Tuesday, June 18, 2019

ONT & The Woodford Liquidity Squeeze

There's an unfortunate chain of events that may end up causing a headache for Oxford Nanopore, and it's completely outside their control.  One of the their key investors has just had his luck - or perhaps more critically his reputation -- at stock picking disintegrate.  Because of some unusual choices, that has potential repercussions for ONT.
The vast majority of companies in the biotech space lose money, particularly early on.  Money must be found to support that early phase in the hope that eventually the cash flow will reverse directions or that someone will be willing to pay that back and more to own the company's assets.  The financial types go looking for money in numerous places, particularly large institutions and wealthy individuals.  

A company going public is in a class of actions termed a "liquidity event".  That is because shares in private companies are not easy to buy or sell.  That's a key part of the concept of going public -- in exchange for reporting and other regulatory requirements the national regulators and public markets enable your stock to be freely bought and sold.  

If you own a mutual fund, one of the key features is that you can enter or exit the fund essentially at any time.  When you enter, the investment managers must find a home for your new funds and when you exit they must provide you with the value of your investment paid in cash.  In contrast, many venture capital firms raise money for a fund which you cannot exit on your own terms.  Once in you are locked in until funds are disbursed.  Since venture capital investments are typically very illiquid, that makes good sense -- if you were to exit the fund where would the managers get the money from?

Neil Woodford is a UK investment manager who for many years had done well.  Somewhat unusually, he apparently formed retail mutual funds which could invest some of their funds in illiquid, private companies.  In a booming market with good success (well, luck) by the managers, these private companies add pizzazz and the opportunity for great gains.  But they are also a double-edged sword which can fall on the manager.

Edge one is that should the private part of the portfolio rocket in value, then a large portion of the value of the fund is in illiquid securities.  Should investors decide to enjoy some of their good fortune, then the manager must sell some of the liquid securities to meet the redemption requests -- which further skews the fund towards the illiquid securities.

But edge number two is even worse.  Should investors decide to exit the fund in large numbers because the fund is dropping in value, then the same problem arises.  Indeed, the worst possible combination is highly valued private companies, eroded investor confidence in the fund and dropping values of the liquid portion.  This is the mess that Neil Woodford appears to be in.  In one of these funds the private portion was up to 10% of assets -- and around a quarter of that appears to be invested in Oxford Nanopore.

Drops in Woodford's fund have triggered disclosures, which alerts more investors that the fund is out of favor.  There's even an official investigation, with allegations that the fund violated statutory liquidity requirements.   Woodford's group has said their goal is reduce the illiquid private company positions to zero.  Which means he somehow needs to dump those positions -- including Oxford Nanopore.

How he can accomplish this will be driven by all sorts of laws and contracts I don't understand or aren't public.  But it does suggest that the stake in ONT will be sold.  Woodford appears to have been just the sort of patient investor a company like ONT needs -- patient to wait out the long development cycle for a radical new technology.  One possible unpleasant outcome would be for the group that agrees to take the shares to be far less patient and start pushing ONT to have a liquidity event -- either an IPO (far more likely), to be acquired, or to cut some huge partnership that involves the partner taking the once Woodford stake.  

None of those can be appealing, unless somehow ONT has lined up another super-friendly investor with the appropriate pocket depths.  Otherwise, it is possible that ONT could be forced (not immediately, but neither on their schedule) into actions they've shown a strong aversion to -- they've clearly never been a rush to an IPO nor have they been super active on the partnership front (though they did cut a $50M deal with Amgen last fall).  I expect that ONT will find a way, but certainly this is an external distraction no company ever needs.

It could, of course, be much worse.  There once was a bioinformatics firm that was bleeding cash and needed an infusion, so their experienced CFO went traveling around to meet with the investment community.  His appointment schedule had the tragic entry which placed him high atop the World Trade Center on September 11th, 2001.  The company, Lion, went into a death spiral not long afterwards.  On an even broader and more horrific scale, that serves as a reminder that events much larger than us and outside our control can determine companies fortunes.


Shawn said...

ONT has already talked about going IPO in the not too distant future. Could be related to Woodford’s troubles, but I think ONT needs to raise more money and likely will be taking this path independent of whoever buys the Woodford shares.

Bertrand said...

Hi Keith, an interesting and informative post (as usual). One (minor) point: when you say "If you own a mutual fund" (third paragraph), surely you mean "If you invest into a mutual fund" or "If you have shares in a mutual fund"?

Anonymous said...

Recent mention of Woodford's situation.