Anatomy of a Merger: 'Hostile Deals Become Friendly in the End, Right?'Published: September 01, 2010 in Knowledge@Wharton
Once pharmaceutical giant Roche Holding decided to acquire full ownership of biotech firm Genentech, leadership at Roche knew there was no going back. Although the two companies had been working together in some form since the 1980s, and Roche had owned a controlling stake in Genentech since 1990, executives at the Swiss pharma company realized that a failed takeover would permanently poison any future dealings between the two. "If we had gone down the path of increasing the ownership stake ... it would have been different," Steve Krognes, a former Roche executive who is now senior vice president and CFO of Genentech, said during a recent presentation at Wharton San Francisco. "But once the decision was made that we were going to go for full acquisition, and that was announced publicly, there was no way back."
On March 12, 2009, Roche announced a $46.8 billion deal to buy South San Francisco, Calif.-based Genentech. But the path to a merged Roche and Genentech was far from smooth. For one thing, the deal played out as Wall Street was thrown into panic, and the economy into turmoil, by a historic recession. For another, Roche went into the deal with the goal of preserving the innovative, entrepreneurial culture that had transformed Genentech from a start-up to a standout, one that had developed Roche's three best-selling products -- the cancer drugs Avastin, Herceptin and Rituxan.
In addition, the first stages of the merger attempt in late 2008 and early 2009 caused hostilities on both sides, sparking a war over how much Roche would pay for each remaining share of Genentech. Furthermore, the buyer was charged with combining the two companies in a way that would not cause the biotech company's scientists to head for the door. Roche realized that it needed more than just Genentech's drugs; the firm also wanted to inject the biotech firm's DNA into its corporate culture.
"When you acquire a company as successful and as good as Genentech, a lot of what you acquire is walking on two feet, and you better be mindful that you want to keep that talent, and keep them happy and engaged," Krognes noted. "Building on what made Genentech great [was] the key principle for Roche management."
The merger came together as two other drug giants were launching takeover bids of their own. Pfizer bought Wyeth for $68 billion in 2009, while Merck paid $41 billion to acquire Schering-Plough. More recently, French drug maker Sanofi-Aventis made public on August 29 of this year its $18.5 billion bid to acquire Genzyme, a Cambridge, Mass.-based biotech firm. Despite an uneven industry track record for similar mergers, Roche, Pfizer and Merck pursued the deals -- and Sanofi is chasing after Genzyme -- in an effort to diversify before facing the expiration of patents on a number of their blockbuster drugs. Once the protection offered by the patents is gone, generic companies are free to begin competing for the business created by the products.
'A Waste of Money'
The relationship between Roche and Genentech began with research collaborations in the 1980s. At the time, Genentech -- founded in 1976 -- was a relatively young company that mostly focused on R&D of new products. Basel, Switzerland-based Roche was founded in 1896 and had been a presence in the United States since 1905. The Swiss firm employed more than 78,000 people at the time of its takeover bid in 2008, while Genentech employed about 11,000. Genentech ended 2008 with a net income of more than $3.6 billion, versus $9.33 billion for Roche. Genentech's net income for 2008 increased 14% over the previous year, while Roche experienced a 5% drop.
When Roche leadership bought 56% of Genentech for $2.1 billion in 1990, "it was a highly controversial move back in Switzerland," according to Krognes. "A lot of people thought it was a waste of money [to buy] a young biotechnology company for $2 billion. But there were a couple of people at the top of the company [who said] ... 'This is the future of [Roche].'"
As the biotech firm's product lines began to take hold in the market, Genentech's growth formed a "hockey stick" pattern, where revenue increased rapidly, creating almost vertical upward growth. "I think probably not too many companies can really show something like this," Krognes said. "[Genentech is] really just a fabulous success, one that was based on some truly innovative and outstanding medicines that have changed lives for a lot of people around the world."
Success also changed Roche's view of its longtime partner. "I don't want to say it's all about dollars, but I think it's quite interesting to see that development and think about ... how Genentech changed over those years," Krognes stated. In the 1990s, the company was all about R&D; more than half of its employees were in the R&D area. By 2008, 75% of Genentech employees were in manufacturing or commercial or administrative -- "and that impacted our partnership in many ways," he noted.
The two companies were competing for the same deals and the same customers. As an example, Krognes pointed to a situation that was brewing in 2007-2008 in which Roche and Genentech went head-to-head in the U.S. market for rheumatoid arthritis drugs. "[Cash flows] were also a key driver in this analysis," Krognes noted. "The cash generation that ... revenues [like Genentech's] bring is quite impressive when you have 40%+ margins. You sit there as the majority shareholder and say, 'I don't have access to that cash. What are they going to do with it?'"
