The recent surge in bolt-on M&A in the life sciences sector is being fueled by the use of contingent value rights.
Notwithstanding favorable conditions, 2022 was a challenging year for M&A in the life sciences sector. While there were a number of reasons for this, one of the key drivers was shifting valuations of biotechs from the highs of 2021 to the lows of 2022, which created widening gaps between the expectations of buyers and sellers. With variability in valuations settling down at year-end, we expected an increase in M&A in 2023 (What to Expect in 2023), and after a slow start, we are seeing it.
As we discussed earlier this year (Bridging Valuation Gaps), when faced with significant differences of opinion on value, there are a number of structures buyers and sellers can use to bridge those gaps, including the contingent value right (CVR). CVRs represent the right of the target company shareholders to receive additional payments when specified milestones are achieved. Initiation of late-stage clinical trials, regulatory approval, and threshold levels of sales for a lead product are common triggers. While contingent payments in the form of milestones and earn-outs are commonly utilized in private company M&A, contingent value rights—their counterparts in U.S. public M&A—have historically been used sporadically. 2022 represented the recent high-water mark with six CVR deals announced.
Thus far in 2023, we are seeing a significant uptick in life sciences M&A and the use of the CVR is an important component of what’s allowing buyers and sellers to get together, particularly for mid- and small-cap deals. As of the end of May, there had been 14 acquisitions of U.S. publicly traded life sciences companies. Of these deals, six had announced equity values of at least $1.5 billion, none of which included a CVR. All of these companies had at least one approved product on the market or in late-stage clinical development (Phase 3/pivotal trials underway or completed) at the time of deal announcement.
On the other hand, seven out of the remaining nine included a CVR as part of the purchase price, demonstrating that, while buyers are showing a willingness to pay up for larger companies with late-stage clinical or commercial assets, they are increasingly hedging a portion of the value in small- and mid-cap deals through the use of CVRs.
Some buyers have historically shied away from CVRs based on perceived litigation risk arising out of potential disputes over whether the milestone(s) were achieved or whether the buyer complied with its “diligence” obligations – obligations to use a specified level of effort to try to achieve the milestone(s). However, the current market is being fueled in large part by buyers seeing the advantages of this structure outweigh the disadvantages, provided that the milestone is clearly defined and the related diligence clause is sufficiently flexible so as to overcome these risks. All but one of the recently announced CVR deals had such a diligence clause. So, it seems that diligence clauses will continue to be part of the CVR package.
Beyond the announced deals, in discussions we’re having with clients and based on deals in the pipeline, it is clear that the CVR is back as a way for buyers and sellers to share value and risk, allowing for a meeting of the minds that may have otherwise proved elusive. We see that continuing, at least in the short term.