Hypothetical Leveraged Buyout (LBO) of Arcus Biosciences (RCUS) by Gilead Sciences (GILD)
Advisor: Mr. Daniel Ong
Onsite Mentor: Alberto Ortega
This research, inspired by a passion for economics and finance cultivated through academic pursuits and mentorship from Mr. Alberto Ortega at Codexis Inc and Dr. Daniel Ong at Basis Independent, explores the hypothetical Leveraged Buyout (LBO) of Arcus Biosciences by Gilead Sciences. Using various financial metrics, this project will outline an extensive LBO model and step-by-step strategic planning that will allow Gilead to utilize the acquisition and maximize profitability. The model will show 5 year projections, and analyze the viability and potential success of a leveraged buyout, taking into account economic indicators, market dynamics, and financial intricacies.The significance lies in contributing to the understanding of strategic decision-making, extensive financial models, and the broader implications of LBOs in the context of the biopharmaceutical industry. Gilead's potential multi-billion-dollar deal with Arcus Biosciences signifies a groundbreaking collaboration that could reshape drug development, impacting R&D trajectories and potentially benefiting millions. Beyond its potential for huge economic windfall, this study serves as a trailblazer for future biotech Leveraged Buyouts, with its model offering accessible insights for students and smaller biotech entities, further democratizing sophisticated financial tools and decision-making processes.
Project Blog
Week 0: Leveraged Buyout of Arcus Biosciences by Gilead, An Introduction and Background
Hi readers!
I’m Revant, and this will be the beginning of my adventure as I create a financial model to analyze a hypothetical leveraged buyout scenario, the acquisition of a company funded by a significant amount of debt. In this case study, we will analyze the feasibility of Gilead Sciences buying Arcus Biosciences. We will explore the synergies between the companies and identify the right levers for a buyout, and create a model for a leveraged buyout with the optimal purchase price and terms of offer together with an extensive 5-year implementation plan.
My passion for economics and finance has been a driving force in shaping my academic journey. It all began in my freshman year when I eagerly enrolled in both AP Macroeconomics and AP Microeconomics courses. These foundational classes ignited my interest in understanding the intricate workings of economic systems and the strategic decision-making processes that drive financial markets.
As I progressed through high school, I had the privilege of taking Principles of Economics with Professor John Taylor, the father of modern monetary policy. Learning from Professor Taylor, a trailblazer in the field, provided me with valuable insights into the intricacies of economic policy and its implications on both national and global scales. His teachings not only deepened my understanding of economic theories but also inspired me to explore the practical applications of these principles in the world of finance.
As I approach my senior year, I find myself immersed in the complex and dynamic world of corporate finance. This course has been a pivotal step in expanding my knowledge and honing my analytical skills. The blend of theoretical concepts and real-world case studies has equipped me with a comprehensive understanding of financial management within organizations.
Investors have been deploying capital since the dawn of the industrial revolution to make acquisitions of companies. Merchant bankers in London and Paris financed industrial concerns in the 1850s. J. Pierpont Morgan's J.P. Morgan & Co. would finance railroads and other industrial companies throughout the United States. In 1955 McLean Industries deal took place for $49 Million paving the way for PE industry evolution. In 1988 Safeway made waves with its $4.2 Billion buyout. Fast forward to Michael Dell and Silver Lake Management buyout of Dell for $21.5 Billion happened in 2013. The overall PE market is a trillion dollar industry with significant impact to the world economy. Arcus is a likely acquisition target for Gilead which is already highly invested in Arcus as its largest shareholder, and the two are already currently collaborating on strategic projects.
This study will thus lay the foundation for a possible buyout by creating a quantitative model based on both strategic business and financial data, and is intended to serve as a quick-start LBO kit for students and industry workers to reference and develop for their particular use.
Stay tuned for next week’s blog as we dive into the dynamic world of finance, acquisitions and leveraged buyouts!
Week 1: Initial Researching
In this first week, I've begun delving into the world of LBO financial modeling. My goal is to understand the key components, data requirements, and initial steps to navigate the rest of the project effectively.
