Ocera Therapeutics: merger arbitrage with CVR

Earlier this month Ocera Therapeutics (NASDAQ:OCRX) announced that it would be acquired by Mallinckrodt (NYSE:MNK) for $1.52/share in cash plus a CVR that could be worth up to $2.58/share. In general I like mergers with CVRs because I think market participants are often conservative with valuing them. I especially like gettings CVRs for free, but unfortunately that is not the case here since the stock is trading at $1.70/share.

The CVR has three milestones on which it will payout:

  • $0.34/share if the first patient is enrolled in a Phase 3 trial for an intravenous formulation of OCR-002 (before 2029).
  • $0.52/share if the first patient is enrolled in a Phase 3 trial for an oral formulation of OCR-002 (also before 2029)
  • $1.72/share if cumulatieve sales of OCR-002 worldwide exceed $500 million before 2029

So to make this merger arbitrage a succes you basically need to hit the first CVR milestone. With a share price of $1.70 you are effectively paying $0.18 for the CVR, and if it returns $0.34/share at some point in the next couple of years it should generate a nice internal rate of return. The merger will be structured as a tender offer that is scheduled to be launched no later than November 16, 2017 and should be concluded before the end of the year. So with most of the cash being returned soon the only thing that really matters is how much are we paying for the CVR, and how much it’s expected to payout.

I know basically nothing about medicine, so take that in mind reading this post, but when reading the press release it’s clear that OCR-002 is not a sure thing to make it to a Phase 3 trial. It was unable to meet statistical significance in its primary endpoint in its Phase 2 trial, but it appears to be that this was caused by using a too low dosage of the drugs. That’s something that’s easy to correct, and Mallinckrodt is paying $42 million for Ocera Therapeutics so they must have a decent amount of confidence that they will not only be able to progress to Phase 3, but also get the product to the market. And I guess if you can make OCR-002 work intravenously there is also a decent probability of making it work orally.

I wouldn’t ascribe to much value to the sales milestone though. It not only requires OCR-002 to become a big success, you also have the problem that for a sales milestone your interests aren’t very well aligned with the company. If they are close to the deadline and close to hitting that $500 million milestone they will have a big incentive to stay below that number in order to avoid the $75 million milestone payment. You don’t have this problem with the two milestones connected to starting Phase 3 trials. Their whole purchase of Ocera Therapeutics will be a waste of money if they cannot start those trials.

To be honest I’m a bit surprised that there is no milestone related to successfully concluding a Phase 3 trial, but I guess that’s a good thing for investors here. Just starting Phase 3 trials is a milestone that is a lot easier to reach than successfully finishing them.

Attaching numbers to the various probabilities is a huge guess, but in my mind something like the following doesn’t sounds unreasonable. Maybe there is a 80% probability of starting a Phase 3 trial, maybe a 20% probability of also doing it for an oral formulation and maybe just a 1% probability of hitting the $500 million sales milestone. This would value the CVR at $0.39/share compared to a market price of $0.18/share, so as long that is roughly in the right direction it would be a good bet. I think it is.


Author is long OCRX

25 thoughts on “Ocera Therapeutics: merger arbitrage with CVR

    1. Alpha Vulture Post author

      I guess the aren’t they most solid phara company to buy this… but they should have the money and resources to pay for the merger and trying to get this into a Phase 3 trial.

      1. Jacob

        Keep in mind you have some MNK credit risk on the CVR payment though. They have a 2023 issue trading in the high 70s context to yield ~10%.

          1. Brion

            In a bankruptcy CVRs will be ranked ahead of equity, but behind nearly everything else. Likely wiped out if MNK files. This one looks like a fairly high probability to make it to Phase 3, but the MNK credit risk has kept me from loading up.

          2. Alpha Vulture Post author

            Thanks, was suspecting as much. Took a quick look at their debt, and see that most of it is due in 2023-2025. Think that they should be able to move to Phase 3 trials long before that, and if they aren’t able to do that I guess it’s unlikely to happen at all. So I guess the credit risk you are running isn’t that big (at least on the first two milestones, the last milestone could take way longer).

          3. Brion

            I agree that they should be able to progress to Phase 3 much earlier than the debt maturity dates. The problem is that debt covenants could be violated well before the maturity dates, and creditors could push them into bankruptcy or take actions that lead to bankruptcy before the CVR payments are triggered.

            As Jacob noted the 2023 trading around 80 is something of an indicator of the credit risk here.

