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Absolute Return Podcast #36: M&A 101: What’s a Contingent Value Right?

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October 21, 2019—Charles Schwab to Allow Investors to Trade Fractional Shares. But Will Individual Investors Benefit?

Alexion Announces Acquisition of Achillion in $930 Million Biotech Deal. What Makes This Deal Unique?

UK and European Union Reach Deal on Brexit. Is Brexit Finally Going to Happen?

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Transcript

Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.

Julian Klymochko: Welcome, investors, this is episode 36 of The Absolute Return Podcast. As always, I am your host during Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering.

Julian Klymochko: We have a number of market events to talk about this week. Nothing too crazy. We have some macro stuff, some M&A, some micro stuff as well.

    • Off the top, we will chat about this Phase 1 deal that the U.S. and China have reached in an attempt to halt and ultimately resolve the ongoing trade war. Now, does this ultimately mark the end of the trade war we have been talking so much about lately?
    • Charles Schwab, they are actually allowing investors to trade in fractional shares, which is really cool. Has not really happened before. We are going to chat about whether or not individual investors will benefit from this.
    • Some M&A news with Alexion announcing the acquisition of Achillion in a nearly 1 billion-dollar biotech deal. What makes this deal so unique?
    • Lastly, we are going to chat about a brief Brexit It seems like the UK and the EU have finally reached an agreement. But is Brexit finally going to happen this time? We will see.

U.S. & China Trade War

Julian Klymochko: It appears we have had a development in the ongoing U.S. China trade war, with Trump tweeting out last Friday that the U.S. and China reached a, quote, very substantial Phase 1 deal, which would entail China to buy 40 to 50 billion in U.S. agricultural goods, largely soybeans. And in return, the U.S. agreed to cancel the previously announced tariff increases that were set to go into effect this week. What these tariffs included were duties on $250 billion worth of Chinese goods. They are going to increase that from 25 percent to 30 percent. Now that is seemingly off the table until whatever new developments we see. Right now are very speculative, a very preliminary deal. Nonetheless, some speculate that Trump tweeted it out right before the market closed, such that we would get a nice rally on the S&P 500, rising over 1 percent on the news. Clearly investors liking this tying of relations between U.S. and China. Who knows? It will actually get a deal out of this. But, you know, on one hand, it shows that these parties are talking. It appears like they are cooperating in terms of getting something done. But we’d like to caution investors. As of right now, this is this very preliminary, speculative. We are expecting, the market’s expecting this Phase 1 deal to be signed next month. However, it could still fall apart. Next step is that President Trump and Chinese President Xi will meet mid-November at the summit of Asia Pacific Economic Cooperation countries, and they are largely expected to sign the deal there. However, you know, there’s been a lot of head fakes ongoing in this trade war where you expect signing to happen, it does not happen. Market goes down, Trump announce something else, threatens more tariffs. It has been a real back and forth over the past 18 months, seemingly close to a trade deal many times, but has not happened yet. Will this be the one? What are your thoughts on it?

Michael Kesslering: Yeah, I guess with regards to the agricultural products and really the tariffs not kicking in. This is really just examples of them not coming to new agreements. It is just stepping back some of their old putative measures that each side came to. On Trump side, it was the increase of tariffs and on the Chinese side; it was stopping to buy agricultural products. There is no real winner in there so far. Let us just bring back some of the measures, as you had mentioned. This announcement was right before market closed last Friday. If I was a cynical person, I would think that the timing of the announcement was pre-planned and aimed at juicing equity prices.

Julian Klymochko: Because Trump use his ultimate scorecard as the stock market doing well.

Michael Kesslering: Absolutely. He has really put his presidency on like on par with the stock market, how the stock market performs. He has really placed his own weighting in that. And when the stock market does go down, it is being blamed on Powell, and the Fed.

