Merger Arbitrage Dynamics: Pharmasset (VRUS)

Gilead ($GILD) is buying Pharmasset ($VRUS) for $137 per share.  VRUS’s main asset is an experimental drug that hopes to treat/cure Hepatitis C.   The merger is being enacted by a tender offer, which was launched yesterday, and will expire January 12th, 2012, pending regulatory antitrust approval under HSR.

So, why am I bothering to write a post about this deal?   This deal in particular illustrates several interesting merger arbitrage dynamics, all in one deal, as evidenced by the particularly wide (and getting wider!) spread.   The $137 price was a huge premium to VRUS’s previous trading range:

 

and the merger documents indicate that GILD was the only one of 5 potential buyers who ended up submitting a bid.   Additionally, VRUS’s value basically comes from a single experimental drug, so any negative results from this drug’s clinical trials would be potentially disastrous for VRUS’s valuation, and would likely kill the deal*.

The current spread is more than 6.5% gross, which is more than 60% annualized (to the mid-Jan 2012 closing date) – a monstrous number by merger-arb standards.   Let’s look at a 12 day chart of VRUS’s trading since the deal was announced, and talk about some of the reasons why the spread is so wide:

 

1) Biotech scares the crap out of traders:  we (traders) know as much about experimental biotechnology as we do about Russian backroom dealings.  That means that no matter how confident we get about the prospects/risks of these drugs, we can never quite feel positive that at any moment we might not get whamboozled with a negative trial result.    That risk is mitigated in this case by what should be a relatively short time needed to close the deal, but the risk is always there.   Fortunately, there are people who ARE experts in biotech, so we talk to these experts and try to better understand the deal.   A colleague sent me comments on the deal that included the term “pan-genotypic nucleotide” and I sarcastically replied “I’m wicked bullish on pan-genotypic nucleotides.”     In other words, it didn’t really help me feel good about anything…

Gilead cannot just walk away from this deal if they get cold feet – they need an adverse safety even from VRUS’s main experimental drug (PSI-7977) in order to be able to pull the plug on the deal – evidence that the drug causes problems.   Alternatively, GILD could walk if they fail to get antitrust approval, or if they would be required to divest one of the main target drugs.

Bernstein wrote a research report a few days ago about how the valuation that GILD is paying for VRUS implies “almost a total eradication of HCV in the developed world.”   That’s irrelevant, in some ways, as GILD can’t just change their mind anyway.   GILD can’t wake up one morning and say “holy crap, we made a huge mistake, let’s walk away.”   The tender docs also show that GILD was very eager to buy VRUS, initially bidding $100 per share, then upping it to $125, $135 and finally $137.

2) Calendar:  we’re talking about year end, where many risk-arb funds like to remain nimble, make sure capital is plentiful, and most importantly: not end up in a position that will blow up their year if it goes bad.

3) Deal size:  This is an $11 B deal.  That’s pretty a decent sized deal, especially given the first two caveats above.  How big will the biggest arb players get in this name?  Maybe there will be 3 funds that have a huge position – which would probably be about $300 MM in this deal – I’m totally guessing here.  But in any case, that leaves a lot of stock left over.   In other words, given the sector risks and the calendar risk aversion, there just aren’t enough buyers to narrow the spread.  “Plain vanilla” holders aren’t sticking around – they’re thinking “sold to you, sucka, thanks for the massive premium” and going out to spend their proceeds on Ipads, Cristal and TGIFridays gift certificates.

4) Rich price: the deal has a huge risk/reward ratio, and if the deal falls through it will be because of a problem with VRUS’s big drug, and the downside for VRUS stock will be severe.  You can make $8, or lose $80.  Of course, notional risk/reward is only half the equation.

5) Self fulfilling prophecy:  As a result of the wide deal spread, journalists start to write articles about how wide the deal spread is, and how it implies risk in the deal, which scares potential buyers even more, and becomes a self fulfilling prophecy.

A very smart merger arb trader who I correspond with daily told me “This spread is stupid.  One of the dumbest I have ever seen.”   The problem, I countered, is that no matter how much he and other arbs similar to him like this deal, they aren’t going to go out and put on $500 MM positions and soak up all the stock that’s coming for sale.  We expect this deal to trade with a wide spread until GILD gets HSR approval, and to still trade with a much-wider-than-normal closing deal spread all the way until the day the deal actually closes.

I am long VRUS, and I have no position in GILD.

-KD

* it takes harmful results to kill the deal, not just ineffective results.

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