Pharma event risk hits investors

Mon Apr 28, 2014 9:14am EDT

(This story originally appeared on IFR, a Thomson Reuters publication)

By Danielle Robinson

NEW YORK, April 28 (IFR) - The heightened level of event risk in the pharmaceutical sector was demonstrated when Allergan, the pharma giant behind Botox, saw its bonds plunge some 10 price points on news that activist investor William Ackman and Valeant Pharmaceuticals International are spearheading an attempted hostile takeover of the company.

Moody's and Fitch both moved Allergan's rating outlook to negative, warning that a successful takeover by the Canadian "serial acquirer" and Single B rated Valeant would crush Allergan's A3/A+ investment-grade credit rating.

Allergan's 2.8% March 2023s plummeted on Tuesday to 84.58 in the secondary market on the news, where they were quoted at 225bp bid/175bp offer over Treasuries - sharply off from 94.53 and 80bp/70bp bid/ask the day before.

Although Allergan quickly adopted a "poison pill" defence in an attempt to prevent a takeover, its spreads failed to return to their former levels, with the 2023s at 200bp on Thursday.

Like many bonds of the best-rated pharmas, Allergan's US$2bn of outstanding debt does not have change-of-control covenants, leaving them open to being subordinated to secured debt of an acquirer like Valeant and a rapid tumble into junk-bond status.

Even if the acquisition is not successful, the name has now been tainted by the agitating presence of Ackman.

"Negative ratings pressure would stem from significant shareholder-friendly actions if Allergan stays independent, including leveraged share repurchases or special dividends," said Fitch pharma analyst Michael Zbinovec.

Ackman's Pershing Square Capital Management, which currently holds 9.7% of Allergan, has teamed up with Valeant to mount the takeover bid, currently valued at US$45.6bn.

Valeant is aiming to become one of the world's top five pharma companies by the end of 2016 and is just one of a swarm of companies in the sector on the hunt for acquisitions.

"We expect the next few years to be particularly active from an M&A perspective and pivotal in the reshaping of the industry," wrote Shubhomoy Mukherjee, a senior pharma credit analyst at Barclays, in an April 3 report, issued before the Valeant bid.

Valeant is proposing to swap each Allergan share for US$48.3 in cash and 0.83 Valeant shares. It says it has committed financing from Barclays and Royal Bank of Canada for about US$15.5bn, which would be broken into "secured bonds, unsecured bonds and bank debt [at an] expected interest rate of around 5.5% on new debt," Valeant said in a filing.

That compares with Allergan 2023s yielding around 4.6% after news broke of the hostile takeover attempt.

STRATEGIC OPTIONS

Big pharma companies such as Pfizer, Merck & Co and Sanofi, are seeking "strategic options for non-core assets", according to Barclays' Mukherjee, while generic drug companies suffering from slowing growth in that business are looking to build portfolios of branded drugs via acquisition.

In the past week it was revealed that Pfizer, which has plans to split into three parts, had made an unsuccessful US$101bn run at AstraZeneca. Novartis also announced a flurry of purchases and divestments involving GlaxoSmithKline and Eli Lilly, which will see both Novartis and Lilly tap the bond markets for funds.

Meanwhile, Teva has stated it is open to acquisitions and Mylan, which has just had its bid for Meda rejected, is looking to do a substantial transaction this year.

"The opportunity is in the fact that the many participants grow so scared of M&A that credit spreads tend to overreact".

US companies seeking to lower their tax rates by re-domiciling to lower tax jurisdictions such as Ireland are also spurring acquisitions.

DISTURBING

The shareholder activist hook-up with a lower-rated firm to buy a higher-rated one is one of the more disturbing trends for bond investors.

"Historically we have seen highly rated pharma companies taking over lower-rated ones," said Michael Levesque, pharma ratings analyst at Moody's.

"In today's landscape the shape of M&A is up in the air - and as the Valeant/Allergan situation demonstrates, it could mean a lower-rated company successfully taking over a higher-rated one and saddling it with much higher leverage levels," he said.

Many total return investors benchmarked to an index are avoiding the sector because of the event risk. "The Valeant/Allergan deal has certainly raised red flags for us," said a senior portfolio manager of a total return fund with more than US$10bn in assets under management.

But not all M&A is bad for investors, and with spreads at all-time tights, getting on the winning side of an M&A trade can generate significant alpha.

"Frankly, in the bond market, the opportunity is in the fact that many participants grow so scared of M&A that credit spreads tend to overreact," said Scott Kimball, senior portfolio manager at Taplin, Canida & Habacht, part of the BMO Global Asset Management stable.

"Yields spiking beyond those justified by the transaction leave companies that look fundamentally solid trading cheap." (Reporting by Danielle Robinson; Editing by Philip Wright)