A huge fund has defended a massive investment in Valeant that has caused an 'extraordinary amount of pain'

Sequoia Fund, the large mutual fund managed by Robert Goldfarb and David Poppe, has posted a letter on the homepage of its website defending its massive investment in Valeant Pharmaceuticals.

Shares of the Canadian drug company have collapsed since last Wednesday. That is when Citron Research, the short-selling firm run by Andrew Left, published a report asking whether Valeant was operating an Enron-like fraud.

Valeant's share price has declined by more than 40% since the report came out.

"We are witnessing a series of attacks against the management credibility and business practices of our largest holding, Valeant Pharmaceuticals International, Inc. Over the past few months, the market capitalization of its shares has fallen by more than 50%," the letter, dated October 28, began. 

"This has caused an extraordinary level of pain, made worse because the most serious allegation leveled against Valeant - that it set up specialty pharmacies as a way to create fraudulent sales and inflate its reported growth rate - is false. As an academic case study, Valeant would be fascinating. As a real life experience, it hurts."

A lot of funds have gotten hit by Valeant's share price decline. The stock ranked No. 10 on Goldman Sachs' stocks that "matter most" to hedge funds list for the second quarter.

Sequoia, which manages $7.5 billion according to Morningstar, has been a long time shareholder of Valeant. The mutual fund first got into the stock in the third quarter of 2010, according to Bloomberg. For a long time, the stock had been a huge winner for them.

Ruane, Cunniff & Goldfarb, which runs the Sequoia Fund, last held 33.88 million shares, or a 9.8% stake, according to regulatory data compiled by Bloomberg. The fund is down around 3.8%, according to Morningstar.

What's more, The Wall Street Journal's Rob Copeland is reporting that two of the mutual fund's board members, Vinod Ahooja and Sharon Osberg, resigned over the weekend after previously voicing concerns about the fund's investment in Valeant. The Valeant stake comprises almost 30% of the portfolio. 

Blaming the short sellers

Citron's report focuses on the company's relationship with Philidor, a specialty pharmacy that distributes prescription drugs for Valeant. Valeant is the only supplier to Philidor, and it also has an option to buy the company. On Wall Street, no one had really heard of Philidor until earlier this month.

Citron has accused Valeant of using Philidor, and an unknown number of specialty pharmacies like it, to generate fake invoices so it can book revenue for sales that never happened.

Valeant has categorically denied all of Citron's allegations.

In their letter, Sequoia's managers also said they don't think there's anything illegal about Philidor. 

"Our consultations with lawyers who specialize in the pharmaceutical industry lead us to believe there is no legal reason Valeant can't advise, control or own Philidor. At least one other large drug company owns its own pharmacy. There is no point in trying to conceal the relationship." 

Sequoia's management went on to blame Citron and Left for exploiting negative sentiment around the stock.

The fund managers then went on to praise Valeant's CEO Michael Pearson. Still, the think the company could do more to work on its reputation. 

We work hard to understand Valeant and its business model. Our belief has always been that Pearson is honest and extremely driven. He does everything legally permissible to maximize Valeant's earnings. One lesson of recent events is that sometimes doing everything legally permissible to maximize earnings does not create shareholder value. All enduring businesses must strive to earn and maintain a good reputation. Because of its large indebtedness and need to tap the capital markets to make acquisitions Valeant in particular needs the confidence of the credit market to execute its business model. The company has no large debt maturities over the next two years, and we believe it intends to pay down scheduled maturities through 2018 out of cash flows. We'd like Valeant to consider paying down more of its debt early and adopting a conservative capital structure that insulates it from the possibility of long-term tightness in the credit markets.

We have been asked by clients and friends why we own such a company. In our view, Valeant is an aggressively-managed business that may push boundaries, but operates within the law. When ethical concerns arise, management tends to address them forthrightly, but in the moment. We would stress the importance of taking a more systemic approach to managing business practices with an eye on the company's long-term corporate reputation. We believe the company will learn from the current crisis the importance of reputation and transparency to all stakeholders, especially the shareholders.

Here's a copy of the letter: