Do Reverse Mergers Create Value?
A Study of Biotech Reverse Mergers and Associated Alternatives
May 31, 2022
As of this writing we find ourselves in an extraordinary moment in biotech history.
More than 190 biotech companies are trading with a market cap below their level of net cash (negative EV). The market is sending a message to the management and boards of these companies that their current programs are likely NPV negative.
Boards have been responsive to these messages as an unprecedented number of biotech companies have publicly indicated that they are exploring strategic options.
Historically, many companies have chosen a reverse merger as the conclusion of a strategic review.
A reverse merger involves a public company issuing new shares to acquire a private company, whose shareholders typically take control of the public company, gaining the listing and cash to pursue a business plan that has better prospects than those of the public company on its own.
The idea is beguiling. A board appears to discharge its fiduciary duties getting out of a business that the market does not value. Further, there are many promising private companies that are open to participating, particularly in difficult markets. Importantly, reverse merger transactions also involve an element of finality. Employees can be terminated. A shareholder vote takes place, and the current company is handed over to new management. Board members can move on.
This is typically capped by a fairness opinion from a financial advisor indicating that such transaction is value positive.
Reverse Merger Performance
Even though almost all reverse mergers are accompanied by fairness opinions that argue that such transactions are value positive (or, at worst, value neutral), there is little ex post evidence that such transactions systematically create value.
To better understand the effectiveness of reverse mergers in generating value in the biotech context, we collected a comprehensive sample of U.S. listed reverse mergers announced in the January 2017 to May 2020 period. We stopped in May 2020 to give enough time to measure returns to shareholders of the reversing company for two years post-announcement.
In total we identified 36 reverse merger transactions.
For comparison, we also collected a comprehensive sample of IPO’s taking place on a major U.S. exchange in the same time period. We required IPOs to be for $50mm or more.
Consistent with the prior literature we have found that reverse mergers underperform the market and their IPO comparators.
In our study, we found that the average two-year market-adjusted return following a reverse merger was -58.9%.2
In contrast, the IPO cohort outperformed the market. The average IPO outperformed its peer group (the XBI ETF) by 30.6% over two years.
Very few reverse merger companies beat the market. We find that 81% of reverse mergers underperform the market by 24 months post-announcement.
There are obvious potential problems with reverse mergers versus IPOs including adverse selection (companies that can’t IPO tend to be the primary users of reverse mergers), lack of research sponsorship, selling pressure from the original public companies’ shareholders, lack of adequate finance and lack of diligence into targets by boards of the companies involved.
We have heard some companies argue that reverse merger shells with more cash or investor support via PIPEs perform better.
To better gain insight into why reverse mergers are involved with poor post-transaction returns we stratified our sample into subgroups that involved a PIPE of $20mm or more or not.
We also stratified the sample by whether or not a public reverse merging company had $30 million in net cash at the time of a transaction announcement.
The companies that reversed with a concurrent PIPE transaction performed worse in our sample. The companies that carried out a concurrent PIPE had an average two-year market-adjusted return of -63% versus -54% for those that did not.
As for amount of cash in the shell, there was a difference in performance. Those that had more than $30 million in cash did better – only underperforming the market by 21%. Obviously, this would still be highly disappointing to the companies involved.
Alternatives to Reverse Mergers
In today’s environment where so many companies have significant cash balances and negative enterprise value, it’s worth contemplating what alternatives might exist to the reverse merger.
In a May 2022 article, for example, Peter Kolchinsky of RA Capital has argued that cash rich shell companies will have a very difficult time completing reverse mergers given the scale of valuation discounts to cash and the dissolution value of many biotech companies.
The point is well taken. If a company is trading at a third of its cash value, the bar to beat some type of dissolution or return of capital is very high.
Kolchinsky argues that companies should be more aggressive in using share buybacks to consolidate down to their core believers.
He notes that pro-shareholder actions at a tough time in 2022 are likely to pay high dividends in the long run.
Corporate Dissolution Approaches
There are a range of alternatives to a traditional Delaware dissolution and liquidation process which requires a shareholder vote and is administratively complex.
The first is a delisting and “go dark” process recently highlighted by Genocea and Kaleido. While lacking in glory, such moves are relatively efficient from a professional fee perspective, involve treating legacy employees with dignity and create a significant opportunity to return cash to shareholders via special dividends.