To kick things off, I explored Wharton Online's PE licensing course to grasp the fundamentals and key terminology associated with the model. However, before diving further, it's crucial to understand:
What is an LBO analysis?
An LBO analysis is a financial tool used by private equity (PE) firms and investors to evaluate the potential acquisition of a company using a substantial amount of borrowed funds. This analysis serves two main purposes: 1. Determining the Maximum Purchase Price: This involves calculating the highest price a potential buyer can pay for the target company while still achieving their desired return on investment. 2. Assessing Financial Feasibility: This ensures the target company can generate enough cash flow to not only repay the debt incurred but also provide an attractive return for equity investors.
Key Components of an LBO Analysis:
A typical LBO analysis involves several key components. These include factors like the estimated purchase price of the target company, the financing structure (debt-to-equity ratio), anticipated interest rates on debt, and the projected profitability multiple at which the company could be sold in the future. Additionally, the analysis involves forecasting the target company's financials over a specific holding period, typically five years. This includes income statements, balance sheets, and cash flow statements, factoring in revenue, expenses (including interest), profitability, assets, liabilities, equity, and debt repayment. Finally, the analysis involves calculating the intrinsic value of the company using discounted cash flow (DCF) analysis, determining the expected return for equity investors (internal rate of return, IRR), and modeling debt repayment throughout the holding period.
Data Collection for LBO Analysis:
To set myself on a path for success, I wanted to outline the kind of data I need to collect, a vital part of the process since the model is highly sensitive to financial inputs and assumptions. The data types can be broken into 4 categories: target company financials, management projections, industry and market data, as well as transaction terms. We can find most of this information through SEC filings, calculations based on these filings, and industry reports. However, we may have to take extra steps in order to create projection data (such as offering memorandum) which often factors in insider information and is not publicly available. Furthermore, creating strategic planning may prove to be a challenge since much of the relying data points are confidential and inaccessible. Looking forward to next week however, I have now understood some basic calculations needed to create key values for the first section: transaction assumptions. I will work on entry valuations, debt assumptions, and tabling.
Week 2: Understanding the Target
Welcome back readers to the second installment of my blog! I was planning on working on transaction assumptions this week but I had to make changes in my plans as I began to retrieve data from Arcus Biosciences SEC filings. I realized the most efficient way to get the work done was to start tabling and figuring out the levers needed for the model to work. Constructing a basic model and then assessing strategic plans to increase the efficiency of Arcus before getting to the full model would greatly streamline the process.
In short this included researching:
A Paper Model:
I revisited a simplified “paper” LBO model that I had originally thought of during the planning phase of the project (back when I first proposed the idea to the panel) to assess the viability of the purchase. I remade the paper model including more accurate data to reflect the SEC filings. Now with this paper model I could outline the key components of the transaction structure, such as the purchase price, sources of funds (equity and debt), and the initial capital structure. This provides a framework for building the full financial model and ensures consistency in the assumptions and calculations. The model also set me on the right path to highlights the critical assumptions and calculate high level returns. The paper LBO model acts as a roadmap for building the full financial model. It outlines the sequence of steps, calculations, and interconnections between different components of the model, making it easier to organize and develop the complete model in a systematic manner.
Pharma Pipeline:
To develop accurate projections for Arcus Biosciences, it is crucial to have a comprehensive understanding of their product pipeline, clinical trial progress, and the competitive landscape within the biopharmaceutical industry. This knowledge will inform the revenue potential and associated operating expenses. Estimating operating expenses is a critical component, encompassing research and development costs, clinical trial expenses, and selling, general, and administrative expenses – all of which are essential for a biopharmaceutical company's operations and growth. Furthermore, projecting capital expenditures and changes in working capital requirements based on the expected growth and operational needs is vital to capture the full financial picture and cash flow dynamics. By thoroughly assessing these factors, a robust financial model can be constructed to evaluate the potential acquisition accurately. Furthermore, understanding the pipeline would allow me to make adjustments to acquisition price based on goodwill, intangible assets etc… and also perform initial sensitivity analysis to assess the impact of changes in key assumptions on the returns and cash flows.