Partners on Paper
Though partners on paper, Genentech's day-to-day operations were fully independent, with no significant collaboration between the two companies, Krognes said. In addition, it was becoming clear to Roche leadership that they were working against a time clock. An agreement that allowed Roche first rights to market Genentech drugs outside the U.S. was set to end in 2015. According to Krognes, the pharma company expected that, when the time came for renegotiation, Genentech would "take Roche to the cleaners," or even decide to sell the drugs overseas on its own.
The drug giant also knew that Genentech's scientists were the brains behind Roche's best-selling drugs, even as product development was stagnant at Roche's U.S. headquarters in Nutley, N.J. "The Roche business in the U.S., frankly, was not doing that well. Nutley has a long and lustrous history, and a lot of great research has come [from there]. But Nutley had not produced anything for a long time," Krognes stated. "The U.S. represents 40% of the world market. If you have ambitions to be a leader in this industry, not to have a good presence in the U.S. is not acceptable."
All of those factors led Roche executives to begin considering how to create a more advantageous business model with Genentech. A full acquisition of the biotech firm was only one of the options they considered. The pharma company's hands-off approach to Genentech extended to the biotech firm's board of directors, where, by choice, Roche members were a minority. "[Roche] could obviously reverse that on short notice," Krognes pointed out. "[But] that certainly wouldn't have helped in terms of collaboration. We concluded that if you go that route, you really have to think a step further.... Obviously you replace the management team. But then you sit back and say ... 'How is that [upheaval] going to be perceived by the [stock] market?'"
Increasing Roche's percentage ownership stake was also an option. The company proposed such a move to Genentech during the second half of 2007, Krognes said, but the biotech firm declined to support it. Roche could have bought the shares in the open market, "but when you are a 60% shareholder, every single share you buy you have to register. And you have to explain what your intentions are."
That left Roche with the decision to pursue a full takeover -- without the alternative of privately negotiating a deal with Genentech's management because, as Krognes noted, "if they already came to the conclusion that, 'We don't want to sell another 5%-10% to Roche,' then what's the likelihood that they are going to say 'Oh, great! Now you want 100%. That's fantastic. Let's do it together.'"
On July 21, 2008, Roche went public with an offer of $43.7 billion, or $89 a share, for the 44% of Genentech that it did not own. Genentech didn't become aware of Roche's plans until a few hours before it hit the news, in a phone call from Roche chairman Franz Humer to then Genentech CEO Arthur Levinson. "The offer came out and [Genentech's] share price went up from the low $80s to approximately $94," according to Krognes.
At the time, analysts believed that the jump in share price was a sign that Roche would have to pay more than it was offering to acquire full ownership. And industry observers wondered why the Swiss company would risk unraveling a partnership that had worked well for nearly 20 years, despite the unlikely coupling of Genentech's "necktie optional" culture with Roche's more traditional buttoned-down atmosphere. Patient advocates were worried too, with several telling The Wall Street Journal that they feared the merger would be the end of a unique relationship in the industry in which Genentech officials regularly met with, and sought feedback from, activists and patient groups.
A special committee formed of three independent Genentech board members considered Roche's first offer. About a month later, they ultimately rejected it as a substantial undervaluation of the biotech firm. The response was not unexpected, Krognes noted, but it was a setback for Roche, which had reason to get the deal completed quickly. Results of a clinical trial testing the effectiveness of Avastin as a treatment for early-stage colon cancer were expected in April 2009; if the feedback was positive, Genentech's share price could jump dramatically and put the deal out of Roche's reach financially. "It was critically important to get the deal done before those results got out, because if it had been positive, the deal would have been gone," Krognes noted. "If it had been negative -- which it was -- we could absorb it."
A Changing World
An already complicated situation became even more fraught on September 15, 2008 when, about a month after Genentech rejected Roche's initial offer, Lehman Brothers filed the largest Chapter 11 bankruptcy petition in U.S. history. The news created a ripple effect that sent financial markets reeling and the economy lurching into a downward spiral. Suddenly, the pharma company's balance sheet for financing the merger looked more uncertain.
Then came a counter bid from Genentech -- $112 a share.
"Banks were going bankrupt and bankers were more worried about, 'Do I have a job?' ... than doing what they were supposed to do" -- keep a finger on the pulse and understand the market," Krognes stated. "The bankers just simply had no idea ... as to our ability to raise this capital. The commitments in terms of bridge financing were coming down, down, down. The price was going up, up, up."