We highlight the obvious point that biotech companies have used creative ways to return cash to shareholders that can be applied in today’s industry circumstance.
The first method, highlighted by the case of Merrimack Pharmaceuticals is an orderly wind down, while staying public.
Merrimack has significant assets in the form of future milestones. Merrimack let go all employees and runs the company with a consultant. Its costs of staying public are quite low and it has kept its NASDAQ listing and has paid two very nice special dividends to shareholders.
Share Buybacks and Self-Tender Offers
The second method is to carry out a partial recapitalization in which shareholders are given the option to tender their shares or stay in the story. This approach has been used for years by private companies such as Adimab to return cash to shareholders who wish liquidity. More recently, XBiotech used a Dutch auction self-tender to return much of the proceeds of a $750 million asset sale of its Bermekimab asset to Janssen.
A self-tender lets shareholders choose whether stay in the company’s story without creating huge selling pressure when some are disappointed with forward plans or past results.
Restarts, Pivots and the Theory of the Firm
Perhaps most relevant in today’s environment is the opportunity to consolidate, pivot and restructure.
The biotech industry features high failure rates accompanied by significant project complexity, information asymmetries and complementarities between team members.
A team that is good at small molecule drug development will struggle to succeed in biologics. Or a team that understands the intricacies of cell therapies and IPSC’s will not, in general, be well suited to taking on protein degradation projects.
We say this to note that the classic thinkers on the theory of the firm (Coase, Demsetz, Klein and Williamson) would all likely argue that firms have particularly high value in biotech.
In this context one should not be surprised to hear that virtually every great biotech firm (e.g., Actelion, Alexion, Celgene, Gilead, Incyte, and Vertex) had numerous failures and did not end in the business that they began in.
What these companies did well was to build great teams. Team building is a costly process that takes time and hard work.
It’s for this reason that we encourage boards to take stock of the capabilities and teams of the companies that they oversee as much as they focus on specific assets.
Human capital and associated teams are probably the most underappreciated asset in biotech.
We specifically encourage companies that are at risk of clinical failure or that have experienced such failure to look for complementary projects that could leverage the skillset of the relevant teams.
Each company’s circumstance is unique, and one must look at each situation for what it is. But, in our experience at Torreya, it has often been the case that value can be maximized through a “restart” or “pivot” deal where team members are preserved, new assets are brought in and business plans rewritten.
There are often opportunities to consolidate across firms, realizing a wide range of synergies across complementary asset portfolios.
The Veru Health Example
We give the example of the Female Health Company which in 2016 found itself with a strong team, a CEO well past retirement age and an underperforming project that had obvious merit.
The Female Health Company went on to merge with Aspen Park Pharmaceuticals which brought on a promising pipeline, a new CEO and a fresh perspective on how to optimize the existing product set.
Since the merger, the stock is up over 1,000 percent and the company has performed quite well – in a way that would have been very difficult to accomplish with a reverse merger.
An important aspect of the economics of “pivot” or “restart” transactions is that they allow the achievement of synergies that are asset specific and, therefore, create the potential for abnormal profits to shareholders.
In contrast, traditional reverse mergers put a company in competition against the IPO market. Reverse mergers also create a significant risk of adverse selection as most private companies would prefer a traditional IPO with research support and a strong investor road show.
Please contact Torreya if you have any questions or comments:
1See Dasilas , Apostolos, Chris Grose, and Michael A. Talias . "Investigating the valuation effects of reverse takeovers: evidence from Europe." Review of Quantitative Finance and Accounting 49.4 (2017): 973-1004; Lee, Charles MC, Kevin K. Li, and Ran Zhang . "Shell games: The long term performance of Chinese reverse merger firms." The Accounting Review 90.4 (2015): 1547-1589 and Adjei, F, Cyree , KB, Walker, MM , “The Determinants and Survival of Reverse Mergers vs. IPOs,” Journal of Economics and Finance, 32, 176-194 (2008).
2The reverse merger company’s market adjusted return was defined as its percentage change in share price over a specified time horizon less the percentage return in the same time period in the ARCA XBI Biotech ETF.