M&A add-ons don’t make for better mousetrap

February 16, 2011

By Robert Cyran
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Contingent value rights are a nice idea. The ones structured for Sanofi-Aventis’ purchase of Genzyme helped close the valuation gap between the two sides and seal the $20 billion deal. It shows how financial engineering can sometimes bridge divides. But the drawbacks of CVRs should limit their use to very special cases.

In addition to the cash price, Sanofi will pay Genzyme shareholders more in stages if certain thresholds are reached in revenue from Lemtrada, a treatment for multiple sclerosis. If sales make it above $2.8 billion a year before the end of 2020, the CVRs will ultimately be worth $3.8 billion — an extra $14 a share, or 19 percent, on top of the $74 a share cash price. Genzyme’s hopes for sales run higher than that. But if revenue fails to reach $1.8 billion a year — a more pessimistic view shared by Sanofi and most analysts — the CVRs will be worth at most around $1 billion, or $4 a share.

Sanofi won’t mind, though, if the drug is a blockbuster. Suppose Lemtrada meets Genzyme’s expectations and brings in $3.5 billion a year. Using the drug industry rule-of-thumb valuation of five times sales for a drug with reasonable patent protection, the drug would be worth perhaps $17.5 billion at that point. That would leave plenty on the table for Sanofi even after paying out on the CVRs.

It’s a neat way to close a gap in expectations for an untested product. The trouble is, investors don’t like CVRs. Their specialized nature and limited shelf-life mean they tend to be illiquid. And the inherent uncertainty tends to mean they trade at a discount, even to an objective estimate of their fair value.

Such instruments are particularly unpopular among the marginal investors that can make or break a deal — the arbitrage players. They tend to buy heavily into companies involved in deals, and they like to bet one way or another. An illiquid add-on that drags a deal’s final denouement out for several years doesn’t suit them.

CVRs are also troublesome to negotiate — “brain damagingly” so in the Sanofi-Genzyme deal, according to one participant. The structure, consequences and policing of these instruments are all complex, a big reason it took more than six months for Sanofi to set the terms of its deal. CVRs have limited uses, but generally they don’t make a better dealmaking mousetrap.

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