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Could highly leveraged acquisition models be a merger control problem?

Competition regulators have recently flagged concerns regarding the impact of highly leveraged acquisitions on the competitiveness of the acquired business (and hence competition more generally). While current legal tests provide some constraint against regulators pursuing such theories in a merger control context closer scrutiny may develop as the political landscape continues to shift. 

Political and regulatory concerns around private equity are not new, but in the UK and US, a new angle is being pursued – highly leveraged models leading to reduced competition in markets. Concerns- fuelled by a cost of living crisis in the UK and a Biden administration focus on greater intervention by antitrust agencies- have been raised that highly-leveraged PE deals raise competition problems and that acquired businesses could be weaker competitors or higher priced operators as a result of a focus on funding debt repayments and shorter investment horizons.

As we discuss below, for now, PE investors can take comfort that, constrained by current merger control law, the UK’s Competition and Markets Authority (CMA) at least shows no signs of putting these considerations into practice but this will be an issue to watch on both sides of the Atlantic as political pressures mount. 

Who’s raising these concerns?

In the US, Lina Khan (Chair of the Federal Trade Commission (FTC)) has been pursuing a broad shake-up of the US merger control regime – and amongst other areas of merger scrutiny, has called on the FTC to investigate whether PE firms contribute to “extractive business models” which may “distort ordinary incentives in ways that strip productive capacity”. The FTC is also examining how the involvement of investment firms may affect incentives to compete.

In the UK, the (outgoing) CEO of the CMA has noted that PE deals “can be highly leveraged, which can make the target companies more vulnerable to failure” – alongside broader public policy issues. Politicians have also weighed in, raising concerns about the recent PE acquisitions of major supermarkets – with the head of the Parliamentary Business Select Committee commenting that regulatory bodies have insufficient powers to intervene “when new owners act irresponsibly”.

Outside of merger control, the CMA has also scrutinised the role and impact of private equity in markets involving vulnerable people or where the resilience of the sector is a concern (especially the impact of high debt levels) – for example in its 2017 market study into care homes for older people and its ongoing market study into children’s social care. 

Lots of talk then – but what’s happening in practice?

Despite political pressure, merger control principles applied to private equity acquisitions have not changed. In most jurisdictions, merger control analyses are constrained by legal tests that focus purely on the competition impact of a transaction within a limited time horizon (typically 2-3 years following the merger), and do not permit account to be taken of wider “public interest” considerations such as impact on employment.  Consequently, regulators can typically only (lawfully) take account of highly leveraged structures in extreme situations where the extent of the leverage could cause the target to fail or exit in the short term or where it could, to a realistic prospect standard, meaningfully reduce rivalry in a market to consumers’ detriment.

However, this position could evolve - even without legislative changes (e.g. via the re-introduction of a public interest test which is seen by the CMA and others as regressive) or a market study or investigation. There are two possible ways this could happen:

1. Agencies treat a highly leveraged model as a acquirer strategy that necessitates price increases or involves under-investment

Outside of a PE acquisition context, regulators have recently considered the post-merger impact of an acquirer’s pre-merger business model or strategy. For example

  • In the UK, in Tronox/TTI, the CMA concluded that there would be a substantial lessening of competition because the acquirer’s business model involved exiting the merchant market (its strategy was to achieve greater vertical integration). 
  • In Australia, the competition regulator raised concerns that BP’s proposed acquisition of Woolworths (an Australian supermarket)’s petrol forecourts may remove Woolworths’ distinctive competitive offer for petrol because BP’s retail petrol strategy tended to “restore earlier, discount later and less deeply”. 

By analogy, in a PE acquisition context, such a theory would translate to being that the acquirer’s business model (driven by a significant degree of debt-to-equity capital) would necessitate price increases by the target post-merger (to pay down debt).  

However, reasoning which treats a change in target strategy as a result of a deal as problematic is controversial since, in many mergers (whether PE acquirers or not), acquirers and sellers/targets have very different strategies. 

It is notable that the CMA did not apply the Tronox or Woolworths reasoning in the recent acquisition of Asda by a PE consortium. Instead, the CMA followed its usual approach, with the primary question being whether there is sufficient competition in the relevant market to prevent a deterioration in price, quality, range, service or innovation.

2. Agencies extend considerations which apply in a forced divestment scenario to the primary merger review stage

While not relevant in the UK, US or EU as part of the initial substantive analysis, leverage is considered at the other end of the merger review process in these jurisdictions: namely where PE buyers are bidders in a forced divestment scenario (for antitrust reasons). For example:

  • We have recent experience of the European Commission considering the track record of a PE buyer - in particular, its investment history and whether it had been prepared to commit capital in order to improve the portfolio company’s competitiveness.   
  • A former key FTC Commissioner noted in a dissenting opinion that a buyer “might be loading up the asset with debt, making it less likely they will have the flexibility to grow the divested business and effectively compete”.

This assertion is open to challenge given that PE investors are, on the whole, driven by the total returns they make on investments and the model involves strong incentives to increase the value of the businesses in which they invest to facilitate exit.

So what happens next?

For now, change is unlikely in the UK given the current state of the law although Government is considering merger reforms to enable greater intervention in, for example tech deals, and it remains to be seen whether the policy shift under Khan at the FTC will involve a different approach to mergers in practice. However, policymakers and regulators may well decide that other legal instruments are better suited to addressing the implications of highly leveraged structures on longer run competition.  These could include the relative tax treatment of debt interest and equity returns; the costs and regulatory requirements associated with public listings; and obstacles to pension funds and insurance companies investing in unlisted equity.

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