Mesoblast, Oaktree and the looming feast
Mesoblast Limited (ASX:MSB, Nasdaq:MESO)
Price at posting: $1.09
THE AUSTRALIAN coast. It is Spring and the last of the Winter storms is subsiding. Capital in the form of plankton is in bloom again and just offshore, the whale, Mesoblast Limited (Mesoblast), has returned to feed.
Mesoblast is a life sciences company that is developing medicines for the treatment of severe inflammatory conditions. Developing and commercialising drugs is an expensive business though and so the whale must return to the shore at regular intervals to take in great gulps of capital. For marine mammals, there is real risk in coming this close to the shore and each year a number pay the price.
Meanwhile, soaring ominously, opportunistically overhead, Oaktree Capital Management, L.P. (Oaktree) surveys the shore – the vulture is looking to feast on a carcass.
The declining share price
Having reached a high of more than $5 in 2020, Mesoblast’s share price has been in decline for some time now. The company has valuable IP but the drug approval process is complicated and has taken longer than the company expected.
As noted by both Mesoblast and its auditors in the 30 June 2021 annual report, Mesoblast was in a difficult financial position and its ability to continue as a going concern was reliant on its ability to refinance its US$60m debt with Hercules Capital, Inc (Hercules) and to fund its continuing operations with fresh capital.
Enter Oaktree, the largest distressed-debt investor in the world. On 22 November 2021, Mesoblast announced that it had successfully refinanced its existing debt with a US$90 million five-year facility provided by (vulture) funds managed by Oaktree.
Mesoblast drew the first tranche of US$60 million on closing of the deal, using the proceeds to repay Hercules. An additional US$30 million may be drawn upon to fund ongoing operations, subject to certain milestones.
Investors wary
Some investors have shown concern regarding the involvement of Oaktree. Funds managed by Oaktree have sometimes been known to employ a loan-to-own strategy – a strategic purchase of debt with an intention to take control of the borrower’s operations at a future date.
For a loan-to-own strategy to be effective, a lender must be able to convert the debt into a meaningful equity stake upon restructuring.
The trigger for such a conversion can be a failure to repay debt or breach of a debt covenant – a condition that must be met by the borrower in addition to repaying the loan. Examples of a debt covenant include, maintaining a financial ratio above a certain level or generating a certain amount of operating income within a specified period. A lender can take steps to recover a debt if a covenant is breached even if the borrower has not missed a repayment.
Not content to simply wait for the flotsam and jetsam that the sea provides, Oaktree have been accused of hastening the arrival of carcasses through their use of restrictive debt covenants.
Australian investors may recall Oaktree’s involvement in Blue Sky Alternative Investments Limited’s (Blue Sky) demise after its breach of debt covenants. In this case, Oaktree offered Blue Sky a tough deal that included the ability to convert part of its loan into a 30% equity stake in Blue Sky in the event of a restructuring.
Blue Sky fell short on a covenant but assured the market that talks with Oaktree to rejig or waive the covenant remained ongoing.
And then in May 2019:
Blue Sky was tipped into receivership by Oaktree. A restructuring took place with the transfer of Blue Sky’s water and agricultural funds to a subsidiary of Oaktree.
Terms of the Mesoblast loan agreement
There is no corresponding clause in the Mesoblast loan agreement that converts the debt to equity upon restructuring. In terms of equity, Oaktree received warrants to purchase 1,769,669 American Depositary Shares (ADS) at US$7.26 per ADS as part of the deal. Each ADS is equal to 5 ordinary shares and so the total shares that may be issued are 8,848,345.
Mesoblast has more than 160 million shares outstanding and so if Oaktree did wish to exercise its warrants, it would end up with a 1.36% stake.
It is therefore hard to see how Oaktree could be employing the same strategy used with Blue Sky. They are simply not going to end up with enough equity in the event of receivership. Also, as distinct from the Blue Sky case, owning and running a life sciences company requires a very different set of skills to managing funds.
A change of strategies
Years of economic expansion, cheap money and government stimulus have meant lean times for those involved in distressed debt lending. Anchorage Capital Group, the second biggest scavenger on Wall Street, announced in December that it would close its US$7.4bn flagship fund after 18 years of operation. The firm noted that there were fewer opportunities in distressed debt lending.
Oaktree, while sharing Anchorage’s views, has taken the opposite approach, closing a US$16bn opportunities fund on 16 November 2021. Oaktree believes it can apply its skills elsewhere.
In a blog post titled, ‘Life Sciences Direct Lending: Just What the Doctor Ordered’, published on Oaktree’s website, Oaktree made the following comment:
“The thesis for life sciences direct lending is also simple: it fills a funding gap in a part of the market with less competition to lend…
But, first, the investor must have the capacity to value this industry’s complex intellectual property.
This creates a tremendous opportunity for direct lending teams who combine structuring experience with in-house scientific knowledge. Being able to accurately identify the most significant inflection points in a company’s value during its life-cycle – such as the timing of meaningful clinical data releases or commercial milestones – can allow a lender to secure attractive deal terms even when deploy- ing capital into a de-risking event.”
Oaktree sees an opportunity to earn attractive risk-adjusted returns through their deal with Mesoblast. The good news is that Oaktree believe that an inflection point in the drug approval process may be just around the corner. The bad news is that until this point is reached, Mesoblast will continue burning cash (and fast based on their most recent Appendix 4C).
The loan offered to Mesoblast is highly structured and reliant on near-term milestones being reached. Failure to meet these or a breach of covenants may cause Oaktree to seek to recover its debt which may force the sale of drug candidates that the debt is likely secured against.
So much flesh will not go to waste
Mesoblast are developing medicines that aim to help sick kids and so it would be a great shame if these assets did not reach commercialisation due solely to a lack of capital. Fortunately, it appears that Oaktree have recognised the value of this IP and so the end of Mesoblast would not necessarily mean an end to the further development of the IP.
In the words of David Attenborough when looking upon the decaying carcass of a humpback whale: “So much flesh will not go to waste.”
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