Editor

Biotech companies, heavy with PhDs studying the safety and efficacy of experimental compounds, would do well to balance the same two factors in their financing instruments, said Brendan Dyson, who specializes in convertible securities in Piper Jaffray & Co.’s San Francisco office.

Last month, we explored "floorless" convertibles, and the crackdown by the SEC to make companies follow the rules regarding how they are accounted for. In this issue, Dyson points to another problem. (See BioWorld Financial Watch, Feb. 27, 2006.)

Convertibles are popular - deservedly so, if done properly, Dyson said. Forty percent of all equity and equity-linked capital raised for biotechnology companies since Genentech Inc.’s 1980 IPO has been in the convertible market. In a study period of follow-on offerings from 1980 to 2005, Piper Jaffray came up with a total of more than $35 billion in the convertible market with just over $41 billion in funding from common stock.

But, of 102 convertibles tracked recently by Piper Jaffray, Dyson said, 40 had to be refinanced. Ten so far have converted, but nine of those did so thanks to a "soft call" or autoconversion clause written into the terms of the deal.

Among those studied, the lone company that managed to do well even without the "soft call": Gilead Sciences Inc., which in December 2000 agreed to sell $250 million of subordinated notes, convertible into Gilead shares at a price of $98.25 per share, a 23 percent premium to the previous trading day’s closing price. The notes had an interest rate of 5 percent with a 7-year term, redeemable by the company after Dec. 20, 2003.

"Their stock went well above the conversion price, and ended up effectively getting converted on time," Dyson said, without going into detail about Gilead or any individual firm. "That’s good news."

Others have fared less well.

Standard provisional call mechanisms permit the issuers to convert their debt to equity as soon as their share price appreciates 50 percent above the conversion price. "Given the volatility of this industry, it makes intuitive sense that stock prices of a third of the provisional call analysis group has already appreciated more than the 50 percent requirement and converted to equity," Dyson said.

Convertible issuers in all industries often seek the lowest cost of capital, often by using a shorter-dated bond with a longer "hard no-call" structure. A biotech firm, though, can be in trouble if their shares don’t rise in the first several years of a five-year or seven-year term, as investors pressure management to refinance early and reduce the debt overhang, Dyson said.

"I hate seeing companies do these deals, where they could almost as easily do another safety profile," he told BioWorld Financial Watch, noting that the figurative metabolism of biotech firms is much different from others.

"A biotech company does the convertible [deal] and then spends the money on R&D," Dyson said. "If the stock doesn’t go up and the bonds don’t convert, they have to raise money to repay the convertible, and the only thing they can use to raise the money is their stock" - which means more dilution.

The problem, he said, lies in the way the deals are structured. The three control variables in Piper Jaffray’s case studies are time, price and redemption terms.

"[Many firms have] chosen to do a ‘hard no-call’ structure, where if their stock goes up, they’re not allowed to force conversion for a period of time," he said. "And if their stock goes down, they feel compelled to refinance because the principal is coming due."

Firms such as Genentech and Amgen Inc., in the 1980s, did convertibles with 15-year terms, each with a two-year period of "soft call," which meant that, if the stock hit a certain price, the firms could, in effect, force redemption of the bonds.

Thanks to market pressures that have "nothing to do with biotech," Dyson said, maturity periods have steadily shortened, so that five years to seven years is now the typical term, with "hard-call" provisions that companies do because it’s easier and cheaper.

This could mean hardship down the road, however.

For the 40 deals that refinanced, the conversion price for the new securities was, "on average, half that of the original" securities, Dyson said, whereas "if all 102 had our auto conversion or a version of soft call, a little over 50 percent of them would have converted."

Of the deals tracked by Piper Jaffray, 28 were issued with "soft call" and nine converted. The "hard-call" deals totaled 74, only one of which (Gilead) converted. "If they’d had soft call, another 14 would have converted," he said.

Autoconversion, which Piper Jaffray often uses, ensures that if a company hits its price trigger - the ‘soft-call’ trigger - for 20 out of 30 days, it has the right to "in effect, split the stock into the [convertible] bond," Dyson said. Piper Jaffray integrated the stock-split mechanism into the convertible deal, he said, "so that when the company earned the right to force conversion, they can. There’s no risk."

Ninety percent of the deals tracked by Dyson’s firm that managed to convert contained the provisional redemption feature - a feature found in only 27 percent of the overall sample, probably because it makes the cost of issuing debt slightly higher. But it’s a small price to pay for the privilege of forcing early conversion to equity if the stock performs well, Dyson said.

Without such protection, stock volatility can make for sweaty palms. In November 2002, Ligand Pharmaceuticals Inc. completed a $135 million offering of five-year convertible subordinated notes to institutional buyers. The notes were convertible at $6.17, but included a three-year "hard no-call" period (which expired at the end of 2005). In April 2004, the company’s stock hit a high of $24.02, four times the conversion price, but the chosen terms of Ligand’s deal prevented the company from forcing conversion.

Almost exactly a year later, the stock hit a low of $4.75. In March 2005, Ligand’s cancer drug Targretin missed its primary endpoints in two pivotal trials evaluating the drug in front-line combination therapy to treat non-small-cell lung cancer. The firm’s stock fell more than 28 percent on that news, and continued to drop.

Ligand’s notes are coming due in November 2007, and Ligand these days is doing appreciably better, selling last week at around $12.50, about twice the conversion price. But Dyson urges companies not to gamble.

"The short-dated, hard no-call structure has a different safety profile, a very poor safety profile," he said. "[As a biotech firm], if my stock goes up, I can’t force conversion because I’m prevented by the terms I chose to write in my own contract, and if my stock goes down, I worry about having to refinance. You set yourself up for a situation where it’s hard to navigate a good outcome."

Details are "pretty arcane," Dyson conceded. "I don’t think the data is well known, because nobody has collected it," he said - but the consequences for taking heed can be clear and undeniable.

"The simplest bond is a short dated, hard ‘no-call’ bond," he said. "In order to do that kind of deal, [biotech firms] take on a structure which doesn’t match their own high metabolism rate, and they end up diluting [for] their shareholders."

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