The heads of the two main US antitrust regulators, Jonathan Kanter (US Department of Justice) and Lina Khan (US Federal Trade Committee), each recently expressed an uneasiness about the lack of antitrust scrutiny of private equity (PE) deals. Mr Kanter told the Financial Times that PE firms aim to “hollow out or roll up an industry and essentially cash out”, a business model that he says is “often very much at odds with the law”. Ms Khan said that “the world of private equity is only likely to get a lot bigger” and that competition agencies needed to “go after this in a more muscular way”.
The UK Competition and Markets Authority (CMA) also raised concerns about PE ownership in its March 2022 market study into children’s social care, a sensitive and important sector, and its Chief Executive, Andrea Coscelli, included reference to highly-leveraged capital structures and their impact on resilience of economies in his recent joint paper (with Gavin Thompson) on this topic. The CMA, European Commission and Dutch regulator ACM have also held PE firms liable for antitrust infringements committed by their portfolio companies, under the well-established rule of parental liability.
But what is the “antitrust case against private equity”? With many PE deals focussing on the life sciences and care sectors, now is a good time to assess this question.
What are the concerns?
No regulator has yet formulated a clear antitrust case against PE. So far, the statements are mostly made in news articles or in the context of sector-specific work. From these statements, the following can be distilled as possible concerns:
- Resilience – Concerns that the over-indebtedness of PE-owned companies will lead to disorderly exit in a downturn.
- Less-effective competitors – The worry that because they are highly-leveraged and focussed on cost reduction, PE-owned companies become less-effective competitors, thus dampening competition in the market.
- Roll ups and missing the bigger picture – Where PE firms own multiple firms in a sector and start merging them (“roll ups”), merger control is ineffective because these are intra-group deals. Also, competition agencies may miss the “bigger picture”, risking an approach that is fine at an individual transaction level, but ends up being too lax overall.
We discuss each of these below, and finish with some closing remarks.
The clearest expression of concerns around over-indebtedness and resilience in antitrust so far can be found in the CMA’s market study into children’s social care. In its March 2022 final report, the CMA found that there were “very high levels of debt being carried by some of the largest private providers, with private equity-owned providers of children’s homes in our dataset having particularly high levels”. In turn, this increased the risk of disorderly exit of firms from the market, which could impact the care provided to children.
These concerns should be viewed in the specific context of a sensitive sector in which disorderly exit would have particularly negative consequences for the children who depend on children’s homes. However, in an indication that these concerns may be of wider application, the CMA’s Chief Executive Andrea Coscelli and CMA panel member Gavin Thompson discussed over-indebtedness in private equity in their joint paper on resilience in the economy. In the paper, the authors say that higher leverage can make businesses more vulnerable to changes in their trading climate, leading to more firm failures. Although the impact of failure is generally greater in concentrated sectors, it can also cause disruption, and risk harm to consumers, in other markets, such as care homes and retail energy, they say.
Mr Coscelli also explained in a July 2021 letter to Darren Jones MP, Chair of the House of Commons Business, Energy and Industrial Strategy Committee, that in extreme circumstances over-indebtedness could play a role in merger control, where the CMA was concerned that the levels of debt being taken on as a result of the acquisition are such that the target may fail post-merger.
It is clear from these discussions that the issue of over-indebtedness and resilience can be approached at a macro level (the resilience paper), at industry level (the market study), and at an individual transaction level, where it may feature as a theory of harm.
At the macro and industry level, the recent downturn following the Covid crisis and the war in Ukraine have exposed weaknesses in Western supply chains. Where this leads to disorderly exits by overleveraged companies, this may raise concerns in other policy areas than competition, such as availability of care, plurality of media, systemic risks to the financial system, and resilience of supply chains. Whether high levels of debt and their impact on resilience are also a competition problem or not depends on the likelihood and subsequent effects on competition of disorderly exit. The more concentrated the market, the more problematic would be the exit of firms that would have been competitive but for the debt they took on.
It is often necessary for competition authorities to assess the levels of competition in a market and the ability of competitors to respond to certain potentially anti-competitive strategies by the firm under investigation. Competition authorities may therefore start to have regard to whether high levels of debt are having a dampening effect on a sector’s vibrancy and, for example, on competitors’ ability to respond to foreclosure strategies or their ability to expand. Agencies would need to define coherent methods to test this, but since they must establish the economic reality in which practices or transactions are to be assessed, it is right that they consider the impact that higher leverage might have on the competitiveness of individual players and a sector as a whole.
At the level of individual transactions, the question is whether an increased likelihood of exit by the target could in itself form a theory of harm. This is possible, though the burden of proof on the competition authority would be significant, as it would have to prove that as a result of the merger, there is a high likelihood of exit in the near future, and this exit would have a significant impact on competition.
PE-owned companies as less-effective competitors
In his comments to the Financial Times Mr Kanter makes the point that highly indebted companies and companies that are looking to save costs may be less effective competitors. He referred to private equity firms “hollowing out” an industry, and to them being motivated by “reducing costs”, which would make the companies involved less competitive.
In his July 2021 letter, Andrea Coscelli similarly noted that the CMA might take action in a merger where the levels of debt taken on as a result of the acquisition are such that the target’s financial position would be affected to such a degree that it would become a significantly weaker competitor (for example, because it would be unable to make significant investments of the kind needed to continue to be an effective competitor). However, he also recognised that 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).