Thanks for reading, see you all next week!
Week 3: Unraveling the Full Model
Welcome back for the third week of my project. Shooting off of last week’s napkin/paper LBO model I began to construct the full LBO chart. This week mostly consisted of number crunching as I began to dissect the target company’s (Arcus) financial data reported through public SEC filings. I started by matching Arcus’s income statement data onto a chart of my own. Through this process I was able to do a surface level investigation of their financial position and deemed that they were burning too much cash. In their reported data we can see that their R&D costs are incredibly high for their revenue which is a result of the structuring of pharmaceutical drug development pipelines. And using this observation I was able to construct some basic drivers for the income statement to improve the business over 5 years. This would include a 10% YOY (year over year) increase in revenues. Furthermore, Gilead will support R&D costs and SG&A costs as a result of their acquisition to help decrease those abnormally high numbers. Thus resulting in a basic 5 year projection shown below:
Gross Margins are WIP and 26% Tax Rate is standard for C corp.
In a similar fashion I replicated balance sheet values and began working on drivers as shown below:
I also constructed a summarize 5 year projection chart (shown below) to help guide me as I work on the full model, and while many of the values are still work in progress, the highlight is the 5 year EBITDA projections which were previously increasing, but are now decreasing as we implemented our own drivers for the income statement. Essentially the growth of the business will stand on decreasing that number and making it as close as possible to zero since it is negative and very high right now.
I will work more on the full model next week. Stay tuned for the next edition of my blog!
Week 4: Negative EBITDA and Model Enhancement
Welcome back readers for Week 4 of my blog! After looking over the results of last week’s work, I noticed a glaring flaw. Biotech companies such as Arcus produce extremely low revenue in their clinical stages while they are still in drug development. This is due to a higher focus placed on technological development instead of sales. Their primary focus is on researching, developing, and testing new drugs. This involves significant investment in research and development (R&D) activities, clinical trials, and regulatory processes. These activities consume a large portion of their resources and don't generate immediate revenue. Since the drugs are still in the clinical trial phase, they haven't received regulatory approval and can't be commercially sold. Revenue generation only begins after a drug gets approved and reaches the market. The drug development process is lengthy and can take 10-15 years on average. There's also a high degree of uncertainty associated with it. Many drugs fail to make it through clinical trials, meaning the investments in development may not translate into future revenue.
Essentially the two takeaways are low revenues and extremely high R&D costs and we can clearly see this in the numbers that Arcus has reported. Arcus generates revenue only from licensing their research findings (patents etc…) and burns an extremely high amount of cash through R&D. While this is normally fine, in our case, the financial model we are building relies on positive EBITDA numbers that can be scaled. Thus, we must find a remedy, and the easiest solution is to factor “hidden revenues” that can be unveiled once their products pass drug approval stages.
Arcus Bio has multiple clinical candidates, including anti-TIGIT, adenosine axis, anti-PD-1, HIF-2α inhibitor, and AXL inhibitor. The success of just one of these products will result in massive increases in revenue, and is common with many other successful biotech companies. By analyzing the clinical stages of their products, industry averages, and past revenue info from Gilead, we can project a new “hidden revenue” (around a 430% increase) and use this in our model. Which will fix our negative EBITDA issues and allow us to scale other dependent values such as net income. New values and projections shown below:
https://ibb.co/ysjW2zY
With this problem fixed, we can now continue with the model. Thanks for joining me this week, see you in the next installment.
Week 5: Strategic Planning
A big part of the LBO process for a private equity company is increasing the efficiency and returns from the target company. The company needs to drive value creation in order to make the operation profitable. The easiest way to understand its importance is to revisit the definition and compare it to a commonly known mechanism: mortgaging.
