March 1, 2009 (Vol. 29, No. 5)
Mark A. Metcalf
Volatile Economy and Need for New Products and Cash Flow Has Created a Buyer’s Paradise
Despite a volatile and uncertain economy, 2009 may be an active year for deals between pharmaceutical and biotech companies. A number of factors, including biotech companies’ difficulty in securing funding and the strategic needs of pharmaceutical companies, are converging to result in a buyer’s market. This could result in an increase in the number of biotech acquisitions by pharmaceutical companies in 2009.
Acquisitions, however, may not be the favored deal structure in 2009 due to an increased focus on risk mitigation. This may lead to an increase in the number of corporate partnering and option transactions, as well as inhibit the completion of acquisitions.
In order to remain competitive, pharmaceutical companies must obtain new products, either internally through research and development or externally through acquisitions, partnerships, or similar transactions. In-house research and development has not filled the void, however, and as a result, pharmaceutical companies have to evaluate acquiring smaller companies with new products, patented technologies, and innovative research teams.
Availability of Ready Cash
Financially, many pharmaceutical companies are well positioned to focus on acquisitions. At the close of the 3Q 2008, the combined cash on hand among the top six pharmaceutical companies was over $70 billion, with Pfizer alone having over $26 billion available.
In contrast to pharmaceutical companies, many biotech companies, both public and private, have insufficient cash on hand and limited access to additional capital. Drops in both market capitalization and ready cash demonstrate the financial difficulties facing public biotech companies.
At the end of November, over 37% of public biotech companies had less than one year of available cash. The biotech market has also seen a significant drop in follow-on public offerings to raise money for existing public companies. In 2006 and 2007 respectively, biotech companies raised $5.77 and $6.31 billion through follow-on public offerings, but in 2008 only $1.73 billion was raised.
Privately held biotech companies face similar capital depletion and limited access to markets. Venture capital investment in emerging biotech companies remained relatively strong in 2008, with $4.2 billion, just short of the $4.4 billion raised in 2007. Many experts expect venture capital investments to slow in 2009. Furthermore, the IPO market for emerging biotech companies was basically nonexistent in 2008. In 2007, 28 biotech companies successfully completed their IPOs, whereas only one occurred in 2008. Additionally, the credit crunch has limited the availability of debt financing for all biotech companies, as the amount of financing raised in 2008 by biotech companies was less than half of that in 2007.
Pharmaceutical companies will undoubtedly benefit from the difficulties facing biotechnology companies in 2009 as valuations will likely be depressed, and consequently, the number of significant corporate transactions may increase. Fewer of those transactions may be structured as acquisitions, than may otherwise be expected when considering generally lower valuations. Despite the incentives to acquire products and technologies and reduced valuations of acquisition targets, risk mitigation will be a significant factor for pharmaceutical companies in 2009.
Although many pharmaceutical companies currently have a significant amount of cash, turbulent public markets and financial system instability will adversely affect access to additional capital in the future, and it is unclear when the U.S. economy will begin a recovery. Moreover, the process for FDA approval of new drugs remains challenging.
As a result, pharmaceutical companies will have to make a more compelling business case to their shareholders before using available resources, and consequently their standards for deals will increase. Buyers will have less tolerance for assuming the risk of potentially unfavorable conditions discovered in the due-diligence stage of an acquisition, even after taking into account a reduced valuation.
This increased emphasis on risk mitigation, together with pharmaceutical companies’ increase in bargaining leverage relative to biotech companies, may have an effect on acquisition transaction terms other than valuation and may result in fewer announced deals actually closing. Buyers can structure acquisition payments so that most of the consideration is payable in the future and subject to contingencies, but this alone may not provide sufficient protection to a buyer. An acquiring pharmaceutical company may demand stringent conditions to closing to provide it with an increased opportunity to avoid completing an acquisition.
The negotiating leverage of many biotechnology companies is likely to decrease as they face fewer alternatives to an acquisition, narrowing fundraising options, and an increase in the number of anxious investors looking for exit opportunities. As a result, sellers may have to accept greater closing risks than would be acceptable under different conditions.
Acquisitions, for example, are often subject to the absence of a “material adverse change” in the seller’s operations or financial condition from the date that the acquisition agreement is executed to the proposed date of closing. Sellers often attempt to exclude from this definition changes in general economic conditions or changes in the seller’s industry, but sellers may not be in a position to successfully negotiate for such protections.
Buyers may also demand other favorable and broad closing conditions, such as the absence of adverse clinical events. The enhanced ability of a buyer to walk away from an announced transaction, together with a reduced tolerance for risk, may result in fewer announced acquisitions of biotech companies by pharmaceutical companies actually closing.
One alternative to an acquisition is an option-based deal, which may become more favorable to pharmaceutical companies as a way to mitigate risk. This structure, which requires a relatively small initial payment and provides an exclusive purchase options upon the results of clinical trials, allows pharmaceutical companies to hedge their financial exposure until R&D risks are known more fully, and avoid overpaying for an unsuccessful drug candidate.
In the recently announced acquisition option transaction between Cephalon and Ception, for example, Cephalon paid $100 million for an option to acquire Ception Therapeutics. Cephalon may exercise the option to purchase Ception for $250 million at any time until final clinical trials are known, thus protecting itself from exposure to risk of failed clinical trials that it may otherwise have to assume in an acquisition.
Ception will also receive the benefit of the initial $100 million investment and shareholders may also receive additional payments tied to clinical and regulatory milestones.
Another alternative to an acquisition is a corporate partnering or strategic alliance transaction. These deals can be structured to give biotech companies the capital needed to complete testing, as well as an infrastructure and finishing level that biotech companies cannot develop on their own without significant expense. Such transactions can also provide biotech companies with a less dilutive source of capital, which is even more attractive considering the recently depressed valuation of many biotech companies and the current financing environment.
Pharmaceutical companies benefit from filling the gap in their current product pipelines and can structure their investment so that, at first, relatively little capital is at risk. Pharmaceutical companies can exit the arrangement if milestones, such as successful clinical trials, are not met, thus avoiding future funding obligations. One recent example of such a strategic alliance arrangement is the Merck/Galapagos diabetes and obesity drug partnership announced in January 2009.
In this deal, Galapagos received $2 million initially with development and regulatory milestone payments that could exceed $228 million. It is also eligible for unspecified sales milestones and royalties for any product that reaches the market. Merck benefits by receiving an exclusive option to license candidates for clinical development and worldwide commercialization.
The combination of the need for new products by pharmaceutical companies and the need for capital by biotech companies, together with a volatile market and uncertain economy, may have a significant impact on the big pharma/biotech deal market in 2009. These factors may drive significant deal activity, despite the economy, and result in a buyer’s market as valuations will likely trend lower in 2009.
A reduced tolerance for risk, however, may result in a larger percentage of announced acquisitions failing to close. Further, pharmaceutical companies will have strong incentives to move away from acquisitions and toward partnering and option deals with biotech companies. As a result the number of acquisitions, relative to other types of corporate deals, may decrease.
Mark A. Metcalf ([email protected]) is partner in the emerging companies practice at Perkins Coie. Web: www.perkinscoie.com.