Thus, a further concern around PE deals may be that they make firms less competitive because they saddle them with debt or because they are focussed too much on reducing costs. This could be an issue in two scenarios: where the merger control assessment is carried out with respect to the PE firm’s acquisition itself, and where the PE firm is the envisaged buyer in relation to a divestment remedy in a different merger.
In the first scenario, it will be rare that mergers will be blocked purely because the target entity will be highly indebted or will look to reduce costs. The competition authority would need to show that the levels of debt are so high or cost reductions so extreme that the company would become a significantly weaker competitor. However, it would not appear to make much sense for a PE firm to invest in a company that will become a weaker competitor (unless there are other reasons why that strategy would be profitable). In addition, to state the obvious, cost reductions can also make a company healthier and more efficient, so it is not clear where the competition agency would draw the line as to when these become so drastic that they make the target uncompetitive.
Therefore, the number of deals in which the target company will be a significantly weaker competitor because of the debt piled onto it, and where for this reason alone the merger significantly reduces competition, can be expected to be small. Nevertheless, more than ever competition authorities should be expected to closely scrutinise the acquirers plans as set out in internal documents, and where there is a suggestion of plans to “hollow out” the company to such a degree that it will be significantly weaker, this may lead to intervention.
The situation may be different in the second scenario, where the transaction involving the PE firm is not the main merger under investigation, but the PE firm is a proposed buyer of divestment assets in a divestment offered to address competition concerns with the main merger. In such circumstances, it may be necessary to assess whether the divestiture fully restores the loss of competition caused by the merger, and if there are concerns that this might not be the case, for example because the acquisition of the divestment assets is funded with a significant amount of debt, then the agency may query whether pre-merger levels of competition are indeed restored.
This seems a valid concern and one that can be tested in a more straightforward way, as the pre-merger performance of the divestment business will be clear, and it can be assessed to what degree post-merger the divestment business will have access to the same capital, resources etc. to be a viable and effective competitor in the market.
Roll ups and missing the bigger picture
Jonathan Kanter also mentioned the issue of “private equity roll ups”, i.e., PE firms purchasing and then merging several businesses in the same sector. He is concerned that such roll-ups create too much market power. In the same newspaper, Lina Khan said that because antitrust agencies often focus on the specifics of an individual deal, there is a risk that they “miss the bigger picture”. Individual transactions may not raise problems, “but in the aggregate you’ve got a huge private equity firm controlling, say, veterinary clinics”.
Many PE deals do fall under the jurisdiction of antitrust authorities, and when they do, the authority is entitled to take into account all companies controlled by the PE firm. However, there are scenarios where PE deals do not receive full merger control scrutiny, for example because smaller acquisitions fall below relevant merger control thresholds, or because non-controlling stakes are acquired (though this is not necessarily the PE business model, and some jurisdictions even allow the review of non-controlling stakes). It can also be the case that even though a PE deal falls under a regulator’s jurisdiction and the PE firm in question is slowly gathering market power in a sector, there are still a significant number of competitors such that the legal threshold for blocking the merger would not be met.
When PE firms merge their existing portfolio companies (the “roll-up” referred to by Mr Kanter), this would not fall to be reviewed by competition agencies, as it would be seen as an intra-group restructuring. This is fair enough, as the authority views the PE firm as a single economic unit, so it can restructure within that unit without coming under antitrust scrutiny.
While their comments are not yet fully developed and we should wait for further guidance, it appears given this context that Mr Kanter and Ms Kahn are mostly stressing that when PE deals come under scrutiny, agencies should not lose sight of the bigger picture. This could involve scrutinising the PE firm’s intentions in making the acquisition (which can be done by reviewing internal documents), testing what the firm is planning to do with the target company, testing the firm’s overall strategy in the sector, and reviewing whether the firm is planning additional acquisitions that may for some reason fall below the review thresholds.
In the EU and UK, agencies have so far not expressed a concern over “roll ups” or the idea that they are missing the bigger picture in PE deals. However, the Chair of the House of Commons Business, Energy and Industrial Strategy Committee Darren Jones MP did raise with the CMA whether the watchdog has sufficient powers to protect jobs and customers in light of a high number of private equity deals. Mr Jones’s comments came around the time when the high-profile PE buy-out of the Morrisons supermarket chain was announced. However, when it subsequently reviewed and cleared that deal, the CMA did not refer to any concerns related to the PE nature of the buyer at all.
The antitrust case against private equity is so far ill-defined. In the short term, it is likely that high levels of debt that are often associated with PE ownership will feature in overall assessments of levels of competition in markets. When agencies carry out sector inquiries of strategically important markets, they may be interested in testing whether high levels of debt increase the likelihood of disorderly exits.
In addition, it is likely that agencies will become significantly more sceptical about PE as a buyer of divestment assets in merger inquiries. Where in the past PE was often the solution in such cases, that ma no longer be the case. Agencies will want to be sure that the ownership structure, strategy and debt levels do not stand in the way of the divestment business becoming an effective competitor.
They may also look to other existing powers to deal with competition concerns around PE ownership. Mr Kanter has already mentioned that he wants to start enforcing Section 8 of the Clayton Act, which prohibits interlocking directorates at competing companies. The CMA could test whether its director disqualification powers stretch to directors of PE firms that own companies that infringe the law, in particular where it is perceived that they had an involvement in the infringement or did not do enough to stop it.