A hypothetical scenario shows us how mortgaging commonly works:
https://ibb.co/XLV8v2Y
LBOs are financial transactions where a company is acquired using a significant amount of debt, with the assets of the acquired company serving as collateral for the borrowed funds. The primary purpose of an LBO is to acquire a controlling interest in a company, typically with the aim of restructuring it, improving its performance, and eventually selling it at a profit. Mortgaging, on the other hand, refers to obtaining a loan secured by real estate property. The purpose of mortgaging is usually to finance the purchase of a property, such as a home or commercial real estate, or to access the equity in an existing property for other purposes, such as home improvements or debt consolidation. Making a profit on a mortgaged investment would involve paying some of the debt over time and having the house appreciate in value.
Similarly, in an LBO, the assets of the acquired company are used as collateral to secure the debt financing. The value of these assets, along with the cash flows generated by the acquired company, provide security to lenders in case of default. LBOs typically involve higher levels of risk compared to traditional acquisitions because of the significant amount of debt used to finance the transaction. However, they also offer the potential for higher returns if the acquired company can be successfully restructured and its value increased.
Shooting off of last week’s evaluation of the company’s clinical positions, I began to match the targeted drivers in order to create a strategic plan. To begin with, optimizing the pipeline is crucial. This involves evaluating and prioritizing pipeline assets based on scientific merit, market potential, and strategic fit. Resources should be efficiently allocated to advance promising candidates through preclinical and clinical development stages. Additionally, exploring opportunities for strategic collaborations or licensing deals can bolster the pipeline with complementary assets. Clinical development excellence is vital for demonstrating the value of Arcus Biosciences' therapies. This entails executing well-designed and efficiently managed clinical trials to generate robust data supporting the safety and efficacy of lead candidates. Innovative trial designs, biomarker strategies, and patient stratification approaches should be leveraged to maximize the chances of success while maintaining close collaboration with regulatory authorities to ensure compliance. Furthermore with Gilead’s purchasing we can merge clinical teams that overlap. Next week I will try to quantify these metrics and create a comprehensive strategic plan.
Week 6: Deep Dive into the Research Portfolio
As I continue the strategic planning process it is necessary to take a deeper dive into what Arcus offers in their research portfolio. Arcus Biosciences is focused on developing various molecules targeting immune checkpoints to treat cancer. Some of their key molecules at this time include: 1. AB122 (Domvanalimab): A PD-1 antagonist being developed for various cancers, either as a monotherapy or in combination with other therapies. 2. AB154 (Tiragolumab): A monoclonal antibody targeting TIGIT (T cell immunoreceptor with Ig and ITIM domains) for the treatment of solid tumors, particularly in combination with PD-1/PD-L1 inhibitors. 3. AB928: An adenosine receptor antagonist and dual antagonist of A2a and A2b receptors. It is being evaluated in combination with chemotherapy and with other immunotherapy agents. In addition, they are also working on Quemiliclustat, an investigational drug for the treatment of cancer. It is an inhibitor of glycolysis, a metabolic pathway that plays a crucial role in the growth and proliferation of cancer cells. By targeting glycolysis, Quemiliclustat aims to disrupt cancer cell metabolism and inhibit tumor growth. As well as: Etrumadenant (also known as AB928), another investigational drug. It is an oral, small molecule antagonist of the adenosine receptors A2a and A2b. Adenosine signaling in the tumor microenvironment can suppress the immune response against cancer. By blocking these receptors, Etrumadenant aims to enhance anti-tumor immunity and improve the efficacy of cancer immunotherapy.
Essentially, the molecules in the Arcus pipeline address the cancer patients with the PD-L receptors that are resistant to current drug treatment. We can compare this to a similar product that has already reached the market, Amgen’s KRAS inhibitor, lumekras. The current market size and current sales for a drug treatment alone, as represented by Amgen stands at around 280 million with 8% year over year sales growth for the next 5 years. Arcus’s comparable cancer molecules are currently in stage 3 of clinical trials and are applicable in lung cancer, as well as GI, pancreatic, and colorectal cancer and thus can be projected to bring in around $500M with a 10% YOY growth in revenue.