Typically, companies finance mergers by securing temporary bank loans prior to raising capital. But the economic turmoil meant that many banks weren't in the position to lend. Roche made the unusual move in early 2009 of going to the bond market before its merger was a sure thing. At the same time, Pfizer was doing the same, even though the Wyeth deal had yet to close. Merck would eventually pursue a similar strategy to acquire Schering-Plough, taking advantage of investors' willingness to lend to companies dealing in products seen as "recession-resistant." Roche sold $16 billion in bonds to fund its takeover of Genentech -- generating a pile of cash and interest payments that the company would be stuck with if it couldn't close the deal.
Roche and Genentech were still nowhere near an agreement. So Roche decided to stop negotiating.
On January 30, 2009, the pharma company began a hostile bid, going directly to Genentech's shareholders with an offer of $86.50 a share -- 3% lower than its initial offer from July. "I think it was a big shock in the market, and certainly the investors were not happy at all," Krognes acknowledged. "We got a lot of flak for that one. But it was, I think, a good move in that you show some price discipline."
Shareholders, meanwhile, shunned the new offer, and analysts doubted that Roche would collect enough shares to complete the deal. In addition, observers became increasingly concerned that the argumentative nature of the process might alienate Genentech scientists and management and cause them to leave the company rather than work at a firm wholly owned by Roche.
Genentech urged shareholders to reject Roche's proposal. Leaders at the biotech firm argued at a March 2009 meeting with investors that the company was worth far more than $86.50 per share, noting its history of success and flourishing drug development pipeline. Meanwhile, Krognes and three other Roche executives went on the road to visit all of the biotech firm's top investors in an effort to come up with a price that would convince shareholders to tender the necessary 50% of the total 440 million shares they controlled. The Roche executives ended the trip in San Francisco where they went for a walk on the Embarcadero and decided to raise Roche's asking price to $93 a share, Krognes said. "Hostile deals become friendly in the end, right? And it was friendly for the last week, when we negotiated a share purchase agreement and a lot of important terms in that merger agreement."
Although some analysts argued that the new offer was still not a fair reflection of Genentech's long-term value, they also noted that the volatile market made the offer more attractive than it would have been otherwise. The price was ultimately increased to $95 a share, with Roche agreeing on March 12, 2009, to acquire the remaining portion of Genentech for $46.8 billion. Although the Swiss company had scaled a major hurdle toward gaining income and innovation from Genentech, leadership still faced the potentially thorny process of creating a unified firm.
In trying to integrate the two companies, the watchword for Roche was "speed, speed, speed," Krognes noted. Roche also wanted to ensure that it would absorb some of what made the biotech firm such a success.
Several Genentech veterans were brought on board in key roles at the combined company, although others, including CEO Levinson and product development head Susan Desmond-Hellmann, ultimately parted ways with Roche. Some Roche management positions moved to the U.S. from company headquarters in Switzerland. "There are always some decisions where you have two people and you have to select one," Krognes pointed out. "[We made] a commitment to select the best of both [companies]. The best person gets the job."
The headquarters of Roche's commercial operations in the U.S. were shifted from Nutley, N.J., to Genentech's offices in South San Francisco, Calif. A Roche facility in Palo Alto, Calif., was shut down and its operations were also relocated to Genentech. The shifts caused about 600 job cuts at Roche operations in New Jersey.
"The feeling [there] was that, 'You guys in the management team are in love with Genentech and you don't care about us anymore.' Many people felt slighted and very unhappy about some of these decisions," Krognes noted. "We're closing Palo Alto. We have gone from 950 people to about 100 people today and we're in the process of selling that site. In Nutley, you go from the headquarters to an R&D center of excellence. An R&D center of excellence is great but it's not the same -- certainly not for those people who were not in R&D."
Manufacturing and commercial operations for the two companies have been combined, but Genentech's research approach has been adopted across the merged firm. Veteran Genentech scientist Richard Scheller is in charge of the combined company's early research and development, and reports directly to Roche CEO Severin Schwan, as opposed to Roche's head of R&D.
"The idea is really that we are together now, so let's pick the best people. Let's pick the best projects. Let's pick the best strategy and do this together," Krognes added. "That's an important part of making sure this investment is a good investment because, as I said a few times, most of the value walks on two feet. That means if value is going to be created in the future, you've got to make sure that you keep that innovative environment."