No one likes to get the call wrong. Alas, it is the nature of the investment game. Reviewing our performance in 2018, our worst call was, without question, Synergy Pharmaceuticals (SGYP). The small pharmaceutical company has filed for bankruptcy and its assets are set to be bought up on the cheap. Bausch Health Companies (BHC) has offered $200 million for them in the court-supervised auction and sale.
Since we initiated coverage of Synergy in October 2017, we published 19 research notes about the company. In our first note, we declared that “After A Stumble, Synergy Pharmaceuticals Is Poised To Rise”. We followed that up with an even worse judged note titled “Not A Falling Knife”. As it turned out, Synergy had a long way to fall.
In our most recent note (published, quite aptly, on Halloween), our tone had changed in light of the company’s imminent financial distress: “Can Synergy Survive This Crisis?” The answer to that last question: No.
What went wrong?
What can we all learn from this sorry case study?
Fighting Goliath: The Hubris of Eschewing a Commercial Partner
Synergy’s first big mistake was to attempt to commercialize Trulance, its drug for the treatment of chronic idiopathic constipation (“CIC”) and irritable bowel syndrome (“IBS-C”) with constipation, on its own.
In January 2017, Synergy won FDA approval for Trulance in the CIC indication. The company quickly opted to pursue a go-it-alone commercialization strategy, meaning it would not license the drug to a larger partner in exchange for upfront cash, milestone payments, and a cut of sales. For most developmental pharmaceutical companies, a commercial partnership can be vital to success. Small firms lack the resources, experience, and clout to make inroads with insurers and prescribers. That is especially true for a product like Trulance, which aims at a mass-market audience.
Synergy faced an even greater challenge in the form of competition. It might have been able to make a decent go of winning market share if it had an open field. But that was not the case. Linzess, another drug for the treatment of CIC and IBS-C, was already in the market. Developed by another smaller firm, Ironwood Pharmaceuticals (IRWD), Linzess is licensed to Allergan (AGN), one of the biggest pharmaceutical companies in the world. Allergan dwarfed Synergy and could afford to invest in advertising, sales, and marketing to protect its status as market leader.
So why were we still bullish on Synergy? For one thing, CIC and IBS-C patients population is huge and growing. Synergy could gradually chip away at the market leader while making inroads with new patients. It also enjoyed impressive clinical results, showing Trulance to be the best-in-class product on the market. Given those factors, we saw a strong path forward, given proper execution.
Rotting from the Head: Feckless Leadership Squandered Opportunities
Synergy stumbled out of the gate in its commercial launch efforts. By the time we began following the company, in early Q4 2017, Trulance had been on the market for months and had made disappointing progress. But there was a clear path forward and prescriptions were growing.
Synergy suffered badly from a lack of effective leadership. Gary Jacob, Synergy’s co-founder and long-time CEO, proved to be incapable of leading the company through the difficult transformation from developmental pharmaceutical company to commercial concern. While investors were growing increasingly worried about Jacob and his team in the latter months of 2017, it was a botched secondary offering in November 2017 that finally crippled market confidence in the company.
The secondary offering, which was announced a day after the company stated its near-term funding needs had been satisfied by a private loan facility courtesy of CRG, left us questioning our core investment thesis. In hindsight, we ought to have called it quits then and there. Instead, we chose to wait and see. We viewed a change of strategy and leadership as necessary and likely. We were proved correct on that score, with Jacob defenestrated in December 2017 in favor of Troy Hamilton. A change of course was essential and it appeared that Hamilton would be able to right the ship.
Hamilton seemed to be doing a much better job in the months following his accession to the top spot. He notched a few wins, including securing commercial partners in several international markets. He also embarked on a strategic review that would put all options on the table. Synergy was finally open to finding a commercial partner. Ultimately, these efforts came to nothing. Synergy stated that the buyout offers it received were below its then-valuation.
How did we get it wrong? We put too much store in the leadership change and overestimated Synergy’s ability to maneuver. The lack of buyout or partnership offers, despite Synergy’s evidently depressed market capitalization, should have been a sign that other players were not so convinced of Trulance’s potential. When a pharma or biotech stock looks dirt cheap and is vocally open to offers, investors might well find useful intelligence in the absence.
Ladies, Liquor & Leverage: CRG Loan Sinks the Ship
The proximate cause of Synergy’s collapse is its failure to meet the covenants set down by its private lender, CRG. In October 2018, Synergy disclosed that it might not be able to meet the loan’s minimum liquidity covenant and, if it could not renegotiate the terms, it would have little choice but to file for bankruptcy.
The CRG loan, which originally looked like a great source of non-dilutive funding, proved onerous almost from the start. The terms expected significant revenue growth over a very short span of time, as well as tough cash balance requirements. While CRG proved quite flexible, allowing amendments to the loan’s terms on several occasions, it ultimately ran out of patience.
Forcing Synergy into bankruptcy still seems counterproductive, a point we made in our last research note on the company. The loan is the largest in CRG’s portfolio and its decision to turn the screws to essentially liquidate Synergy does little to support its claimed role of “premier healthcare investment partner” to a multitude of companies. The harsh terms and ultimate forced fire-sale will likely make future borrowers warier of doing business with the lender.
But the real culprit in the CRG loan debacle is Synergy itself. It had the ability to seek alternatives, such as a commercial partner, when it opted for a loan whose terms would prove impossible to meet. Management failed in its duty to shareholders by taking on a loan to support an already struggling commercialization strategy. A more expeditious strategic review and pivot could have saved Synergy the ignominious fate it has now earned.
There are a couple worthwhile lessons that may be drawn from the CRG affair. Firstly, loan terms really matter and investors should read them very carefully. Not many lenders are as deviously sophisticated as CRG, perhaps, but that does not excuse insufficient due diligence. Secondly, investors should be wary of non-dilutive financing when it is predicated on major near-term changes in performance. Synergy had to start executing at a much higher level almost immediately if it was to meet the terms of its loan. It seemed to be getting there, but the pivot ended up taking far too long.
Investor’s Eye View
Developmental pharmaceutical companies spend most of the early phase of their existences fighting to get a drug through the clinical trial and approval process. When the FDA approves a company’s first viable commercial product, it ought to mark a major turning point. It means the company will finally be generating revenue and will (hopefully) no longer have to keep relying on dilutive stock offering to keep the lights on. Synergy was fortunate with Trulance, a product with huge commercial potential. As recently as April 2018, annual peak sales were estimated to reach $500 million. Even half that would have made Synergy astonishingly cheap.
The decision to go it alone was Synergy’s original sin. This was compounded by incompetent, arrogant management. The CRG loan was the instrument of Synergy’s destruction, but it was not the true cause.
We got this one wrong. As a result, we are tweaking our healthcare investment strategy to be far more skeptical of small drug developers that try to make the transition into independent commercial players. We do not reject any and all go-it-alone commercialization efforts, but we will likely steer clear of any that tries to tackle a mass-market product. And we will definitely not invest in cases where there is an established market leader with the financial firepower to protect its position.
Investors should be very careful when investing in any early-stage biotech or developmental pharma firm. Synergy offers a clear illustration of a number of red flags of which investors should be ever mindful.
As the bell tolls for Synergy Pharmaceuticals, listen closely. We may all learn something useful for the future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.