          4. Alpha Vulture Post author

            I see they amended the tender offer to clarify this, among other things this was added:

            (3) The text under the heading “Is your financial condition relevant to my decision to tender my Shares in the Offer?” in the Summary Term Sheet of the Offer to Purchase has been amended and supplemented to insert the following new paragraph at the end of such heading:
            “While, for the reasons stated above, we do not believe our financial condition to be relevant to your decision to tender your Shares, you should consider the following in connection with your decision to tender your Shares:

            • Mallinckrodt’s financial condition could deteriorate such that it would not have the necessary cash or cash equivalents to provide to Parent and Purchaser to make the required payments under the Merger Agreement and the CVR Agreement;

            • holders of CVRs will have no greater rights against Parent and Mallinckrodt than those accorded to general unsecured creditors under applicable law;

            • the rights of holders of CVRs will be effectively subordinated in right of payment to all of Mallinckrodt’s and Parent’s secured obligations to the extent of the collateral securing such obligations;

            • the CVRs will be effectively subordinated in right of payment to all existing and future indebtedness, claims of holders of capital stock and other liabilities, including trade payables, of Parent’s and Mallinckrodt’s other subsidiaries; and

            • the filing of a bankruptcy petition by, or on behalf of, Parent or Mallinckrodt may prevent Parent or Mallinckrodt, as applicable, from making some or all payments that become payable with respect to the CVRs.”

  1. JG

    Couple of quick ones:
    – I am not sure, but i don’t think I saw an end date/deadline for the Product Sales Milestone, but might have overlooked
    – No pharma expert at all, but phase 2 trials seem to have the lowest success rate at 31%, with phase 3 at 58%


    – I would say that IF they get one product to market, they are pretty likely to hit that sales target, otherwise I don’t think their whole investment of buying and developing OCRX drugs makes sense to begin with. However, I think you would be looking at 2023-2025 or something for that to become plausible
    – As timelines are pretty long for clinical trials, valuation depends very much on how much IRR you require to hold this type of asset.
    – Also note: Usually in this type of situations there is a small chance that the merger/acquisition falls apart as you know. So I think the implied value for the CVR is currently a bit bigger than (price-1.52). You are exposed to Deal risk and should be compensated for that.
    -All in all I concluded its undervalued (using a 20% IRR) but not by a huge amount.

    1. Alpha Vulture Post author

      * I’m also not a pharma expert, but when you did a Phase 2 trial and you found that 1. The compound you made does lower ammonia in the blood (that was what it was supposed to do), 2. the degree of reduction was correlated with the dosage and 3. the clinical improvement was correlated with the amount of ammonia reduction I’m thinking that you have a pretty good shot a making this work. A lot more promising than the average candidate before having started a Phase 2 trial. Although maybe I’m seeing this way too optimistic.

      * I agree that there is a bit of deal risk, and also a bit of opportunity cost of putting cash in this. But think both are extremely minimal. If this would be a cash deal at $1.52 it should probably trade at $1.51.

      * A 20% IRR sounds pretty awesome to me. Especially since this return is mostly uncorrelated to the stock market.

      1. pietje

        Also note that the base rate for phase 2 trials *attracting buyers for your company* is probably higher than average.

        From the tender docs:

        On July 14, 2017, Mallinckrodt delivered to Ocera a revised non-binding letter of intent for an acquisition of Ocera. The updated proposal included a $65 million upfront cash payment with a total potential cash consideration of $532 million. Of the contingent consideration, (i) up to an aggregate of $217 million would be payable following receipt of certain regulatory approvals of OCR-002 for specific indications in the United States and Europe and (ii) up to an aggregate of $250 million would be payable upon the satisfaction of annual commercial sales milestones. Mallinckrodt reiterated that the offer was subject to completion of due diligence and that Ocera was expected to have a minimum cash balance of $3 million assuming a closing by September 30, 2017. Mallinckrodt requested 45 days of exclusivity and asked for a response by the end of July 2017.

        On August 25, 2017, Mallinckrodt submitted a revised letter of intent to Ocera with a significant reduction in deal economics. The updated proposal included a $45 million upfront payment without any potential contingent consideration. Mallinckrodt reiterated that the offer was subject to completion of due diligence and that Ocera was expected to have a minimum cash balance of $3 million assuming a closing by September 30, 2017. Mallinckrodt indicated to Ocera and MTS that the reduction was a result of Mallinckrodt’s then current belief, based in part on the results of the pK/pD Study, that the IV formulation of OCR-002 would require another Phase 2 clinical trial to establish the optimal dose before the program could advance to Phase 3 clinical trials.

