Show me the money: should the extent of debt leverage be part of a competition agency’s merger control analysis?

The recent acquisitions by financial sponsor investors of two major UK supermarkets have raised concerns by Parliamentarians (including from the head of the Business Select Committee) and in the media, about highly leveraged structures leading to reduced competition in markets.

In particular, a number of retail grocery commentators have noted that Asda, the fourth largest supermarket in the UK and the historic low price leader on fuel, has become less aggressive on fuel pricing since being acquired by a financial sponsor consortium, which includes investors with existing petrol forecourt investments, and which operate in a higher priced portion of the petrol market. 

Platypus now asks the question: is the fact that an acquisition is highly leveraged relevant to a merger review (and should it be?).

Recent Government and Competition Agency commentary on highly leveraged models

Lawmakers in the UK have commented in the context of the Morrisons acquisition that: “Given previous highly leveraged purchases of high street brands, which have ultimately resulted in administration, job losses and pension fund shortfalls, there is concern that regulatory bodies have insufficient oversight or powers to intervene when new owners act irresponsibly”.  

Indeed, more generally, the CMA’s CEO has noted that: “Private equity is an important source of business finance but, as you note, these acquisitions can be highly leveraged, which can make the target companies more vulnerable to failure. At a macroeconomic level, rising corporate leverage can also amplify the effects of the business cycle and the impact of economic shocks. Separately, public policy questions have been raised about the possible impact of private equity investment on employment; and the treatment of private equity in the tax system.”

In addition, in a 28 September 2021 blog, a member of the FTC’s Competition Bureau stated:

“…we are seeking to ensure our merger reviews are more comprehensive and analytically rigorous. Cognizant of how an unduly narrow approach to merger review may have created blind spots and enabled unlawful consolidation, we are examining a set of factors that may help us determine whether a proposed transaction would violate the antitrust laws. Providing heightened scrutiny to a broader range of relevant market realities is core to fulfilling our statutory obligations under the law. To better identify and challenge the deals that will illegally harm competition, our second requests may factor in additional facets of market competition that may be impacted. These factors may include, for example, …how the involvement of investment firms may affect market incentives to compete”.

The CMA response

Despite political pressure, the CMA’s response to date has been consistent: since the Enterprise Act 2002 focusses on a “pure” competition test (i.e. do we have a good ol’ fashioned SLC), and no longer includes any reference to “public interest” considerations, the fact that acquisitions may be effected by investors using highly leveraged structures is, all things being equal, outside their lawful purview. Leverage would only be relevant if it could have an appreciable negative impact on rivalry in a market over time to the detriment of consumers.

The CMA, for example, has said that in practice:

“this means that the CMA would need to show that the levels of debt being taken on as a result of the acquisition are such that the target would be likely to fail post-merger, or at least that its financial position would be affected to such a degree that it would become a significantly weaker competitor (for example, because it would not be able to make significant investments of the kind needed to continue to be an effective competitor). It will often be difficult to assess at the time of a merger whether gearing will affect a target’s competitiveness (and over what time frame), and demonstrating such an effect to the requisite legal standards may therefore be a significant challenge. The CMA would also need to show that the target’s failure (or a significant weakening in its competitiveness) might have a substantial impact on competition in a market, for example by leading to price increases for consumers. The CMA would therefore need to be satisfied that remaining competitors and the potential for entry and expansion would not be sufficient to ensure effective competition in the relevant market regardless of the fate of the target (and the possible acquisition of its assets by other market participants)”.

And we have seen this in action. In a previous wave of supermarket takeovers in 2003, a proposed bid by a Philip Green investment vehicle, Trackdean, for Safeway plc was criticised in some corners due to the degree of acquisition debt involved. The Office of Fair Trading (OFT) considered, however, that Trackdean was putting the finance up itself, following a model it had already used successfully in the acquisition of Arcadia and that it was “reasonable, therefore, to accept that gearing would be sustainable” and that this issue did not raise (or cause) competition concerns. In the event, Trackdean did not bid, Safeway was acquired by Morrisons in 2003 and, albeit many years later, Arcadia went into administration, as a result of a combination of the migration of retail sales online, high leverage and pandemic related impact on trading, in 2020.

But it wasn’t always so. The previous UK merger legislation, the Fair Trading Act, involved a public interest test. As a result, the OFT and Competition Commission (CC) considered public interest issues in circumstances where capital gearing and interest cover ratios of the merged company would result in such financial stringency that the acquired business might be denied adequate funds for capital expenditure, be put under pressure to give priority to short-term considerations in order to generate funds to reduce borrowings, or be forced to implement measures of rationalisation leading to substantial job losses.

For example, the CC remarked in Elders/Allied Lyons (1986) that gearing and interest levels could impact their funds available for investment, lead to short term decision making and potential job losses with a view to reducing borrowing. And the CC subsequently noted in Swedish Match/Gillette (1991) that exceptionally high gearing would reduce the competitiveness of Wilkinson Sword, inhibiting competition in the wet shaving market.

A controversial extension of conventional merger control analysis?

So the conventional view, in the UK at least, is that highly leveraged acquisition structures aren’t likely to impact the traditional SLC analysis, except in extreme circumstances involving likely failure/exit of the target as a result of the debt package. However, there is a question as to whether this position could evolve given, for example, the CMA’s recent approach to assessing the post-merger impact of pre-merger business models. 

