Sunday, December 11, 2011

Pharmasset - Interesting Merger Arb Candidate

Though I usually shy away from merger arb candidates for fear of getting run over by the proverbial steam roller, Pharmasset's trading price ($129/share) relative to Gilead's all-cash offer of $137 has recently piqued my interest. Pharmasset is one of the leading biotech companies developing a drug to treat hepatitis-C, one of the fasting growing markets in the healthcare arena. Unlike other experimental drugs on the market which must be used with alpha interferon, a type of drug injected once a week that can cause severe flulike symptoms and other side effects, Pharmasset's drug candidate, PSI-7977, is the first all-oral treatment regimen, which does away with the need for interferon. Rather than rehash Gilead's investment thesis for acquiring Pharmasset, I would point readers to this article from the NY Times DealBook "Gilead to Buy Pharmasset for $11 Billion" for background on the company and the hepatitis-C market.

Gilead has recently announced a tender offer to acquire Pharmasset's outstanding shares (click here for details). The tender offer is slated to run through January 12th, with Pharmasset investors receiving cash shortly thereafter (usually takes 1-3 business days). As such, investors can set themselves up to receive an approximate 75% annualized gain by buying Pharmassset's shares today.

While financing risk often explains a sharp discount to the offer price, Gilead's offer is not contigent on financing. Further, the company recently raised $3.7 billion by tapping the bond market, which when combined with more than $2 billion of cash on its balance sheet, will provide Gilead with ample capital to effect the tender.

So why is Pharmasset trading well-below the offer price given the high likelihood of the deal closing within the next month? Firstly, I think investors are spooked by the massive premium that Gilead offered for the company. At approximately 90%, the downside risk is very signficant should the deal not go through. While I think this is a very low probability, particularly since Gilead raised its offer multiple times before winning over Pharmasset's board, merger arb specialists are undoubtedly taking into account the pre-deal price when assessing their downside exposure.

Secondly, at ~$10 billion, Pharmasset's sizable market cap likely explains some of the gap. There is simply not enough merger arb capital out there to absorb the supply of paper being sold from long-term Pharmasset holders (who rightfully sold out of their position when the deal was announced). This is particularly the case as we head into the end of the year when investors naturally become more risk-averse. Last thing a trader wants is for a merger arb position to blow up in his face as he is wrapping up the year, particularly since the transaction won't close until after the new year.

Finally, the last reason (and perhaps the most pressing concern for risk arb) traders is an unusual provision in the agreement, called a "Key Product Event". To avoid me misinterpreting the provision, here it is in its entirety:

A “Key Product Event” is any serious adverse event that (i) is determined by an independent safety review committee overseeing the safety of the relevant clinical study to be directly related to PSI-7977 (not predominantly related to any compound with which PSI-7977 is coadministered) and to have: (a) resulted in death; (b) been life-threatening; (c) required inpatient hospitalization or prolongation of existing hospitalization; (d) resulted in persistent or significant disability or incapacity; (e) resulted in a congenital anomaly or birth defect; or (f) required significant intervention to prevent permanent impairment or damage and (ii) (x) results in the FDA’s placing a clinical hold on the development program of PSI-7977 or (y) is likely to result in a significant delay in the development timeline of PSI-7977 as of the date of the Merger Agreement.

The key point to note is that efficacy is not enough for Gilead to pull out of the deal - the drug must have resulted in death or be life-treatening. While I am not a scientist and certainly not in a position to render any opinion on Pharmasset's drug, one has to have faith that Gilead has done substantial diligence on this issue before committing to buy the company (and raising its offer 3 times before finally winning the prize).

My own personal view is that short sellers are grasping on this issue to try and push the stock down. After rising to as high as $135 after the deal was announced, Pharmasset's shares have steadily declined to $129, providing a huge windfall for put buyers that bought near-term puts following the deal's announcement. With that said, I think the fears surrounding the Key Product Event are creating a very compelling risk/reward for those investors willing to look past the noise created by short sellers.

If anybody has anything intelligent to add to the discussion please feel free to drop me a line. Hopefully, I am not missing the steamroller as I reach for a couple of nickels:)