        So they probably need to redo the Phase 2 trial.

  2. JG

    Ah I checked – termination date indeed applicable, missed that one. Not a biggie imo, as the value of the sales milestone does not add so much to the CVR value currently (perhaps it does when you have a really low IRR modeled)

  3. Martin

    A little bit downside risk:
    In the event the Offer Acceptance Time occurs on or before December 31, 2017 and the Company’s cash and cash equivalents are insufficient to pay and fully discharge the Indebtedness (as defined in the Merger Agreement) and Transaction Expenses (as defined in the Merger Agreement) on or prior to Closing (the “Closing Shortfall”) by more than $250,000, the aggregate amount payable pursuant to the first occurring Milestone Payment (as defined below) shall be reduced by the full amount of the Closing Shortfall. In the event the Offer Acceptance Time occurs after the December 31, 2017 and the Indebtedness and Transaction Expenses due and payable as if the Closing were to occur on December 31, 2017 exceed the Company’s aggregate balance of cash and cash equivalents as of December 31, 2017 by more than $250,000 (the “Measurement Date Shortfall”), the first occurring Milestone Payment shall be reduced by the full amount of the Measurement Date Shortfall.

  4. pogonific

    Interesting – it’s hard for me to see how this is anything other than a pure gamble if you have no idea what the probabilities are.

    One thing that may be interesting – a previous employer of mine sold a pharma company for cash + CVRs. The acquirer then themselves got acquired, and despite promising trial results, the new acquirer simply did not consider the drug strategic, so they stopped persevering with it. Given the timescales on this, MNK itself getting acquired at some point doesn’t seem unlikely, and then it’s (even more) of a crapshoot. Good luck with this.

    1. Alpha Vulture Post author

      No idea is perhaps a too strong label. I’m pretty clueless, but I do have some idea’s about what is likely and what isn’t likely to happen. Attaching exact numbers to that is a bit of an arbitrary process, but that’s what makes investing interesting. You are always working with both unknown and unknowable probabilities. This is really not that much different from buying a cheap stock at a low P/E ratio for example. You don’t know how much profit they will make in a few years, you don’t know what multiple the market will assign, you only have an idea that it is probably too cheap right now and that it will turn out alright for you on average.

      About the CVRs, yeah; that’s certainly something that could be somewhat problematic. The CVR has of course language that the buyer (and any potential future owner) has to make a diligent effort or something along those lines to make those milestones, but that’s pretty subjective. Although if they would simply stop the whole development of the drug they would be getting into a legal mess for sure.

  5. Ben

    Thanks for the article. I used to also like playing CVR deals – it makes a lot of sense that they would be undervalued. But in practice, I haven’t had very good results with these – the main reason is probably that the co often has the ability to cheat (eg delay drug development a bit to avoid paying to CVR). I’ve invested in maybe 10 of these deals and suspect my return on them has been close to 0. Curious if you’ve had a different experience.

    1. pietje

      Looks like DYAX will pay out, they recorded close to the full liability on their balance sheet and phase 3 results were ‘stellar’. Safeway also paying out. Media General CVR paid out. Not too much experience but looking good so far. Maybe it depends on the structure of the deal. If companies have an incentive to delay / cheat then yeah, maybe they are not as good as we think they are but in general my experience has been good so far.

    2. Alpha Vulture Post author

      Given that the milestones are often far in the future it’s too early to tell for me. But so far my experience has been positive. Some have paid out already, and I expect some others to deliver good results next year, and most importantly: I have never spend that much capital to acquire them.

      1. Ben

        Thanks for the thoughts. Good to hear that DYAX and SWY will payout. I guess I just have a sour taste in my mouth after having been burnt by gcvrz, wmgiz, celgz, and rna. Also interactive brokers acted like they were going to “cancel” the SWY cvrs of their customers since there had been no activity in years, though that was resolved.

        1. Alpha Vulture Post author

          I think that cancellation of the SWY CVR was a storm in a teacup. Also got a lot of messages about it, but wouldn’t have really mattered. If/when they would have paid out you would have gotten your money anyway. I don’t know why they would do it, but it would mostly have been an administrative thing that would really only have impacted people lending out the CVR or borrowing it.

          Not familiair with all the CVRs you listed there. Think the GCVRZ was a bit of a different beast since it was 1. tradable and 2. mostly sales based milestones (with tight deadlines).

