The recent acquisitions by private equity investors of two major UK supermarkets have raised concerns by UK Parliamentarians, (including 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 private equity consortium, which includes investors with existing petrol forecourt investments, and which operate in a higher priced portion of the petrol market.

This blog considers the extent to which highly leveraged structures in a private equity context in particular is relevant to merger review.

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”.

Meanwhile across the Atlantic, Chair of the FTC, Lina Khan called on the FTC to investigate whether private equity firms contribute to “extractive business models” which “may distort ordinary incentives in ways that strip productive capacity…”.

In addition, in a blog from 28 September 2021, 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”.

Finally, Dr Andrea Coscelli, the CEO of the Competition and Markets Authority has noted that:

“in common with other advanced economies, the UK has seen a growth in the number and value of private equity-funded buyouts. 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.”

The Competition Agency response

Despite political pressure, the response of merger agencies, to date, has been the same: since merger laws have focussed on a “pure” competition test, without recourse (as in the previous UK legislation) to “public interest” considerations, the extent to which merger control agencies can take legitimate account of highly leveraged structures in a merger control context is very limited.

Agencies can only take such considerations into account to the extent there is evidence that the amount of leverage 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)”. (emphasis added)

In a previous wave of supermarket takeovers in 2003, a proposed bid by a Philip Green investment vehicle, Trackdean, for Safeway plc was thought by some third parties to raise concerns in relation to high leverage post-merger, given the degree of acquisition debt involved. The then 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 competition concerns. In the event, Trackdean did not bid, Safeway was acquired by Morrisons and Arcadia went into administration, with a combination of high leverage and pandemic-related impact on trading, in 2020.

Under the previous merger legislation in the UK, the Fair Trading Act, a public interest test was involved as part of the analysis of a merger. The OFT and Competition Commission considered in several cases that public interest concerns arose where capital gearing and interest cover ratios of the merged company, which would result in financial stringency, might deny the acquired business adequate funds for capital expenditure. This would put the acquired business 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 Competition Commission remarked in Elders / Allied Lyons (1986):

“This does not mean that these [gearing and interest cover] ratios can be ignored. The market attaches importance to them, and departures from what it perceives to be normal levels may cause doubts to arise about the strength of a company's position and its prospects. […] It is also necessary to look at such factors as cash flows, the purpose and terms of the company's borrowing, the nature of any assets acquired by use of the borrowed funds and the time within which the level of gearing is likely to be bought down. A company which has borrowed heavily in order to finance an advantageous takeover, and is in a position to reduce that borrowing within a reasonable time, may be in quite a different position from a company forced to borrow heavily because of poor trading results and facing the prospect of a mounting burden of debt. In some cases increased gearing, if it is based on good commercial judgment, may even indicate more effective use of available equity funds.

We therefore have to assess what Elders' capital gearing and interest cover would be following the merger and whether, in Elders' circumstances, they would be such as to indicate a degree of financial vulnerability which might lead, at worst, to the possibility of complete collapse. Even if that did not come about there might be such financial stringency that the Allied-Lyons businesses retained by Elders would be denied adequate funds for capital expenditure, placed under pressure to give priority to short-term considerations so as to generate funds to reduce borrowings, or be forced to implement drastic measures of rationalisation leading to substantial job losses.”

And the OFT subsequently noted in Swedish Match / Gillette (1991):

“The exceptionally high gearing, a consequence of the structure devised by Wilkinson Sword's main competitor, is a factor which is likely to impose some inhibitions on Wilkinson Sword's ability and propensity to engage in aggressive and innovative competition.

[…] Nonetheless, an important potential competitive strategy, of gaining market share by lowering prices, is likely in our view to have been effectively ruled out by its debt structure and gearing. The pressure to repay its debt is also likely to affect its expenditure on R&D, and on advertising and promotion […] are important in this market. The range of products offered by Wilkinson Sword is therefore likely to be adversely affected. It is also likely to limit its risk-taking and innovation

[…] the structure of the transactions relating to the acquisition of the CP Division by Swedish Match NV, by placing a heavy burden of debt on the company, may be expected to reduce the competitiveness of Wilkinson Sword and inhibit competition in the wet-shaving market. This effect is a consequence of each of the merger situations we are considering”.

A paper by the Department of Trade and Industry on Mergers Policy (1988) noted some of the concerns in relation to highly-leveraged acquisitions, including the risk of “post-merger divestment [being] inherently destructive […].”. However, it concluded that “[t]he Government's view is one of scepticism as to whether there is normally a divergence between the interests of private decision-makers and the public interest where leverage[d] bids are concerned. […] Therefore the Secretary of State will not normally regard high leveraging on its own as a ground for reference [to an in-depth merger control investigation]. However, he will continue to consider referring such bids when he believes that a high degree of leveraging, combined with other features of the bid, may pose dangers to the public interest."