Julian Klymochko: Right and some market participants view that as a potential weakness and that the Chinese could capitalize on. Thus far, they have not done that yet. However, speaking on incentives here, we got Chinese growth numbers out for the last quarter and it fell to 6 percent, missing estimates. So annualized growth of 6 percent. It was below analysts’ estimates of 6.1 percent, and this was China’s lowest economic growth in over 27 years, so clearly this trade war is having an effect on Chinese economic growth. And we talk about how the stock market is so important to Trump while President Xi of China, what he holds so dear to his heart is economic growth. So as those numbers are coming down, their whole dynasty is really threatened over there, so that’s something to keep in mind. And that negative economic developments from this trade war and their effect in China is really incentivizing them to also get a deal done, just as Trump is incentivized to get a deal done to get the S&P 500 up.

Michael Kesslering: Absolutely. One last thing that I did want to mentioned on the subject of the trade war. Is that when they do codify this agreement in the coming weeks, when they finally get it written down. One thing Trump did mention is that it will address intellectual property concerns, which thus far haven’t been a part of the negotiations, but from many of the folks in private industry in the U.S., especially in the tech sector. This is really top of mind as many of these tech companies, U.S. based tech companies are really trying to break into the Chinese market. But what you’re seeing is that intellectual property laws really aren’t respected in China, especially not with regards to U.S. intellectual property. So that will be something to really follow to see whether he actually follows through with that, because that’s something that has a really large impact, perhaps more than many of these other measures.

Julian Klymochko: Yeah, that is a good point. There are a number of additional considerations that were not at all part of this phase one deal, such as Huawei, the Chinese mobile and Tech Company. There is the technology transfer aspect of it, the intellectual property and the protection of American intellectual property in China. So there is a whole host of issues, which is why we are being real cautious on this, but like we said, this is progress. And because of that, investors should be happy with it thus far.

Charles Schwab

Julian Klymochko: So in a bid to attract a younger clientele, discount brokerage firm Charles Schwab announced that they will be introducing the trading of fractional shares, which is brand new. Obviously, up until now, you have only been able to trade in round numbers of shares back in the day. Used to be only round lots, being in the hundreds of shares, but now you can trade in a one share if you want. There is a lot of high priced shares out there, whether they be Amazon, Apple, Tesla, shares of that nature. Now you can actually will be able to trade through Charles Schwab and I am sure many discount brokerage firms will follow. You will be able to trade fractional shares. So get a piece of Amazon, which is about twelve hundred bucks, you know, maybe spend 20 bucks on it and get a fraction of that. This move follows a recent elimination of commissions on stocks and ETFs; basically throughout the entire discount brokerage industry. It started with a threat from RobinHood and it has kind of proliferated as we’ve previously discussed on the last podcast. Now, with commission free trading the norm, brokers are looking to find ways to attract new clients to boost other parts of the business that could become more lucrative as their investments grow. They are trying to get young investors before they have a lot of money. Get them entrenched on their platform such that when they do have a lot of money that they remain a client.

But one of the reasons they did it, as I indicated, like amazon.com, is it’s a very pricey stock. It is actually almost two thousand dollars a share.

Michael Kesslering: Berkshire’s hundreds of thousands.

Julian Klymochko: Yeah Berkshire class-A is in the hundreds of thousands of dollars. However, they do have class B, which is still quite expensive.

Michael Kesslering: I believe it is still over a thousand.

Julian Klymochko: Yeah and so they are trying to encourage and ultimately just make it easier for investors to participate. There is actually a tech start up called Social Finance. They have waded into fractional trading as well. They launched it back in July. They did this sadly after noticing some clients delayed investing and chose companies based on share price rather than fundamentals and for an investor like myself, this is just heart breaking when you have amateur investors who are really unsophisticated buying stock based on just the price rather than actual fundamentals of the underlying business.

