OncoMed Pharmaceuticals (OMED) – Merger Arbitrage – 65%+ Upside

Current price: $0.77

Merger Consideration: $1.26

Upside: 63%

Expiration: expected H1 2019

Merger Announcement and Preliminary Proxy

The idea was shared by Jason

 

This is an all stock micro-cap pharma cross-border merger arbitrage situation with no possibilities to hedge the short leg of the trade.. Does not sound very exciting, but the spread stands 63% and if CVR pays out this would be a multi-bagger.

In Dec OncoMed Pharma (OMED) and Mereo Biopharma (MPH.LN) announced a proposed combination which has been unanimously approved by both boards. Exchange ratio based on OncoMed’s net cash balance at completion (table below) is expected to be 0.61 shares of MPH (in US listed ADR form) for each OMED share.

In addition to the share exchange, OMED shareholders will also receive CVR that will pay out additional ADRs/cash if certain BD milestones are achieved with OMED’s key clinical programs.

It’s difficult to see significant downside in OMED stock from current levels. OMED is currently trading at an implied EV of negative $33M based on est. 12/31 cash and about 20% above all-time lows reached before the combination was announced

Furthermore, the merger notes in the proxy suggest that OMED had received 6 non-binding indications of interest while it was reviewing strategic alternatives, so there could be an alternative path forward should the Mereo transaction break.

 

Key Risks

With a spread this significant, there is clearly some hair that comes with this opportunity, so below we are addressing some of the key risks:

• Liquidity and borrow – we’re dealing with relativelly illiquid stocks and this opportunity probably does not make sense for anyone other than PAs or very small funds (or larger players who accept liquidity risk). Additionally, it is near impossible to hedge this trade because we have not found any Mereo borrow.

• Exposure to Mereo share price movements – given it appears nearly impossible to hedge out Mereo risk, we must live with the price action. Important to note that there is no meaningful clinical data expected to be reported until 2H2019 and so, assuming no new news between now and merger close, where should Mereo trade? The company currently has 4 distinct programs in phase 2 trials, all focused on rare diseases (3 acquired from Novartis, one licensed from AstraZeneca). We think, using conservative discount rates, the market is essentially pricing in a ¼ success rate with these programs before adding any net cash. The stock is also trading basically at a 52-week low and the current enterprise value stands at a slight discount to the invested capital in the company to date (we estimate at ~$155M). For what it’s worth, Mereo’s business plan seems sound – acquire non-strategic programs from big pharma that have already invested clinical/safety/IP horsepower to build a portfolio of “de-risked” programs. Also worth noting that when Novartis originally sold the programs to Mereo in 2015, they only took stock and haven’t sold shares to this day (own 19.5%).

• OMED shareholder approval – legacy OMED shareholders have been absolutely smoked on this investment – this was once a $B company. Sitting on big losses combined with trading well below cash and being forced to take presumably illiquid ADR shares in a UK listed company does not sound great. However, we have a few reasons to believe that there is a high likelihood the deal gets approved. Firsly, management and BoD with 11% ownership have agreed to vote in favour of the merger. Next, here has been a significant turnover in the shareholder base – close to half the shares outstanding have turned over since the announcement. Additionally, it looks like the vast majority of top 15 OMED shareholders were actually buyers in 3Q so they are likely sitting on a decent gain on those trades heading into the merger. Also, the Mereo CEO is a partner at Phase4 Ventures, which owns 5% of OMED. Additionally, another venture firm, Delphi Ventures owns another 5% of OMED. Phase4, Delphi and Woodford Investment (largest Mereo shareholder) have all invested together in the past. Finally, Celgene and Glaxo combined own ~14% of OMED and given the more strategic rather than economic nature of their investments, I would gather they would lean towards rolling the dice to get some insight into the combined company (and perhaps some additional scale/liquidity) for an exit down the road.

• Fx – since OMED shareholders are taking ADRs in a UK listed company, there is inherent Fx risk in the deal. Should the pound dramatically fall in value, this would significantly impact the economics to OMED shareholders. With that said, even if we were to assume $/pound parity and that OMED hits the minimum cash at closing of $38M, this would still imply ~40% upside (assuming a stable Mereo stock price).

• Mereo walks – the breakup fee for Mereo to walk is only $1.7M which at face value, isn’t a real “stick”. However, I think there are several considerations to this point. For one, $1.7M isn’t as minor as face value when the company probably ended the year with ~$20M of net cash. When you factor in transaction fees, etc. I think this is a non-trivial expense for Mereo. Perhaps more important is the opportunity cost – Mereo is undoubtedly investing substantial resources into getting this merger done and should otherwise be focused on its next fundraising. Lastly, it’s worth noting that the current CEO of Mereo was actually on the board of OMED and resigned in order to pursue this transaction.

 

Note on the CVR

In addition to the share consideration, there is also a CVR linked to the two most advanced OMED clinical assets.

The TIGIT element of the CVR relates to a $35m cash milestone if Celgene opts-in for the continued development of the antibody program before the end-2019 (interesting dynamic here in that CELG owns ~7.5% of OMED). CVR holders will receive ADRs equivalent to 100% of this opt-in payment, with the cash retained by Mereo.

OMED’s NAVI program also has a attached CVR related to any progress in partnering the program; 70% of the net proceeds of any cash milestone payments received by Mereo for five years post-completion will be received by OMED shareholders (subject to a cap of ~$80M), with the balance retained by Mereo.