In a period of economic, political and regulatory change, how can companies plot the right course for M&A success?
Merger control in a changing world
Global economic growth is back on the agenda and companies are once again looking to position themselves for success by pursuing mergers and acquisitions. But what are the prerequisites for success in an increasingly disrupted world?
Welcome to the second White & Case merger control publication, the first edition of which was warmly received. Earlier this year, it became apparent that an update was required, not so much driven by regulatory change, but rather to take into account policy shifts.
For example, we have seen the US catch up with Europe in relation to vertical mergers, the AT&T/Time Warner review being the most prominent recent example. At the same time, the European Commission has forged ahead again with a focus on conglomerate mergers and innovation markets. Perhaps the Dow/DuPont merger has attracted the most attention, as authorities now get out their telescopes and look far into the horizon to identify anti-competitive harm. There is a sense among the Commission’s hard-liners that in the past too many mergers wriggled through without proper analysis. Our own view is that it may be legitimate to look ahead to try and identify harm (after all, that is what merger control is all about), but this long lens should not be forgotten when it comes to reviewing the synergies that a merger may create. However, Europe has set the tone, and we expect other authorities to follow.
Europe also seems to be taking the lead (and others will follow due to the prospect of publicity-garnering fines) in relation to procedural infringements. The argument for pursuing companies for inaccurate filings, for example, is that such violations call into question the very system of merger control. Be that as it may, due process needs to be followed in such cases, and this may divert valuable resources to past cases as opposed to dealing with the current case load. In other words, pursuing a few flagrant cases may be necessary to set a precedent, but they should not become regular items on the authorities’ agendas (bringing with them attendant increases in filing times, and costs). Our view is that the authorities should confine their focus to statements that would have yielded a very different outcome, not mere technical infringements.
This leads us to the subject of gun-jumping. Again, viewed from afar, this should not be a problem in no-issues filings, and authorities typically have the tools to unwind a completed merger. The maxim ‘no harm, no foul’ ought to be applied to these cases to ensure that valuable resources are not frittered away on them.
In sum, our assessment is that the global system of merger control continues to limp along. However, the costs associated with a system containing myriad controls are increasingly high. Looking ahead, we wonder whether a fundamental overhaul is needed to ensure that transactions that pose no problems are not saddled with the costs imposed by the global system. (Yes, this will mean some authorities will have to relinquish jurisdiction in certain instances, safe in the knowledge that a transaction will be reviewed elsewhere.)
But more importantly, we continue to believe that the system of mandatory pre-merger review is fundamentally flawed and that instead we should shift to a system of voluntary merger control in which only mergers that present genuine issues need to be notified. Ironically, when commentators question whether the UK system of merger control needs to change in light of Brexit, one of the things that we would not change is the voluntary nature of the system.
The European Commission is increasingly concerned that market consolidation will harm innovation and has changed dramatically the way it examines the impact of mergers on innovation. Merging parties should be prepared for it.
When it comes to mergers within the digital landscape, the greatest challenge for regulation is to strike the right balance as regards enforcement. How are EU authorities taking action and what does this mean for the innovation economy?
The European Commission is paying greater attention to investors who hold stakes in multiple companies in the same industry and considering how this concentration of influence might have an anti-competitive effect.
The merger control assessment for transactions involving private equity firms has become increasingly complex as, over the years, they have grown to become industry giants with a well-established industry presence. Today, they typically control a large number of portfolio companies and tend to focus on investment in clusters or specific sectors. Moreover, private equity transactions often have a clear industrial rationale driven by pre-existing portfolio companies and do not constitute a mere financial investment.
In the majority of cases, therefore, the establishment of filing requirements requires a thorough assessment of the control structure of the fund involved in the transaction in order to identify the relevant turnover for the merger filing analysis. When it comes to substantive assessment, complexity derives from the need to cover potential horizontal overlap and any vertical relationship between the private equity portfolio companies and the targets.
An upfront merger filing analysis including the substantive review has become an essential part of the overall deal, and will include—in certain cases—establishing whether (and to what extent) remedies will be needed to obtain timely clearance.