When assessing the suitability of a purchaser in a remedies context, the CMA guidance notes that a “highly-leveraged acquisition of the divestiture package which left little scope for competitive levels of capital expenditure or product development is unlikely to satisfy [the capability] criterion”.

A controversial extension of conventional merger control analysis?

The conventional view in the UK is that regard cannot be had under the current state of the law, except in extreme circumstances involving likely failure/exit of the target because of the debt package, to highly leveraged structures. However, there is a question as to whether this position could evolve given, for example, the CMA’s approach to the impact post-merger of the pre-merger business model in another (non-private equity case).

In its January 2021 decision in Tronox/TTI, involving a (vertical) merger between producers of feedstock for metallurgical purposes, the CMA concluded that there would be a substantial lessening of competition as the acquirer (Tronox) had a pre-merger business model (a strategy to achieve greater vertical integration) that restricted output, (i.e., it would withdraw from supply on the merchant / third party sales market) leaving a near monopoly on the merchant market post-merger.

The CMA said in the Tronox case:

“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.” (emphasis added)

In a private equity acquisition context, the analogy would be that the acquirer’s business model (for example, one driven by a significant degree of debt to equity capital), is such that price increases (necessary to pay down debt) are a necessary feature of the post-merger business plan for the Target. The rejoinder to this is twofold:

First, why would a price increase be profitable, if it was not already profitable in the case of a simple transfer of ownership in non-overlap businesses (for example, where a family run manufacturing firm is sold to a PE sponsor without competing interests)?

Secondly, if a price increase would be profitable post-merger, are equity investors necessarily more patient than banks? I.e. is dividend release necessarily more long term than debt?

This sort of reasoning, 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 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 secondly that in a great many mergers (and not simply those by private equity sponsors), the acquirer’s strategy differs from that of the seller/target but the primary question for the competition agency considering the merger is whether there is sufficient competition in the market in question to prevent a deterioration in price, quality, range, service or innovation (“PQRSI”).

It is notable that the CMA did not apply this reasoning in the recent acquisition of Asda, by a private equity consortium. In that case, the CMA 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.

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

Although not presently a relevant consideration in UK, US or EU merger control analysis where private equity is the purchaser subject to merger review, somewhat anomalously, there is however track record for considerations relating to leverage to be considered at the other end of the merger review process: namely where private equity is a potential buyer of businesses required to be divested for antitrust reasons. We have recent experience of the European Commission considering the track record of a private equity buyer - in particular the history of its previous investments and whether it had been prepared to commit capital in order to improve the portfolio company’s competitiveness. In a recent case, the divestiture trustee carried out sensitivity analyses in relation to the debt package to be committed to the divestment acquisition if various interest rate and cash flow scenarios occurred.

This concern was a feature of the Former Federal Trade Commissioner Chopra’s (whose protégé, Lina Khan is the current Chair of the FTC) dissenting opinion in relation to the Abbvie/Allergan consent in 2020.

In that dissent, the former Commissioner noted that “... the 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”.

Finally, 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 who bid 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

PE investors can take comfort, for now, in the statements made by the CMA in response to pressure around the Asda and Morrisons acquisitions in relation to the scope of existing UK merger rules. But a cold wind is blowing, not least as a result of statements made by the FTC and there exists an anomaly in treatment between divestment situations and initial merger analyses. There is also the possibility that regulators decide short of merger control reform (re-introduction of a public interest test being a regressive step in the view of most agencies), that other legal instruments are better suited to the task of considering the implications on longer run competition of highly leveraged structures. 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.

Is market investigation the panacea?

In a market study/investigation context, questions of ownership and capital structure (including private equity ownership) have traditionally not been central because the source of consumer harm has been found to lie elsewhere. But in some cases, for example involving vulnerable parties or the resilience of the sector they have formed part of the CMA’s consideration. For example, as part of its 2017 study into care homes for older people, the CMA assessed how far the debt levels of providers affected the sustainability of the sector, and the ability of the market to meet future capacity. Additionally the CMA’s on-going study into the children’s social care market is currently considering (among other things) whether the status of care providers (i.e., local authority, private equity, non-private equity or third sector) affects the price and quality of the placements they provide, and their financial resilience albeit the CMA has provisionally concluded that the ownership profile has not led to systematic differences in outcomes for children or investment.

The words of Dr Coscelli in a grocery deal context, may prove a bell-weather for a further sector-wide review in fuel or grocery.