Gilead also has a number of approved and marketed oncology products as well as many others in clinical testing. Gilead Sciences has been actively involved in the development of therapies for lung cancer. Lung cancer remains one of the leading causes of cancer-related mortality globally, with non-small cell lung cancer (NSCLC) being the most common subtype. One of Gilead's notable contributions to lung cancer treatment is through its acquisition of Immunomedics in 2020, which brought Trodelvy (sacituzumab govitecan) into its portfolio. Trodelvy is an antibody-drug conjugate (ADC) targeting Trop-2, a protein overexpressed in many solid tumors, including lung cancer. It delivers a cytotoxic payload directly to cancer cells, potentially improving efficacy while minimizing systemic toxicity. Clinical trials evaluating Trodelvy in lung cancer have shown promising results, particularly in patients with metastatic disease who have previously received multiple lines of therapy. In these trials, Trodelvy demonstrated meaningful antitumor activity and durable responses, leading to its approval for the treatment of metastatic NSCLC in certain patient populations. Thus upon acquisition, Gilead’s pre-existing architecture built for quick drug approval can be applied, saving upto 300M in R&D costs and contributing to operational infrastructure (average R&D costs for late stage cancer drug approval as reported by BMJ). Next week I will make this into more concrete steps and return to the model to calculate returns on the investment.
Week 7: Back to the Model
The main goal for the LBO model is to calculate returns on the original investment. There are two key values to take into account: MOIC (multiple on invested capital) and IRR (internal rate of return).
MOIC represents the ratio of the total proceeds generated from an investment to the initial amount of capital invested. It is calculated by dividing the exit value (proceeds) by the initial investment amount. MOIC provides a straightforward measure of how many times the original investment has been returned. Higher MOIC values indicate greater returns relative to the initial investment. IRR represents the annualized rate of return generated by an investment, taking into account the timing and magnitude of cash flows. IRR reflects the rate of growth a project is expected to generate and is often used to compare the profitability of different investment opportunities. Higher IRR values indicate more attractive investment opportunities with higher returns relative to the capital invested. Both MOIC and IRR are crucial for assessing the risk associated with an LBO investment. They provide investors with insights into the potential returns relative to the capital deployed and help evaluate the risk-adjusted performance of the investment.
In order to calculate these two values, we will have to assess a couple more factors including: cash flow statements, debt scheduling, interest scheduling, and exit valuations and return schedule.
Cash Flow Statements: These statements outline the expected cash inflows and outflows over a specified period, typically the forecasted lifespan of the investment. In an LBO context, cash flow projections are crucial for estimating the ability of the acquired company to generate sufficient cash to cover operating expenses, service debt obligations, and provide returns to investors. Accurate cash flow projections form the foundation for assessing the financial feasibility of the LBO and calculating metrics like Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC).
https://ibb.co/MPkkPxx
Debt Schedule: A debt schedule outlines the repayment timeline and terms of the borrowed funds used to finance the acquisition. It details the principal and interest payments due on the debt over the investment horizon. By mapping out the repayment structure, including any amortization and balloon payments, the debt schedule helps determine the cash flow requirements and assess the risk associated with servicing the debt under various scenarios.
https://ibb.co/Yy2FxJ2
Interest Schedule: The interest schedule delineates the interest payments associated with the debt financing. It specifies the timing and amount of interest payments based on the outstanding debt balance and the applicable interest rate. Interest schedules are vital for calculating the interest expense, which directly impacts the cash flows available for debt servicing and investor returns. They also play a significant role in determining the overall cost of debt and its impact on the financial metrics of the LBO model.
https://ibb.co/cv10t0k
Exit Valuations and Return Schedule: Exit valuations estimate the potential proceeds from selling the acquired company at the end of the investment horizon. These valuations consider factors such as projected future cash flows, comparable company multiples, market conditions, and strategic buyer interest. The return schedule outlines the distribution of proceeds to investors, including repayment of debt, payment of accrued interest, and distribution of profits. Exit valuations and return schedules are crucial for calculating the realized returns, including IRR and MOIC, which measure the profitability and efficiency of the LBO investment.