My thoughts with respect to fractional trading, I think it is actually a negative for investors, and here is why. So you $50 to invest. Is it wise to be buying a fraction of Apple share or a fraction of Amazon share? I think it is much smarter for an unsophisticated or new investor with only $50 dollars to invest. I think it is much more intelligent to buy a broad based index such as the S&P 500 or Wilshire 5000, the MSCI Global ETF. You are able to buy a share for $50 or less, so there is really no need to really traffic in fractional shares in my opinion. In addition to the elimination of commissions, obviously getting something free instead of paying is great. However, there could be negative effects if it encourages unsophisticated investors to engage in more trading because studies have shown that the more trading you do as an amateur trader, the more money you lose. But what are your thoughts on this development in the discount brokerage space?

Michael Kesslering: Yeah, I have a few comments on this and I guess the first being that this actually is not quite as innovative as it sounds is, this kind of already exists in a way in the form of just ETF, index ETF. Is you can buy a fractional portion of the underlying companies of the S&P 500 just through buying the (SPY) ETF.

Julian Klymochko: A much smarter idea because then they are widely diversified in your own point zero, zero one of a share of this company. Point zero, zero two of a share of this company and you get a basket of 500 of those in one trade as opposed to trading a fraction of one business.

Michael Kesslering: Absolutely, and so for the less sophisticated investors, you know, like somebody that doesn’t want to put the time into investing, that is the route to go is the more diversification as opposed to, you know, betting it all on Amazon, you know, just based on your shopping experience, is there. The other aspect and this is really kind of the inner piping of the infrastructure behind the stock market and exchanges is, you know, this will actually really seems like it would be difficulty, a big difficulty from an accounting perspective. Looking at who owns what, and especially with regards to voting results and voting rights during corporate actions. As in the past, we have seen during different M&A scenarios where there is a vote, where there will be more votes cast than there are shares outstanding, sometimes in a hilarious amount over the shares outstanding.

Julian Klymochko: Yeah, that is why fractional shares, they really do not make a lot of sense from a fundamental business standpoint. If you are invested in a company, it really does not make sense to have a fraction of a share because one share basically gives you a vote, in most corporations, right?

Michael Kesslering: Absolutely. With the exception of I guess dual voting classes. But for the sake of the argument, like get one share one vote is what most companies should really strive towards in terms of corporate governance, something that we’ve mentioned a lot on this podcast. But the last thing I wanted to bring up, is that this really isn’t free. Schwab will and they always do this. This is kind of part of what they do is they send your order when you make an order on their brokerage platform to a market maker. And that market maker has paid them for your order flow. So they are known as high frequency traders, and so the price paid by investors for a fractional share, since you cannot go on to the market. This market maker cannot go into the market and just buy a fractional share. So my assumption is that you will get a worse execution price by buying and selling these fractional shares.

Julian Klymochko: Yeah, I think ultimately the way it would work is discount brokerage firms like Schwab would sort of inventory all the different fractions in order to make them into a whole share. Nonetheless, when they are farming off your flow to high frequency traders, ultimately the unsophisticated investors get picked off.  It is really not free trades, you’re paying that through worse execution price.

Michael Kesslering: Absolutely, and so the question really just becomes, is the cost of this, you know, higher execution prices, presumably, is that worth the ability to trade lower dollar amounts more frequently?

Julian Klymochko: Right and then we are also contrast that to the pricing developments over the past 20, 30 years. You go back way back then, stocks traded in, you know, large fractions of one eighths, which is a massive spread, and you also page huge commissions. Significantly, well, obviously, it is now free, but it used to be in, you know, percent range where you would say pay fifteen, hundred dollars per trade, which is significant. So that is obviously a really, really, great development for investors there. However, we really caution on unsophisticated investors utilizing these fractional shares to go and buy fractions of companies without really doing any due diligence. Typically, that scenario, it adds to inefficiencies in the market, which is positive for professional investors, hedge funds, etc. However ultimately the unsophisticated investor will suffer, and with the proliferation of index ETFs, that has really made the market seemingly quite a bit more efficient because it has taken a lot of the so-called dumb money, unsophisticated investors out of individual securities and into the index where they are not sort of adding to inefficiencies throughout the market.

