September 11, 2010

Merger Arbitrage : TRBN/ EBS

I usually do not get interested in risk arbitrage situation unless there is the potential to earn out-sized absolute return. Most risk arbitrage offer around 15-20% annualized returns, and actually less on large deals. However this one offers great odds for the price of participation.

The idea is not mine it was emailed to me from a reader so hat tip to G&B.

Emergent BioSolutions (EBS) is acquiring Trubion Pharmaceuticals (TRBN) in a deal valued at up to $135.5 million. Emergent will pay $96.8 million, or $4.55 per share in cash and stock, upfront for the company and issue milestone-based Contingent Value Rights (CVR) worth up to $38.7 million more. Milestones are based on mid- and late stage clinical trials of TRU-016 for the treatment of chronic lymphocytic leukemia and non-Hodgkin’s lymphoma, which is partnered with Abbott (ABT).

The math is simple for this merger arbitrage: there are no returns from the merger cash and stock consideration. However you will get the CVR for free at current prices, well close to it for 2 cents. SO effectively you have a cost free shot at earning $1.9 over the next 36 months. You can’t get better odds than these.

When the deal was announced the implied value of the CVR was 27 cents. However now it is 2 cents. See the progression of the implied value in the table below.
  • Will the merger close:
    • financing issues: cash consideration for the financing is $27 million only, while TRBN has cash and short term investment of $45 million on its balance sheet as of June 30, 2010. So EBS is actually getting paid to take the company to ensure its going concern.
    • TRBN shareholder’s vote. Management own is 5% of the company and I think there is abig likelihood that shareholders will vote yes for the deal
    • regulatory approval: already cleared.
  • Will the CVR pay out?
    • Pfizer potential for cancellation of their clinical studies as they have cancelled a program before merger announcement in July. The amount at risk is $12million. Pfizer decided to pare the dumped drug, TRU-015, comes as Trubion released trial results showing a higher than usual placebo response in a mid-stage trial, or not so exciting results. Pfizer picked up rights to both drugs as part of its 2009 acquisition of Wyeth. It is possible that Pfizer is paring rationalizing its R&D spending so some of these clinical studies will be canned.
Even a 5% probability of CVR payout will ensure to earn four times your invested capital. I was in at 3 cents CVR implied value.


Anonymous said...

Sorry i am not sure i understand the CRV math:( I'm a relative newbie.

1. Let's say i buy $10K worth of TRBN (i.e. approx. 2242 shares)

Scenario 1:
The acquisition goes through:
1. I get $4.55 per share.
&& the CRV is paid out

Scenario 2:
The acquisition goes through:
1. I get $4.55 per share
&& the CRV is not paid out

What is the upside per share in Scenario #1?

Thanks in advance for the clarification.


Sami said...

i did not explain it properly.
so first establish the arbitrage buy buying lets say 2242 shares of TRBN and shorting 368 shares of EBS.

if the acquisition closes,in Q4 you will get the following:
cash : $1.365per share
EBS Shares worth: $3.03per share of TRBN held
total $4.4 (TRBN trades at $4.42)

and 2242 CRVs entitling you to claim $1.9 per CRV if clinical studies are successful according to predefined milestones.

so the implied value of the CRV is 2 cents( TRBN current price $4.4 - merger consideration $1.365+ $3.03)

in scenario 1, if the CRV pays the maximum amount you will get $1.9 per share or ($1.9* 2242) your cost is $44.84 , or( .02* 2242)

in scenario 2 if the CRV does not pay at all your will lose $44.84.

hope that helps.

Anonymous said...

Very cool, that makes a whole lot more sense :) So it looks like a decent risk/reward situation.. let me read up more on these companies and see if i still feel like going ahead with this arb. play.

thanks a lot!


neil said...

Your table appears to be broken

neil said...

Thanks for the idea. This has a lot of potential. However after some thought, it could equally reflect a 4% chance of failure (numbers are rounded).

* CRV expected value at closing = 50c
* 4% chance of failure
* TRBN returns to 2.50 on failure ( 52 week low is 2.29)
* Assume EBS does not rise on failure
* TRBN cost of equity is 13%
* Deal is about 3 months from closing
* TRBN @ 4.43 , EBS @ 18.48

96% chance of 4.685 (current deal price + 50 discounted by 1/4 of 13%) = 4.5
4% chance of -1.93 = -.077

You can obviously establish different expected values of the CRVs, your expected losses etc.

Given that around 5% of friendly deals fail then TRBN may in fact be overvalued.

Sami said...

yes off course. the big risk is if the merger does not close. maybe this be part of the risk/ reward proposition rather than the implied value of the CRV.

but from financing and regulatory perspective it is looks good and chances are there are not big hurdles there.

now what it is left is the shareholder vote .

i think the market is discounting the CRV due to pfizer cancelling a clinical trial in july and it is expected that may cancel more as they finish integration with weyth.

Sami said...
This comment has been removed by the author.
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