Interesting pharma M&A stat….

From this Bloomberg article: recent pharma acquisitions of >$500M have been at an average 71% premium to their pre-deal market price.

The article suggests that this is driven by the large number of Big Pharma's products going off-patent and therefore needing to be replaced. This is true, but I think there's also the partial explanation of a cost of capital arbitrage.

Pharma companies tend to have a cost of capital just a few points more than the borrowing from the Fed. This figure can be calculated for each pharma company, but let's just assume 8% over the long run, but with today's low interest rate QE2 environment, that might be more like 6%.

Biotechs, - even public biotech's - have a MUCH higher cost of capital. This too varies based on company, disease-focus, maturity, etc., but probably somewhere in the range of 12-18% today, or 2-3X big pharm.'s cost of capital.

Big Pharma companies (generally) trade based on earnings multiples, while biotech's tend to trade on the value of growth, which is risk-adjusted by the biotech firm's MUCH higher cost of capital.

Consider the forward and trailing P/E ratios of the first 7 pharmas that came to mind:

So let's say that you've got a blockbuster ($1B in revenue) at typical pharma margins (27% operating margin - we'll use that as a stand-in for EPS.)

That suggests that on a forward basis, the blockbuster is worth $3.25B (forward P/E of 12 x ($1B x .27)) to the pharma.

But if the blockbuster has sales of only ~$250M at this point, and $1B in revenue is still years off, the discounted (risk-adjusted)  value is much less perhaps half the value of its' forward value under the wings of a pharma company.

This example is pretty much a reflection of the setting of the HGSI-GSK merger talks. HGSI had $130M in revenue (JV revenue) and a market value of <$1.3B immediately before GSK launched their $2.6B takeover offer.

What I've described above - pharma's lower cost of capital relative to biotech driving M&A activities - is nothing new, but with interest rates today low enough that borrowing costs are almost negative for big pharma, it should really only be news if Big Pharma WASN'T buying, irregardless of the oncoming patent cliff.

Thanks to FierceBiotech for pointing out the article.

Interesting deals......

Two transactions from the last month that intrigued me:

Transgenomic (TBIO) raised $22M from a group of investors. Congrats to TBIO, as they attracted new capital equal to about 40% of their market cap including from a very serious investor (RJ Kirk's Third Security.) This financing allows TBIO to rise above the small cap services/genomics/diagnostics crowd, and lets them focus more on business than on financing. Gaining the imprimatur of RJ Kirk isn't bad either.

(Also an acknowledgement of TBIO's very nice 3-yr stock performance.)

What made me curious about the deal is:

1) the size. While one blogger calls the raise too large relative to their $1M/yr cash burn, I'd expect that TBIO has some really good uses in mind for the fresh capital, perhaps to shop around earlier, younger diagnostics plays to plug assays into their sales channel. My perception is that acedemics are asking for stiff terms to commercialize novel diagnostic IP, bargains can be found among capital starved start-ups.

2) the fact that Kirk/Third Security are injecting equity into TBIO.......to repay the debt owed to Third Security by TBIO. (TBIO owes ~$8M as part of their prior deal to buy Clinical Data/s (i.e. Kirk's) prior PGx assets.

This isn't anything unscrupulous, like, say Elan's early 2000's Enron-esque equity investments to get R&D expense off of their books while pumping their book value. (Wish I could find a link for this.) Instead, it's an interesting way for Kirk to continue to bet on pharmacogenomics while also returning some value on the investment in the short run. (The definition of "short run" is liberally applied here. Kirk's PGx investment interest goes all the way back to the purchase of Genaissance (2004?)) Kirk & team have turned over a tertiary asset from their Forest Labs/Clinical Data deal into an interesting chunk of a publicly traded company. (albeit OTC BB)

One of these days I'll have to dive deeper into Kirk's activity, particularly Intrexon, his synthetic biology company, and affiliates such as Ziopharm and Adeona.....

The other transaction that caught my eye:

Warp Drive Bio founded with $125M in seed financing.

When I first heard of this deal, I was stunned by its' size. I've come down a bit after learning more details, but I still can't rationalize it. (Never mind the realization that the headline science of Warp Drive combines two absolute graveyard priorities: natural products and genomics. That's a conversation for another day)

It looks like only $75M is committed cash financing. My guess is that Sanofi is contributing $50M in research support, less any research assets contributed. The press release suggests that this will cover 5 years of operations. (Let's ignore that business plans & research agendas change over 5 years.)

If you're an early stage VC, you're targeting a 40% annual ROI, but you won't pull the trigger that doesn't look like a potential 10X return. If the VCs behind the deal expect 10X liquidity in 5 years, then they'd target an enterprise value for Warp Drive in 5 years of $1.25B (158% IRR), but be happy with  5.4X (40% IRR on $675M EV in 5yrs.)

These figures are nuts, but I guess that's how Third Rock (not Third Security) does it - they also started Foundation Medicine with an enormous seed round ($34M last year.)

I really hope this isn't the only way that start-ups will get off the ground in the future. By now it is apparent that there's a big gap between start-up requirements and VC interest - VCs really need to deploy large amounts of capital ($5M chunks minimum, likely in syndicate with other firms resulting in rounds of $10-$20M in new capital. Only deploying capital at this level makes their VC models economical, while most early stage discovery companies think in terms of $1M-$5M rounds, otherwise their interests are diluted to nothing.

If Warp Drive is the rule, rather than the exception, only big ticket discovery efforts with star quality SABs and pharma partners at launch will draw financing, meaning that pre-clinical discovery will slow significantly.

My guess is that Warp Drive and Foundation are the exception rather than the rule, and that their VC parents have the 'curse' of too much capital to manage.

Or at least I hope so.