Merger Arbitrage With CVR
Till last week Sigilon was a $10m market cap failed biopharma quickly burning through its large pile of cash. But then on June 29, pharma giant Eli Lilly announced the acquisition of SGTX at $14.92 in cash + CVR of up to $111.64/share. Shares skyrocketed +400% on the day. Eli Lilly is as credible a buyer as it gets and the merger is unlikely to break. Currently, investors are paying $7/share for the CVR part of the consideration.
I really wanted to like this setup as it has most of the attributes that the market usually misprices – tiny and potentially underfollowed nanocap, de-risked return of most of the invested capital in the short term, multi-bagger upside on the stub (paying $7 for a chance to get $111). However, after some digging, I find this setup too risky. But your take might be different, so I am sharing my research notes below.
The total acquisition consideration consists of:
- $14.92/share in cash.
- $111.64/share CVR that will pay out:
- $4.06/share, upon first dosing of SIG-002 in the first human clinical trial. IND submission is planned for 2024, so the first human trial will probably be in 2024/2025.
- $26.39/share, upon first dosing of SIG-002 in Phase 3 trial. That’s probably 2027 at the earliest.
- $81.19/share, upon receipt of the first regulatory approval of SIG-002. I would expect this to be a 2030 event only.
I do not think the merger will break, so the initial cash payment is already in the bank. The market values the CVR portion at $7/share. Assuming the below-listed probabilities for the CVR payouts and discounting these by 5.5% rate, the fair value of the CVR lands at $11/share, only slightly above the current market valuation.
- 80% for reaching Phase 1;
- 20% of progressing from Phase 1 to Phase 3;
- 10% for moving from Phase 1 to approval.
In probability-weighted present-value terms, the first two payouts are worth only $6.5/share. So at current prices, this setup is a bet on the SIG-002 approval. The odds for attaining Phase 3 and drug approval stages are in line with historical approval stats (see here and here). These odds might not be fully applicable in Siligon’s case/technology, but at least should serve as a directional reference. I have used a rather high 80% probability for Phase 1 as the SIG-002 treatment has been in development already for a number of years and its sister program had reached Phase 1 a couple of years ago.
Using much more optimistic probabilities (95%, 40%, 20%), CVR would be valued at $23/share.
By my count, the Siligon has c. $40m of cash as of Q2’23 and is burning around $10m per quarter. So the cash portion of the acquisition consideration ($35m) is approximately equal to the cash on Siligon’s balance sheet. Eli Lilly is not paying anything for the value of SGTX technology and products developed so far, that part is left for the CVR optionality.
Siligon aims to develop cell-based therapies/cures that are encapsulated using its proprietary SLTx platform. Cell/molecule encapsulation is the key here as it is necessary in order to protect the foreign cells (the part that is encapsulated) from the immune system reaction after insertion of these encapsulated cells into patient’s body. However, the encapsulation layer still needs to allow the cells inside of it to function properly and excrete the required hormones/proteins.
The main development product, SIG002, is the treatment for Type 1 Diabetes – pancreas produces little to no insulin that is necessary for cells to absorb glucose/energy from the bloodstream. At the moment there is no cure for this disease and most patients undergo lifelong insulin therapy. This is how Siligon’s CEO described their treatment under development:
The goal is really to develop a functional cure for type 1 diabetes, and that our aim is to develop a cell therapy that does not require immunosuppression, that achieves independence from the administration of exogenous instrument. There is a proof of concept for cell replacement therapy from the clinical islets treatment field. Islets are isolated from a donor pancreas and delivered into the portal vein of the liver. This treatment requires immunosuppression. There is a shortage of doing on islets.
So to address this supply problem, we started with induced pluripotent stem cells, the iPS cells, and extend them here, demonstrated on the right in culture, to differentiate them into islets containing insulin-producing beta cells. And to protect the system cells islets from the immune system, we encapsulated them in our spheres.
So far the SIG-002 appears to be very promising pre-clinical trials on mice (10K):
Early experimental data demonstrated that even with xenogeneic cells from different species, rat islets, shielded with Afibromer technology, remained functional for long periods of time, normalizing glucose control in streptozotocin-induced diabetic mice.
In this study, MIT implanted 0.5 ml of one-layered spheres containing rat islets in the peritoneal cavity of healthy mice, treated with streptozotocin, or STZ, to invoke diabetes. Mice were then tested for blood glucose levels every three days for 330 days until the mice were sacrificed. This experiment was repeated three different times with similar results each time with cohorts of five mice, consistently achieving blood glucose measures under 200mg/dL, normal blood glucose level for mice. In addition, in another MIT study, human islets differentiated from embryonic stem cells were placed into STZ mice and, in this study, normal blood glucose levels were maintained in mice for the duration of the study.