Modern merger intervention, based not on target debt-loading issues, but purely on the different market strategy and business model of the acquirer has an Australian precedent, albeit controversial and preliminary (as the transaction was abandoned before a final decision could be reached) featured in the Australian Competition and Consumer Commission’s Statement of Issues in its 2017 consideration of the proposed acquisition of Woolworths’ (an Australian supermarket) petrol forecourts by BP. In that case, the ACCC indicated that it had concerns about the removal of a distinctive competitive offer (and in particular one in which the supermarket tended to actively lead price discounting or quickly reacted to price discounting by other retailers) with the acquirer’s retail petrol strategy which tended to “restore earlier, discount later and less deeply”.

This reasoning is controversial given both that it meant that the ACCC raised concerns of price increases in non-overlap areas as a result of BP’s higher price strategy (both in absolute terms and in terms of timing of price reductions), and second that in a great many mergers (and not simply those by financial sponsors), the acquirer’s strategy differs from that of the seller/target but the primary and standard horizontal question for the competition agency considering the merger is whether the merging parties are close competitors pre- merger and if so, if there is sufficient competition in the market in question to prevent a deterioration in price, quality, range, service or innovation (“PQRSI”) post-merger.

Platypus notes that the CMA did not apply the ACCC’s Woolworths-style reasoning in the recent acquisition of Asda. In that case, the CMA did consider the post-merger incentives of the acquirer but concluded that the costs of maintaining Asda’s low price policy in fuel would increase post-merger but that as Asda is perceived as a value led retailer and a price leader in fuel, the benefits to it of continuing the pre-merger strategy (including on its grocery margins) outweighed the costs of reduced margins in fuel.

However, on one view, the CMA has branched out just as the ACCC did, in peculiar circumstances. In its January 2021 decision in Tronox/TTI, involving a (vertical) merger between producers of feedstock for metallurgical purposes, the CMA let go of a long-standing implicit idea about horizontal unilateral effects SLCs in UK merger control: that it should involve the merger of horizontal competitors pre-merger (or in the relevant counterfactual). 

The CMA concluded that there would be a substantial lessening of competition on a horizontal basis as the acquirer (Tronox) had a pre-merger business model (a strategy to achieve greater vertical integration) and had announced it “intends to use all of TTI’s production of chloride slag internally” (i.e., it would withdraw from supply on the merchant / third party sales market) resulting in an output restriction and leaving a near monopolist third party on the merchant market post-merger.

The CMA said:

“The merger control regime under the Act is designed to capture structural changes that have a significant effect on rivalry in a market over time (and therefore competitive pressure on suppliers to improve their offer to customers, for example through lower prices) ... A merger that gives rise to an SLC will be expected to lead to an adverse effect for customers, and therefore evidence on likely adverse effects will often be key, but it is not necessary for the CMA to demonstrate actual adverse effects.” 

and

"the CMA considers that it is not necessary to demonstrate that merging parties would profit from an SLC for one to occur".

Accordingly, the basis for the CMA’s horizontal unilateral effects SLC was the fact that the acquirer’s business model and in particular its plans for the target resulted in merchant market exit – which reinforced the market power of a third party rival to the target. 

If Tronox can cause a horizontal SLC via third party market power despite no horizontal overlap on that market, then the question arises whether any non-overlap acquirer could cause the same type of SLC – even if the reasons for the withdrawal of the target from one particular market may be different (whether a different approach to business model, or a high target debt strategy). 

For example, if a no-overlap developer decides to buy one of two struggling cinemas multiplexes in Basingstoke, and turn it into badly-needed local housing, the merger creates a local cinema monopoly, traditionally sufficient for intervention (see Basingstoke Cinema To Be Sold), at least pre-streaming. Unlike a public interest test, a pure SLC test does not allow for these trade-offs other than in the exercise of discretion as to whether to inquire into a merger at all.

Extent of debt leverage as a relevant consideration in forced divestment scenarios

So – as a starting point, we wouldn't expect the CMA to take leverage into account where for instance a private equity purchaser is undertaking a standalone acquisition, except where its financial structure raises concerns regarding solvency etc.

However, at the other end of the telescope, there is track record for considerations relating to leverage to be considered in the purchaser approval process, with competition authorities expressing caution in their approval of private equity purchasers (for instance raising concerns regarding their commitment to the relevant market and stress testing their resilience in certain cash flow scenarios).

Indeed, in the UK at least, there remains the spectre of industrial strategy in relation to analysis of a counterfactual to a merger where several possible bidders are involved. Recent cases including eBay/Adevinta and Cellnex/Hutchison have involved the CMA deciding that there were alternative (and less anti-competitive) purchasers in the counterfactual to the merger. The logical extension of the divestment thinking above is that a PE purchaser despite bidding the highest price might be found to be a less competitive purchaser if it lacks the track record of making ongoing investment in portfolio companies. 

Conclusion

So – where do we stand now? Statements made by the CMA in response to pressure around the Asda and Morrisons acquisitions give some comfort that leveraged structures are unlikely to feature prominently within the existing UK merger framework. But a cold wind is blowing, not least given current global sentiment regarding leveraged buyouts and, from an analytical perspective, there remains an anomaly in treatment between divestment situations and initial merger analyses which is not wholly explicable by reference to different legal tests applicable to the inward investment versus a remedy divestment. 

While we wouldn’t expect the CMA to steer towards full scale merger control reform (re-introduction of a public interest test being seen as a regressive step), it may be that the CMA concludes that other legal instruments (for instance scrutinising resilience of a market as a whole as was examined in the care homes and children social care market studies) are better suited to the task of considering the implications of highly leveraged structures on competition.