharmaceutical company to offer this type of incentive to a pharmacy. However, it is pretty clear what those milestone payments represent: an earn-out.

Distributor incentive or earn-out?

When one company acquires another, it can structure the deal so that part of the acquisition price is contingent on meeting performance targets -- the target company receives partial consideration upfront and must earn the balance. The milestone payments above look suspiciously like earn-out -- which makes sense, because without them, it would appear that Valeant had dramatically underpaid for the right to buy Philidor.

Valeant ponied up $100 million for the purchase option, plus a $33 million "time-based" milestone payment on January 2015 for a business that generated $189 million in revenues in the third quarter -- an annual run rate of nearly $750 million.

While Valeant may not have acquired Philidor according to the letter of the law, I'll leave it to the reader to decide whether or not this was a de facto acquisition.

What is obvious in hindsight...

Valeant terminated its agreement with Philidor effective Nov. 1, 2015, which forced the specialty pharmacy to fold. (Valeant represented essentially all of its revenues.) The reputational damage had been done, however, and it will take enormous efforts -- and significant time -- to repair it. Was it worth it to create and then conceal the relationship with Philidor? I'm certain former CEO Michael Pearson would say the answer to that question is now obvious. Unfortunately for Valeant and its shareholders, he was unable to come up with that answer without witnessing the consequences of his decision.