Alexion announcing the acquisition of Achillion

Julian Klymochko: Interesting deal in the biotech space with Alexion Pharmaceuticals acquiring biotech firm Achillion Pharmaceuticals for nine hundred thirty million in cash. This was at a 73 percent premium. Now, that consideration is really, what we want to talk about here because this is a really interesting one. Achillion shareholders will get mainly cash. So six dollars and 30 cents cash per share. In addition to that, this is where the interesting part comes in.

They receive potential additional two dollars per share in the in the future. And it’s in the form of what’s known as a contingent value right or CVR. Strategic rationale behind the deal. Will this deal expands Alexion’s presence in the treatment of rare blood disorders, which has been obviously a big and growing space. Now I wanted to touch on this non-tradable contingent value right. This is part of the deal consideration up to $2 in addition to the $6 and 30 cents. If investors are paid the full $2, this will represent a significant portion of the consideration, roughly 20 percent. The way these ones work is, cash will be paid to Achillion shareholders if certain clinical and regulatory milestones are achieved within a specific time period. Specifically, there are two upcoming binary events, which will occur after the deal has closed, assuming it closes successfully. Obviously subject to shareholder vote, subject to regulatory and anti-trust approvals, which certainly are no slam-dunk. However, the way these contingent value rights work is two stages. You get paid $1 per share for the U.S. FDA approval of one drug that they manufacture and another dollar per share. If they get to initiate Phase 3 on another drug. I just wanted to highlight that for investors, if they ever come across a merger or acquisition deal involving CVR or contingent value rights, they are fairly common in the biotech space where you have these pre revenue biotech companies working on drugs and they find it difficult to value the future potential of some drugs in development. Well, one way they can sort of narrow that bid-ask spread between the acquiror and the seller is to offer this CVR contingent value right to investors such that they can recognize some of that value down the line after the deal closed. Now, we do see this in other industries, right.

Michael Kesslering: Absolutely. You do see them in some of the resource space as well, and really where this comes from is in the private markets, when a company is selling perhaps to private equity or to a strategic acquiror, is the management team will typically have some sort of earn-out where it’s just more incentive to ensure that a transition in the case of a small private business as they’re acquired by the private equity firm so that they’re still incentivized to make sure that strategic gets all their synergies. They could be revolve around that as well as just overall making sure that that goes smoothly. But specific to this deal, I mean, it was a reasonably large premium, and so one thing is that these shareholders of the company, especially a biotech company, they typically are bullish on the drugs that the company does have. There just needs to be a little bit added incentive these shareholders to sell their shares unless they really think that the company’s in dire straits.

Julian Klymochko: Right, and so I want to caution investors somewhat on this deal. Specifically, the market was valuing these CVR roughly 10 to 20 cents per share. You have to take into account the time value of money. Obviously, they will take quite a while to pay off and then you are going to risk it, so the market’s effectively saying, you know, there is $2 is ultimately up for grabs. We are only going to assign a 10 to 20 cent percent probability of that occurring. In addition, we do not see these only in biotech, although that is probably the most common. We have seen this, as you indicated, in resource plays. One recent one was when Exxon Mobil bought Interoil and they issued investors a CVR on the amount of resource in their assets that were located in Papua New Guinea. So that’s another example of where company pays out shareholders and then further down the line. Once that value is established on this additional asset, they can come to terms and pay out additional consideration for the true value of that asset. But cautioning investors here, these are non-tradable, such that the deal clothes you’re effectively stuck in them, can’t trade out. They are just going to stick in your account and you just have to wait and hope for the best.