  6. Ben's Jamin

    Ocera’s management is not a shining example of integrity (more below), so under normal circumstances, I would consider their guesstimates/probabilities to be garbage reverse engineered into by boutique M&A shops. That said, this situation is not normal given some alignment with management’s blatant self-interest. For instance, observe the very crafty way in which they describe how optionholders (constituting primarily themselves) will eat out of CVR payments:

    “….Parent and the Company have agreed upon a model calculating the gross cash amounts payable with respect to each Out of the Money Company Stock Option, if any, at each Milestone Payment Date, which model is attached as Section 2.9(a)(iii) of the Company Disclosure Letter.”

    Now, obviously, one imagines that the referenced “model” is a waterfall-type calculation that increases the CVR share count by an option tranche’s count anytime cumulative payments (post-dilution) exceed that tranche’s exercise price. However, since the Company Disclosure Letter is…undisclosed, there’s no way to know for sure. Thus, while I noticed you’ve used a 29M share count, to be conservative, given management’s nature in this case, it probably makes more sense to use the fully-dilutive 30M or so shares, particularly since they’ve been aggressively cancelling high-watermark options and replacing with more underwater options in the past 2 years, rendering the recent WAEP figure somewhat irrelevant. Small difference to the per share figures, but merger arb is a tight game after all.

    Back to management. While I’m no fan of theirs, I am not oblivious to their incredulous self-interest and thus, going “long” that is an important behavioural consideration here:

    Jan 30: OCRX announces top-line phase 2b results, which disappoints, relatively speaking since everyone was expecting it to meet the efficacy standards “pre-negotiated” with the FDA (time difference stat. significance). Stock craters 70%
    March 8: Linda Grais, CEO, shrewdly highlights that drug works at higher doses (unclear whether negotiations with buyer had begun at this point, but these things take time and it would be weird if the next few course of events were coincidental). Stock recovers 60% to $1.40
    March 29 & June 12: OCRX comp committee grants a combined 1.14M restricted stock units, which vest fully if mgmt is fired without cause within t-3 to t+12 months of a change of control event (this pretty much answers the question of whether they were in some prelim negotiations by March). In other words, as at March 29, mgmt had authority to issue roughly 1.2M shares pursuant to OCRX’s equity plan, and rather than issue options, chose to fully blast common holders with 1.14M RSUs, worth $2.7M if Milestones 1 & 2 are achieved. The rationale for this — and I’m not making this up — was “the compensation committee’s desire to deliver equivalent value to our named executive officers using fewer authorized shares.”

    We can compare these “gifts” to their salaries over the past 5 years and we’d see that they’re pretty significant. Not quite the last bank robbery of their lives, but the difference between 1 and 2M shares if milestone 3 is met is very very significant.

    1. Alpha Vulture Post author

      I didn’t use any share count in calculating these amounts/share, I simply started with the $2.52/share figure for the CVRs provided in the press release. I’m pretty sure the company knows what kind of number to use to calculate the expected number of outstanding shares. FWIW: This implies a share count of 29.8 million.

      To account for the options properly would actually increase the value of the CVRs a little bit. Some of the options presumably wouldn’t be in the money when the first milestone is hit, so the cash payment per share might actually be a bit higher than calculated while the cash payment per share for the second and/or last milestone(s) might be a bit lower. This is good for us :).

      You can by the way read in the solicitation statement the whole background of the merger, including the timeline of it all (discussions with Mallinckrodt started in January).

      1. Ben's Jamin

        Indeed, that’s I pointed out: $10M on roughly 30m shares would imply 33 cents, not 34, but perhaps as you say, they’ve assumed some gradual creeping up of sharecount (rather than using fully dilutive amount) even though no one will know sharecount until milestones are hit or not hit. Just weird that they’d withhold the model being used to calc that.

        Right, the evidence as at initial announcements was sufficient to conclude they had held meetings by March, but thanks for pointing out the proxy materials subsequently released. The fact that they issued 1.14m of the max dilutive stock awards (a value equivalent to mgmt’s last 2-3 years salary combined, if Milestone 1+2 alone hit) is a highly important human bias marker, perhaps moreso than notoriously ephemeral POS estimates in pharma cvr situations.

        Most curiously, had the contrasting drama of drug efficacy failure followed by the “heroics” of Linda Grais and team to highlight the potential for higher dosage to improve efficacy not happened, mgmt couldn’t have easily gotten away with robbing shareholders with that sort of “gift.” In fact, they would have been stuck with way OTM options. Yet another important behavioural element I think.


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