Transactions involving private equity firms are often subject to merger control requirements because their turnover exceeds the relevant thresholds and normally result in a change of control over a target. In most cases, to establish whether a competition authority has jurisdiction over a transaction, the relevant turnover to be taken into account will be the financial income of the private equity firm and the revenue generated by all its controlled portfolio companies, which are deemed to be part of the same 'group.'
The notion of control encompasses rights, contracts or any other means which, either separately or in combination, confer decisive influence on an undertaking.
The private equity firm will typically acquire sole control over a target by acquiring: (a) the entire capital; (b) a majority interest; or (c) a minority shareholding that confers veto rights over the target's strategic decisions. Veto rights resulting in (negative) joint control relate to decisions on matters such as the target's budget, business plan, major investments or appointment of senior management.
In other cases, the private equity firm will acquire joint control over the target, either together with another private equity firm or institutional investor or together with pre-existing shareholders or the founders of the target. The acquisition of joint control increases the likelihood of merger filing requirements. The assessment of whether the private equity firm will be acquiring control requires a case-by-case analysis, which would be conducted both on a de jure basis and a de facto basis, in particular when the founders are still involved—as shareholders and/or as managers—in the business of the target. Even the acquisition of a minority stake above a certain percentage without any controlling rights may trigger filings in EU Member States (for example Germany and Austria) and in extra-EU jurisdictions.
The EU Commission's Jurisdictional Notice 139/2004 describes control as the 'power to determine strategic commercial decisions' of another undertaking (so-called 'positive control') or the power to veto such decisions ('negative control'). In this regard, the Jurisdictional Notice provides guidance on transactions involving investment funds.
The Jurisdictional Notice notes that '[i]nvestment funds are often set up in the legal form of limited partnerships, in which the investors participate as limited partners and normally do not exercise control, either individually or collectively.' As such, investment funds tend to acquire shares and voting rights that confer control over portfolio companies in their capacity as mere investment vehicles. Control is then ordinarily exercised by the investment company that has set up the fund, not the fund itself, through the investment group's organisational structure—for example by controlling the general partner of the funds and/or by contractual agreements, such as advisory agreements. In that way, the investment company generally acquires at least indirect control over the portfolio companies held by the investment funds.
Different fund structures
Although the Jurisdictional Notice provides general guidance, the corporate structures that involve investment funds must be assessed on a case-by-case basis. Often, private equity firms are organised through different funds, and each of these funds controls a number of portfolio companies. In some cases, it could be argued that the fund involved in the transaction is not part of the same 'group' as the other funds, and that therefore these should not be taken into account for turnover purposes or in the substantive assessment. To support such a position, it may be helpful to show that funds within the same private equity firm are managed by different general partners. However, this may not be sufficient to persuade the EU Commission (and other competition authorities) if, for instance, the same managers are board members of different general partners established by the private equity firm or if the general partners are supported (or supervised), for instance, by the same investment committee or advisory committee. In addition, by structuring each fund independently and by taking this position before competition authorities, private equity firms would have to carefully implement effective safeguards to avoid any coordination and exchange of competitively sensitive information between the funds and portfolio companies controlled by the different funds. This may increase the risk of Article 101 TFEU infringements.
In a few cases, a limited partner may hold more than half of the limited partnership of the fund. This may be the case for a large institutional investor. Although it is unlikely that the limited partner exercises any controlling rights over the investment fund, its turnover would still be relevant to establish merger filing requirements.
There is also an increased tendency in the public sector—for instance in China and in the Gulf area—to establish investment funds acquiring controlling stakes in European companies. Although these investment funds may be set up in the legal form of limited partnerships, public authorities may still exercise (indirect) control over them. Any link between the management of the fund and public authorities may raise questions about the possibility for the state to exercise decisive influence over it. In addition, a public entity (alone or together with other public entities) acting as a limited partner—especially in cases with a large shareholding in the limited partnership—may raise questions as to the independent exercise of investment and other strategic decisions by the fund. In short, a case-by-case analysis is needed to establish whether the investment fund shall be viewed as a state-owned entity, to which specific merger control rules may apply.
As these examples show, considering all funds (and their respective portfolio companies) as part of a single economic entity for merger control purposes may not necessarily reflect the actual structure of a private equity firm. That said, there are a few jurisdictions (including the US and Canada) that diverge from this approach: In these jurisdictions merger control rules are applied to the fund(s) involved in the transaction being assessed, rather than to the private equity 'group'.
