Companies and private equity funds shopping for U.S. biotechnology and pharmaceutical corporations have discovered a neat way to lubricate deals in a volatile market: place all the risk associated with the acquisition on the backs of investors in their target corporation.
The key to their strategy is a financial instrument called a contingent value right (CVR). Essentially, CVRs are derivatives whose value is tied to future events, such as product performance or revenue targets. If the event occurs, the CVR holder can collect, but if the milestone is not reached, the holder gets nothing.
The terms of the CVR contract, and the milestones involved, are spelled out in an attachment to the proxy solicitation for the deal that is sent to shareholders. The proxy itself is generally made available as an exhibit to a Form 8-K filed with the U.S. Securities and Exchange Commission (SEC) by the target company.
The conditional nature of CVRs makes them valuable in breaking logjams in price negotiations. When a would-be acquirer's offer is spurned as too low by a target corporation, the deal can be sweetened by using CVRs to promise future rewards.
Shareholders in target companies may not get as much cash or stock in the transaction as they would like, but they do get the equivalent of a lottery ticket.
After the financial crisis vastly amplified market volatility, CVRs began to play an increasing role in many mergers and acquisitions, especially in the risk-laden biotech and pharmaceutical sectors. In the last two years the instruments have been employed in deals proposed by Sanofi-Aventis (NYSE:SNY), AstraZeneca (NYSE:AZN) and Ligand Pharmaceuticals (Nasdaq:LGND), among many others.
CVRs do have some downsides for investors, however. For one thing, the fact that the value of CVRs is largely dependent on future events presents challenging taxation and accounting issues.
Financial Accounting Statement 141(R) requires that CVRs be recorded at "fair value" as of the acquisition date on the issuer's books as a liability. Each subsequent quarter, the issuer must conduct a quarterly review of the chances that the payments will be made.
Because the issuer determines the fair value of the CVR by designating a discount rate that purportedly estimates the likelihood that the milestones will or will not occur, the fair value measurement itself is highly controversial.
Moreover, the Internal Revenue Service (IRS) has yet to offer clear guidance on the tax classification for the "event" type of CVRs common in deals. In Revenue Ruling 88-31, however, the IRS concluded that a different kind of CVR used for hedging should be treated for tax purposes as an option.
If the IRS follows the same rule for event-type CVRs, the issuer recognizes no gain or loss on the CVR issuance, the repurchase of the CVR, or the lapse of the CVR, but a target shareholder generally must recognize an immediate capital gain or loss taking into consideration the fair market value of the CVRs received on the date of distribution. Target shareholders may also be required by contract to agree to treat any payments made pursuant to the CVR as additional consideration for the sale of their stock in the deal.
An additional risk CVR recipients are required to bear is CVRs' lack of liquidity. Although some CVRs are registered tradable securities, the majority are non-transferable because the issuing company does not want to incur the additional cost, disclosure obligations, and legal responsibilities associated with registering them with the SEC.
Even registered "tradable" CVRs are often extremely illiquid because their value is so highly speculative. For example, Électricité de France's (FP: EDF) CVRs began trading at 82p per CVR in 2008 and are currently at only 30p per CVR. CVR holders have little legal protection because it is unclear what, if any, enforcement mechanism is available should CVR covenants be breached -- short of expensive and protracted individual litigation.
The most troubling aspect of CVRs from an investor standpoint, however, is the way the instruments redistribute risk in deals. In a normal transaction, the would-be corporate acquirer bears considerable risk in negotiating the deal price: an offer that is too low will likely be rejected by the target's board, or superseded by a higher offer from a competing suitor. If the acquiror pays top dollar, however, it bears the risk that, if the acquisition is not profitable, it has paid too much.
CVRs can transfer much of the risk normally borne by acquirers to the shareholders in the target corporation. Instead of offering more for the target and bearing downside risk, the acquirer can use less cash or stock, and effectively defer part of the purchase price to a later date, or, indefinitely. After all, CVRs are only payable upon the occurrence of some milestone event by a future date. If the milestone is never reached, or is reached, but too late, the acquirer pays nothing.
While there is no doubt that CVRs can effectively circumvent arguments about current value, in the wake of a financial crisis fueled by risky and speculative financial instruments, investors are right to be wary of the unknown.