Valeant Pharmaceuticals Inc. (NYSE: VRX) has represented the largest stake in Bill Ackman’s $12.5 billion Pershing Square Capital Management hedge fund, and gained vast notoriety on the street as aggressive accounting practices and questionable drug pricing drew the ire of politicians. Ackman, who holds a seat on Valeant’s board, assured concerned senators in an April 2016 testimony that the company installed improved processes to more appropriately examine all relevant variables when setting prices for vital patient medications.

Valeant acquired and significantly raised prices of Nitropress and Isuprel by 212% and 525%, respectively, prior to the release of generic equivalents for the drugs. Adding to the firestorm, Valeant’s mail order distribution channel was scrutinized after reports of accounting missteps resulted from the company’s relationship with shuttered Philidor Rx Services. As a result, VRX shares dropped precipitously from levels exceeding $262 in August 2015 to a close of $27.56 on May 20, 2016, which was a decline of 89%. Scorched investors surfaced from the ashes, learning valuable lessons about blindly following the pros without performing due diligence of their own.

Concentrated Portfolios

Investing in hedge funds requires substantial capital. Most portfolios require minimum investments of $1 million and have a lock-in period of one year, allowing withdrawals one time per quarter thereafter. Ackman’s portfolio holds 11 issues, with VRX distinguishing itself as the principal detractor from the fund’s 2015 loss of 20.5%, compared to the S&P 500 Index’s meager gain of 1.4% with dividends reinvested. Risk associated with highly concentrated portfolios is manifest in Pershing’s experience throughout 2015 and leading into 2016.

When big bets on individual issues go awry, shareholders and managers suffer the consequences. Hedge fund managers are compensated on assets under management (AUM) in addition to profits. Thus, as investors in the funds bemoan losses, fund managers such as Ackman take huge hits in compensation as portfolio values dive and redemptions erode assets under management (AUM). Conversely, when the stock picks are ripe, those same heavy weightings equate to significant outperformance. In the 10-year period from 2004 through September 2014, Ackman’s portfolio returned a cumulative 627% net of fees, compared to 119% for the S&P.

Leverage

Knowing which companies to avoid is as important as picking winning issues. Skipping over companies that amass huge amounts of debt, such as Valeant, remains a sound strategy in the long-term, even though some upside might be missed. While a lack of transparency spurred Valeant’s downward spiral, the company’s next obstacle manifests in its $30 billion debt load. While the company has never missed a debt payment, Valeant must file its annual report by the end of July 2016 or face default, a situation in which all loans must be repaid immediately or, alternatively, a renegotiation with creditors pushes interest rates higher. The crux of the matter revolves around the loan structure. Most of Valeant’s debt is owned by collateralized loan obligations (CLO), meaning that 753 funds with 103 managers hold the company’s loans, and 50% of those funds would need to agree to a restructuring. Valeant said that it intends to file the 10-Q on or before June 10, 2016.

Transparency

In an arena in which the mere appearance of impropriety sends shareholders scrambling for the exits, investor skittishness spells trouble. Valeant never disclosed its relationship with Philidor, a specialty mail-order drug distributor. While Philidor only contributed 7% to the company’s revenues for the third quarter of 2015, a series of negative accusations surrounded the alliance. Valeant denies any wrongdoing and claims revenue from Philidor did not meet the requirements for disclosure, yet the allegations gave rise to short selling and an overall erosion of trust by shareholders. Investors felt that deals shrouded in secrecy might indicate cloudiness in other areas of the company’s operations, and the selloff commenced.

Takeaways

Valeant's saga offers valuable lessons to investors. Primarily, institutional money managers, despite their past successes, make mistakes. If those mistakes are to be avoided, thorough research is key. A company exhibiting long-term fundamental strength, with low levels of debt, often trumps upstart flashes of brilliance, and diversification serves to tame risk before it runs wild.