Brexit

Julian Klymochko: Big news on the Brexit front now. Is the finale finally here? Well, let us chat about it. What happened was Prime Minister Boris Johnson of the UK. His government struck a draft deal with the EU, the European Union for the country’s exit from the bloc. Basically, the deal is subject to a high stakes vote in British parliament to become effective and that’s happening on Saturday, or by the time listeners have heard this podcast, it would have already happened.

This deal came together seemingly in the nick of time because Brexit was set for or they’re going after the October 30 first Halloween hard Brexit deadline. Now, just to give some listeners some background here, the original Brexit referendum was held in 2016. So over three years ago, it’s been delayed twice. It has kind of been non-stop news in the market for a number of years. It has caused all sorts of volatility in currency markets, equity markets, fixed income markets and a lot of global economic uncertainty. So if they could finally sort this out. That would be incredibly positive for investors all over the world. Now, why are they trying to do this Brexit? Why is the U.K. trying to leave the EU? Well, the proposed deal would leave Britain freer to set its own rules and strike its own trade deals independently from the EU, which was really a key demand a Brexit supporter. Had some quotes from a couple involved in the deal.

The European Commission chief, John Claude Juncker tweeted, “it’s a fair and balanced agreement for the EU and the UK and it is a testament to our commitment to find solutions.” British Prime Minister Boris Johnson also heralded the agreement. He tweeted that, “the negotiators had reached a great new deal.” Now, this accord has been endorsed by leaders of the other 27 EU countries. That seems all good and well. However, it does face a formidable challenge in winning the backing of parliament in the UK, which is really the last hurdle that they have here. One political party said it would not support the deal. So it’s really uncertain whether they’re not going to get Brexit done on a vote on the weekend. However, investors will be watching closely this Saturday a vote on this Brexit deal.

Some market action. The pound sterling, the UK currency was kind of all over the place, volatile, rallying, tanking back. So a lot at stake on this Brexit vote and this seemingly close to being done Brexit deal. What are your thoughts on it and the implications?

Michael Kesslering: Yeah, so just going back to some of the terms and over the last month, what the EU and the Boris Johnson administration. What they were negotiating over is the main sticking point seemed to be ensuring that there was no land border in Ireland. Between Northern Ireland and Ireland, that was a main issue as well. Looking forward here, I guess to Saturday is, you know, if it does not make it through the House of Commons, there is really two options. There could be another referendum with over the terms or another election. Now, Johnson would prefer an election because he does actually lead in the polls currently. But, you know, ideally, for the sake of the UK, this is something that really needs to be in the past for the country. This has been over three years and that as well. On the other side, if it does make it through the House of Commons, it would be a transition period for the next 14 months while they move into negotiating a trade agreement with the EU. That would be the first step, and then they would start negotiating trade agreements with other countries.

Julian Klymochko: Right. The work just begins and would like to mention the other scenario if this vote does fail is a hard Brexit and no deal Brexit on October 30 first, which would be very economically destructive, but not just the UK, which would bear the brunt of it, but also the EU. I mean, it would be tough on both sides. I believe no one is really interested in a hard Brexit, no deal on Brexit, so that looks unlikely. If it passes, they exit the EU with the deal, they still got a lot of work to do, but market participants will obviously like that. That will relieve a lot of tensions globally and really get past that hurdle that the market has been dealing with for the past three plus years. I guess investors will be paying close attention on Saturday as to what happens. From there then hopefully that’s the end of the Brexit story and we have to stop worrying about it, stop talking about it. But if it isn’t, then I guess we get to look forward to more market volatility.

Michael Kesslering: Yeah, it’ll be interesting to watch the futures price action over the weekend, regardless of the scenario. As you know, over the weekend, futures volumes are lower. The price movements are more amplified, so that will be something for you if folks have some spare time to take a look at the futures prices.

Julian Klymochko: And that is it for our latest episode of The Absolute Return Podcast, if you like it. You can always check out more at absolutereturnpodcast.com, if you really liked it, be sure to give us a review, tell your friends, colleagues, co-workers, family about it. Until next week, we will chat with you soon. Cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.