In October of 2016, the EU Commission launched a public stakeholders' consultation on evaluation of procedural and jurisdictional aspects of EU merger control. Two aspects of this consultation are of particular interest for private equity transactions.
First, the EU Commission is contemplating the introduction of a deal size threshold, complementary to the current turnover thresholds. A likely consequence of the additional threshold is that more transactions would be caught at the EU level, resulting in additional burdens for private equity firms, especially for those investing in new technology businesses.
The EU Commission is also considering extending the scope of application of the EU merger control simplified procedure. Broadening its application to transactions involving a vertical relationship and to acquisitions of joint control over a target with no activities within the European Economic Area territory would contribute to a reduction of the burden on private equity firms involved in transactions that do not present substantive issues.
As in most jurisdictions, the parties acquiring control in a transaction that meets the EU jurisdictional thresholds are required to notify the EU Commission and are subject to a standstill obligation barring them from implementing the transaction before clearance. The EU Commission can impose fines of up to 10 per cent of worldwide group turnover for intentional or negligent breaches of such an obligation. With the EU Commission (and other competition authorities in Member States and worldwide) cracking down on breaches of gunjumping rules and of the standstill obligation (for example in Case M.7993, Altice/PT Portugal, Altice was recently fined €125 million), private equity firms must carefully assess their filing obligations and ensure they obtain clearances prior to completing their transactions or exercise any control over the target companies.
Moreover, the EU Commission can impose fines of up to 1 per cent of worldwide group turnover for intentionally or negligently supplying incorrect or misleading information in the context of merger control filings, regardless of whether the information has any impact on the EU Commission's decision. The EU Commission is actively enforcing its powers in this context (see the fining decision in Case M.8228, Facebook/WhatsApp and the ongoing investigation in Case M.8436, General Electric/LM Wind), and it recently stressed the importance of complying with the obligation to provide correct information, in order for it to be able to make decisions 'in full knowledge of accurate facts'. Therefore, it is crucial for private equity firms, as notifying parties, to ensure that information provided by all the parties involved in the transaction, including the portfolio companies and the target, is accurate and complete.
So, while the large majority of private equity transactions still do not present substantive issues, having no (or limited) overlap with the targets' activities, private equity firms' increasingly large portfolios may trigger competition issues. In this respect, the rules of the game have changed for private equity firms involved in controlled auctions. Where in the past the absence of any competition issues often gave an advantage to private equity buyers, today overlaps with other portfolio companies are more frequent and industrial bidders may have an advantage.
This evolution requires private equity firms to conduct an in-depth assessment of the potential horizontal overlaps and vertical links between the target and the portfolio companies. Where the private equity firm controls a large number of portfolio companies active in the sector of the transaction, the data-gathering process may prove very burdensome. Moreover, in cases in which a private equity firm is contemplating joint control together with a co-investor (for instance, another private equity firm), the assessment of horizontal overlaps and vertical links must be extended to the co-investor's activities and its portfolio companies.
Therefore, it is recommended that this analysis be conducted up-front, allowing—in the case of competition concerns—early-stage remedies to be proposed, especially where a deal is time-sensitive. Competition authorities usually welcome informal remedies discussions at the early stage of the notification process, and even during the pre-notification phase, where applicable. Such discussions increase the chances of obtaining a conditional clearance (subject to remedies) in Phase I and mitigate the risk of competition authorities opening lengthy in-depth (Phase II) investigations. Negotiating a remedy package in Phase II may also increase the risk for private equity firms of having to divest certain assets, or an entire business, under time pressure and with limited bargaining power.
Also, transactions with a clear rationale to consolidate the business of one of the portfolio companies could, in theory, trigger a 'conflicting interest' between the private equity firm and the portfolio company, with the private equity firm being typically more risk-averse on competition issues than its portfolio company.
Ultimately, private equity firms now need to take a more strategic approach to merger control issues. They must be pro-active in conducting merger control analysis before initiating a transaction. A good understanding of filing requirements and substantive issues (if any) is crucial in coming up with a plan to address any issues upfront, to avoid lengthy Phase II investigations and allow transactions to close without undue delay.