SBHMY - Heightened U.S.-China Tensions Threaten F-star Deal

Summary

• The recent unprecedented national security incident created by suspected Chinese spy balloons and other aerial objects ratchet up geopolitical tensions and put F-star's acquisition by Sino Biopharmaceutical at significant risk.
• F-star's controversial acquisition by Sino Biopharmaceutical subsidiary invoX has been under review by CFIUS for more than 190 days, indicating intense scrutiny of the deal.
• CFIUS made the rare decision to issue an interim order preventing the closing of the deal in the early morning of Dec. 29, 2022, highlighting the significant national security concerns.
• Unprecedented national security tensions are likely to harden opposition to the deal by certain members of CFIUS, foreclosing the possibility of deal approval.
• F-star's limited liquidity and significant cash burn risk significant dilution, and possible bankruptcy, if the deal fails. The stock could fall as low as $2 or less on deal break.

The recent unprecedented national security controversy related to the shooting down by U.S. F-16 and F-22 fighter jets of an alleged Chinese spy balloon, and other aerial objects over U.S. and Canadian airspace, has significantly ratcheted up geopolitical tensions between D.C. and Beijing to levels not even seen during the Cold War. These tensions dramatically reduce the likelihood of the deal receiving CFIUS clearance, as committee members with a more hawkish stance toward China are likely to feel emboldened in their opposition to the F-star Therapeutics (FSTX) deal, undermining the prospect for consensus among CFIUS members on a mitigation agreement enabling the closing of the transaction.

On June 22, 2022, F-star entered into an agreement to be acquired by invoX Pharma Limited, a UK subsidiary of Sino Biopharmaceutical Limited (SBMFF)(SBHMY), for $7.12 for share. One condition of the acquisition was the receipt of CFIUS clearance.

The parties filed a notice with CFIUS on Aug. 2, 2022, and have pulled and refiled twice, stretching the roller coaster review to nearly 200 days as of the date this article was written. The length of the review and the rare step of issuing an interim order preventing the parties from closing the transaction highlight the significant scrutiny this deal is under. Furthermore, the company has disclosed that CFIUS has informed the parties that the deal raises unresolved national security concerns.

The length of the review, the issuance of the interim order, and the disclosure that CFIUS has identified national security risks makes it clear this is a highly scrutinized deal with a low likelihood of approval.

CFIUS committee membership includes the heads of many agencies of the executive branch, including the Department of Defense and the Department of Homeland Security. Certain members of CFIUS, particularly those members affiliated with defense and intelligence agencies, have a particularly hawkish stance toward China. They view the current geopolitical situation, even before the unprecedented spy balloon national security incident, as practically equivalent to being on a "war footing" with Beijing. These members are predisposed to block all deals that raise a national security concern involving Chinese acquirers.

The recent controversy around the alleged Chinese spy balloon has no precedent in U.S. history, making for a truly unique and tense geopolitical environment. As of Feb. 13th, 2023, U.S. F-16 and F-22 fighter jets have shot down at least four different aerial objects, some of which were confirmed by intelligence officials to be operated by China for the purpose of espionage, over U.S. or Canadian airspace - the first such occurrence in U.S. history.

Certain members of CFIUS, if not all, are likely to be significantly alarmed by this unprecedented national security provocation by China. They are likely to be less inclined to approve a deal with identified national security risks, particularly one that involves the transfer of potentially critical biotechnology to a Chinese acquirer while these geopolitical tensions remain hot and unresolved. If CFIUS blocks the deal or the parties were to voluntarily terminate the transaction, the shares are likely to fall to $2 or less as the company has very little liquidity, is burning cash, and invoX is unlikely to be permitted by CFIUS to make an equity investment on deal failure.

While the UK regulatory agency in charge of enforcing the UK's National Security and Investment Act (NSIA) cleared the deal last fall, it is widely understood that CFIUS only factors in its own assessment of national security risks as it relates to the U.S., and has no qualms about quashing deals where the majority of operations are based in another jurisdiction. CFIUS's decision to block the acquisition of the South Korea-based Magnachip Semiconductor Corporation (MX) is just one of many recent examples.

Indeed, while it's possible that the disclosure by the company that they believed they are in the late stages of negotiating a mitigation agreement with CFIUS is a positive sign that clearance might be forthcoming, it is by no means clear that such a mitigation agreement would permit the closing of the transaction. It's possible, for example, that the parties are negotiating to remove the interim order to permit the minority equity investment contemplated by the merger agreement in the scenario where CFIUS fails to clear the merger. The latest 8-K filed by the company only mentions that they believe they are in the late stages of negotiating the terms of a mitigation agreement that would "permit the removal of CFIUS' interim order." It does not, however, specify whether such removal would permit the closing of the merger transaction. It's important to keep in mind that the interim order likely burdens the parties with many restrictions that they would be motivated to remove as soon as possible, whether or not such removal would enable the parties to close the transaction.

Furthermore, while those hoping for CFIUS clearance might find comfort in the fact CFIUS rarely sends a transaction to the president with the recommendation that it be formally blocked, it's important to note that CFIUS need not formally block a deal it prefers not close, as it has other tools at its disposal. For example, the committee can indefinitely drag on a review and put extremely onerous terms on any mitigation agreement that undermines the commercial rationale for a deal, burdening the parties with uncertainty and expensive delay until the parties get the hint and decide to withdraw their notice and terminate the deal voluntarily. Indeed, many would-be acquirers ultimately prefer exiting a deal via this route so as not to be marked a national security risk that has received the rare, ignominious honor of receiving a formal presidential block.

The current geopolitical tensions surrounding the alleged Chinese spy balloon and other aerial objects in United States airspace are unprecedented in modern times, and it raises serious risks for sensitive acquisitions involving Chinese acquirers currently under CFIUS review. F-star's drawn-out and controversial deal is likely to experience significantly increased risk of deal failure on account of the heightened geopolitical tensions. Given the limited liquidity, financial distress , and cash burn at F-star, a highly dilutive capital raise - and potential bankruptcy - is possible if the deal were to break. The stock could trade below $2 per share in a deal break scenario.

Assuming the shares trade down to $2.50 on a deal break, the current share price is roughly pricing in a 50/50 chance of deal completion. We believe these odds are much too high given the elevated geopolitical tensions, and investors would be wise to avoid going long this arbitrage deal. With a modest cost to borrow (Interactive Brokers quotes 8.4% at the time of writing), enterprising investors with a greater appetite for risk might consider a short going into next week's tender offer deadline of Feb. 20.

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