Halcyon Pharma: Funding the Patent Cliff
Halcyon Pharma plc has EBITDA of £80m and net debt of £120m. Its bank facilities require net debt/EBITDA below 3.0x and EBITDA/interest cover above 4.0x. Existing debt of £120m carries 5% interest. A patent expires in 18 months, and the board needs £200m for late-stage trials and a launch. Three options are under consideration: (i) a five-year amortising term loan at 6.5%; (ii) a rights issue at a 25% discount to the current £4.00 share price, with 100 million shares in issue; (iii) a convertible bond with a 3.5% coupon and a conversion price of £5.20. The finance director favours debt because equity is expensive and the shares are undervalued. The largest shareholder, with 18%, has said it will not subscribe in full to a rights issue. The board wants to protect its investment-grade rating and retain flexibility for a possible acquisition in two years.
1. Calculate the covenant headroom under the term loan and assess whether it is viable.
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Leverage
Pro forma net debt = £120m + £200m = £320m. Net debt/EBITDA = £320m/£80m = 4.0x, above the 3.0x covenant. To comply, EBITDA would need to be £106.7m (£320m/3.0), a 33% increase that is unlikely before the patent cliff.
Interest cover
Existing interest = £120m × 5% = £6m. New interest = £200m × 6.5% = £13m. Total interest = £19m. Interest cover = £80m/£19m = 4.2x, only just above the 4.0x covenant. A 5% EBITDA fall to £76m gives exactly 4.0x.
Conclusion
The term loan breaches the leverage covenant at drawdown and leaves almost no interest-cover headroom. It is not viable without an equity component, a covenant waiver or a credible EBITDA recovery plan. The finance director's view that debt is cheaper ignores covenant capacity and distress risk. If the bank treats the convertible as debt, leverage is also 4.0x, although interest cover would be higher: coupon £7m plus existing £6m = £13m, cover 6.2x. The convertible therefore eases cash interest but does not solve the rating and leverage problem.
2. Calculate the theoretical ex-rights price and the value of the rights. Discuss the implications of the largest shareholder not subscribing.
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Rights issue arithmetic
Subscription price = £4.00 × 75% = £3.00. New shares to raise £200m = £200m/£3.00 = 66.67m. Total shares = 166.67m. TERP = (100m × £4.00 + 66.67m × £3.00)/166.67m = (£400m + £200m)/166.67m = £3.60.
Value of one right = TERP − subscription price = £3.60 − £3.00 = £0.60. Each existing share carries 0.667 rights, so the value per existing share = 0.667 × £0.60 = £0.40. The 25% discount to the cum-rights price becomes a 16.7% discount to TERP.
Non-subscription by the 18% holder
If the 18% shareholder does not take up its rights, its holding is diluted. It would receive 18m rights; if it sells them, it captures £10.8m (18m × £0.60) but its percentage falls to 18/166.67 = 10.8% if everyone else subscribes. If it does nothing, it loses value. The board should arrange full underwriting and a sub-underwriter, or use a placing plus open offer. A rights issue repairs the balance sheet, protects the rating and preserves debt capacity for the acquisition, but it transfers value to new investors at a discount and may signal distress if not explained well.
3. Recommend a financing solution, with reasons.
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Recommendation
A £200m rights issue, fully underwritten, is the safest solution. Pro forma net debt stays at £120m, net debt/EBITDA is 1.5x and interest cover is 13.3x (£80m/£6m). That restores investment-grade headroom and leaves capacity for the acquisition in two years.
Handling the largest shareholder
The 18% holder's reluctance can be managed with a sub-underwriter and a clear explanation that the issue protects future earnings. If it still refuses, a placing plus open offer may be better than a deeply discounted rights issue.
Why not the alternatives
The term loan breaches the leverage covenant and leaves interest cover at 4.2x; it is too risky when the patent cliff could reduce EBITDA. The convertible is a compromise: lower cash interest and a £5.20 conversion price, but it still counts as debt for rating purposes and creates uncertainty over conversion. If the board insists on debt, it should size the term loan at £80m–£100m so net debt/EBITDA stays below 2.5x and interest cover above 6x, and fund the rest with equity. The acquisition should be funded from the restored balance sheet, not from the project money.