Tip For Roche: Pay For Genentech with Non-Cash CVRs

genentech logoIn an unhappy reminder of January 2008, deals continue to collapse or see reductions in price. After the trouble at Rohm & Haas (ROH), the acquisition of Genentech (DNA) by Roche is another large deal officially on the list of downward revisions in price. On Friday, Roche (RHHBY.PK) announced it would take a $86.50 per share tender offer directly to shareholders, Roche logodown from a $89/share proposal back in July. In the meantime, Genentech traded as high as $99.14 in anticipation of an increase in what was seen at the time as a lowball bid. Genentech’s board rejected the $89 bid as inadequate.

Roche owns 55.8% of Genentech already is seeking to acquire the remaining 44.2%. If structured as a tender offer, the deal will occur in two steps: In a first step, Roche will attempt to gain control of at least 95% of the shares. In a second step, it can squeeze out the remaining shareholders. Genentech is incorporated in Delaware, where a squeeze-out is possible only if Roche controls more than 90% of the shares.

The question is whether Roche stands a chance to get to the 90% level through a tender offer. No single shareholder owns more than 5%, and only Fidelity comes close with 4.8%. However, most analysts were looking for a $100+ acquisition price, so it will be a challenge for Roche to get shareholders to tender at a lowball bid. Moreover, the proxy advisory firms are unlikely to support the deal (proxy advisors also pronounce on tender offers, although there isn’t actually a proxy vote involved).

In the absence of a positive recommendation by Genentech’s board, Roche will not even be able to obtain a top-up option, a popular trick whereby a target company dilutes holdout shareholders by issuing new shares to the buyer until it reaches the 90% threshold and can force a squeeze-out. Without the support of Genentech’s board, Roch will not be able to use this route.

It gets even better for shareholders: under an affiliation agreement between Roche and Genentech dating from 1999, Roche must obtain the opinion of two investment banks chosen by Genentech before it can effect a squeeze-out. With many analysts pinning the value of Genentech at over $100, the board can simply pick those banks that put the highest value on its shares.

We are not sure why Roche decided to come back to shareholders with a lowball bid. Maybe they think they can raise it back to $89 and make it look like a generous bid then. Or maybe they really have problems obtaining financing. In that case, it would make sense if Roche pays Genentech’s shareholders with an earn-out, such as CVRs. ViroPharma’s (VPHM) recent acquisition of Lev Pharmaceuticals is a good example of how CVRs can be used in the pharmaceutical sector to take some risk out of the equation for the buyer while providing shareholders with participation in the upside. ViroPharma paid only some 60% of the consideration in cash and 13% in stock. The remainder were two CVRs that represent about 27% of the total value. The two CVRs will pay out if Lev’s Cinryze drug reaches certain milestones in the approval process or sales of at least $600 million within 10 years.

Roche’s tender offer is a case where Genentech’s board is in a very strong position and can extricate a significant premium from Roche. With some creativity in the structure of the deal the interests of Genentech’s shareholders and Roche can be aligned. In particular in the current difficult funding environment, CVRs are an attractive instrument that takes some risk out of the deal without forcing Genentech investors to give up the upside. We would expect that the total payout for Genentech shares should be significantly higher than the current lowball bid of $86.50 if CVRs are used.

Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which holds interests in Genentech. He is the author of the upcoming book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

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