Week 8: Sensitivity Analysis
Hi readers, welcome back for week 8 of my blog, where I will make some more finishing touches to my model. A key component that we are missing is the sensitivity analysis which would assess how changes in key assumptions impact the metrics that we calculated in the last week such as IRR and MOIC. Here’s how sensitivity analysis is conducted in the context of an LBO model and why it’s useful even after calculating initial return values:
Identifying Key Assumptions: Before conducting sensitivity analysis, it's essential to identify the key assumptions driving the LBO model. These may include factors such as revenue growth rates, operating margins, capital expenditure requirements, and exit multiples.
Varying Assumptions: Once the key assumptions are identified, analysts can systematically vary these inputs within a reasonable range to see how changes affect the outputs, such as IRR and MOIC. For example, they might increase or decrease the assumed revenue growth rate by a certain percentage or adjust the exit multiple.
Impact on Returns: Sensitivity analysis reveals the sensitivity of investment returns to changes in these assumptions. Analysts can identify which assumptions have the most significant impact on returns and where there is the most uncertainty. This insight helps in understanding the risk profile of the investment.
Scenario Analysis: Sensitivity analysis often extends to scenario analysis, where multiple assumptions are varied simultaneously to create different scenarios. For instance, analysts might explore a base case, best case, and worst-case scenario to understand the range of potential outcomes.
Risk Management: By understanding how changes in assumptions affect returns, investors and lenders can better manage risk. Sensitivity analysis helps them identify potential pitfalls and develop strategies to mitigate them. For example, if the investment returns are highly sensitive to changes in revenue growth, the management team may focus on strategies to diversify revenue streams or strengthen customer relationships.
Communication with Stakeholders: Sensitivity analysis is a valuable tool for communicating with stakeholders, including investors, lenders, and company management. It provides transparency regarding the assumptions underlying the financial projections and allows stakeholders to assess the robustness of the investment thesis.
Refinement of Investment Thesis: Even after calculating initial return values, sensitivity analysis can lead to refinements in the investment thesis. It may uncover opportunities to enhance returns by adjusting strategies or negotiating better terms.
https://ibb.co/GkCk7KS
By conducting sensitivity analysis, stakeholders can make more informed decisions and adapt their strategies to maximize value creation.
Week 9: Compilation
We are nearing the end of the project, and my work on the development of the model and its results are nearly complete. Thus, this week I began compiling my efforts and began preparing for the presentation. With minimal addition to the content of the project, I will take this week’s blog as an opportunity to overview the LBO process, now having nearly finished the process.
Here's an overview of the steps needed to create and assess an LBO model:
Gather Information: Collect detailed information about the target company, including its financial statements, historical performance, market outlook, and any other relevant data.
Build Assumptions: Make assumptions about key variables such as revenue growth, expenses, capital expenditures, working capital changes, and tax rates. These assumptions will drive the financial projections for the target company.
Create Projections: Develop a set of projected financial statements for the target company, including income statement, balance sheet, and cash flow statement. These projections should typically cover a period of 5 to 7 years, reflecting the expected holding period of the investment.
Determine Purchase Price: Calculate the purchase price of the target company based on factors such as its current market value, potential synergies, and the desired rate of return for investors.
Structure Financing: Determine the optimal mix of debt and equity financing for the acquisition. This involves deciding how much debt can be used to finance the purchase while still maintaining an acceptable level of risk.
Model Debt Repayment: Project the repayment schedule for the debt used to finance the acquisition. This will typically include both principal repayments and interest payments.
Estimate Returns: Calculate the expected returns for investors based on the projected cash flows from the target company, the financing structure, and the exit strategy. Common metrics used to evaluate LBO returns include Internal Rate of Return (IRR), Return on Investment (ROI), and Equity Multiple.
Perform Sensitivity Analysis: Assess the sensitivity of the LBO model to changes in key assumptions such as revenue growth rates, discount rates, and exit multiples. This helps to understand the range of possible outcomes and the associated risks.
Hope this can clarify once again how I have attempted to assess this financial scenario between Arcus and Gilead and perhaps shine a new light, now as I have completed most of the brunt work. See you guys next week.