Aside from Siligon Therapeutics, there are a number of other companies working on similar encapsulation techniques and even focusing on Type 1 Diabetes treatment. Vertex has already received IND clearance and is about to start Phase 1/2 clinical trials for VX-264, encapsulated cell therapy for the treatment of Type 1 Diabetes. The same goes for Sernova, which has recently announced very positive interim Phase 1/2 results with the first cohort of 5 patients achieving insulin independence using its Cell Pouch System transplants. So in a way, we could say that SIligon is 1-2 years behind these companies.
Siligon already had one treatment, SIG-001, based on the same SLTx encapsulation technology, in Phase 1/2 trials for Hemophilia A. However, upon retrieval of the spheres from one of three patients in the trial, it was found that the spheres were covered in pericapsular fibrotic overgrowth, or PFO, meaning that the spheres were being attacked by the immune system, specifically the thing Siligon’s encapsulation technology was trying to avoid. FDA placed clinical hold on this study. This failed trial clearly shows that Siligon’s SLTx technology platform is still far from being a sure hit.
The company claims to have incorporated a number of subsequent platform optimizations designed to minimize or otherwise avoid the potential for a patient’s immune response of the other product candidates. But it is not clear how will the FDA view SIG-002 in light of the already failed trial (10K):
In November 2021, we reported that spheres covered with PFO were observed during a retrieval procedure in our Phase 1/2 study of SIG-001. Our remaining product candidates have been developed using the same SLTx platform that supported the development of SIG-001 and we may therefore encounter similar challenges in development of other product candidates developed using this platform.
Further, the FDA or other regulatory authorities may not allow us to pursue further development of any of our product candidates as a result of the issues presented by the serious adverse event reported in our Phase 1/2 clinical trial of SIG-001 or our finding of PFO, particularly if we are unable to demonstrate an acceptable risk-benefit profile for product candidates developed using our SLTx platform.
Relationship with Eli Lilly
The cash consideration alone presents 270% buyout premium to the pre-announcement prices. Some investors might regard this as an expression of confidence from Eli Lilly that the development program will successfully sail toward regulatory approval. However, Eli Lilly is just paying for the cash on Siligon’s balance sheet and CVR milestones are actually reducing the contractual payments that were already in place.
Siligon has been cooperating with Eli Lilly for the development of Type 1 Diabetes cure since 2018. From 10-K:
In April 2018, we partnered with Eli Lilly and Company, or Lilly, to develop cell therapies for the treatment of T1D, including SIG-002. Under the terms of the partnership, we are currently leading execution of the program through IND submission and Lilly, a global leader in diabetes, will develop and commercialize the program worldwide. We expect to conduct IND-enabling activities for SIG-002 in 2023, with an expected IND submission in 2024. We received an upfront payment of $62.5 million as well as a $13.1 million equity investment from Lilly. We are eligible to receive up to $165.0 million in regulatory milestones and $250.0 million in sales-based milestones and tiered, from mid-single to low-double digit, sales-based royalties. In 2019, Lilly invested an additional $12.0 million as part of our Series B financing.
I was not able to locate specific details of milestone payments from the 2018 agreement, but the key point here is that in case the treatment is approved and commercialized, Eli Lilly would be paying less on the CVR milestones ($275m) than it would have paid under the 2018 agreement ($415m in total).
On top of that, Eil Lilly is currently footing the bill for all ongoing expenses related to SIG-002 development even if Siligon remains an independent entity.
Lilly is obligated to reimburse the Company if the costs exceed $47.5 million to complete the services, which occurred in September 2022.
So Eli Lilly is buying SGTX at its cash value, is eliminating the obligation to inject additional funds into the company, and is also reducing the payouts in case the treatment is commercially successful. Instead of instilling confidence, such a deal raises the material risk that Lilly might be aiming to limit further cashburn by terminating SIG-002 early. Real intentions are hard to tell at the moment, but in a situation where SIG-002 is terminated early, CVR payouts would be zero.
Adding all up
So what we have so far is:
- CVR investment that makes up 1/3rd of the total SGTX share price. I prefer situations where CVRs are given away for free or with minimal investments.
- Prolonged timeline with the second CVR payout only likely happening in 2027 and the third in 2030.
- Minimal upside using statistical averages for drug approvals.
- Return on this investment mostly skewed on the eventual approval of SIG-002.
- Already failed trial for the treatment based on the same SLTx encapsulation technology.
- Eli Lilly is only paying for the cash on the balance sheet with the rest of the value in the CVR option.
Given this, I find investment in SGTX to be too risky at the current market prices.