Managing antitrust risk historically has not been regarded as an essential skill for private equity buyers. The proposed buyout of Dynegy Inc. by Blackstone Group LP should change that view. Although it now appears that Dynegy has rejected Blackstone’s revised “best and final” bid to acquire the company, Blackstone’s approach nonetheless demonstrates that the ability to identify and manage antitrust risk can enable private equity buyers to structure potentially high-return transactions that otherwise might appear to be beyond their reach.
The Blackstone/Dynegy deal has been much in the news of late. First, major shareholders came out against the deal as initially proposed. Blackstone responded by upping the purchase price. Then Dynegy effectively rejected the revised offer by announcing on November 23, the day shareholders were supposed to vote on the Blackstone deal, its intention to solicit new bids. Blackstone may not end up winning the prize, but it appears that they will not walk away empty-handed as their agreement with Dynegy entitles them to a $16.3 million breakup fee if Dynegy ends up accepting a bid greater than $4.50 per share during the next 18 months.
Missing from the coverage of the deal, however, has been any recognition of how the use of a strategic partner and the assumption of some antitrust risk enabled Blackstone to propose what for them was a cash-free acquisition. Private equity buyers may be able to employ a similar approach in other deals if they can develop the capability to assess and manage antitrust risk, something private equity buyers haven’t had to do very often. Fundamental to developing these skills is understanding the recently released U.S. Department of Justice and Federal Trade Commission Horizontal Merger Guidelines (“New Merger Guidelines”), which we summarize in this article.
Dynegy is a wholesale provider of electricity. Like other producers in this sector, Dynegy’s stock price had declined precipitously since the onset of the recession, down about 90% from the summer of 2008. A glut of low-cost natural gas had also driven down electricity prices and contributed to its decline. In a bet that the markets for electricity would rebound, private equity giant Blackstone proposed to acquire Dynegy, a company that, despite its weakened condition, owns and operates more than 20 U.S. power plants with an enterprise value, comprised mostly of debt, of over $4.6 billion.
Blackstone initially offered to acquire Dynegy for $543 million (roughly $4.50 per share), which it upped to more than $600 million ($5.00 per share). But Blackstone did not have to put any cash into the deal. Instead, Blackstone conditioned the purchase of Dynegy on the simultaneous sale of four Dynegy natural gas-fired power plants to NRG Energy Inc. (“NRG”), a rival power generation company, for $1.36 billion. By using this approach, Blackstone could have netted more than $750 million in cash while still owning what was left of Dynegy. Together, the transactions, therefore, demonstrate how a private equity firm can team up with a strategic buyer to pull off a deal that otherwise might appear to be beyond its reach, all without bank financing.
As a general matter, it is in the seller’s interest to maximize the number of interested buyers. Blackstone’s incentives in its proposed second-step sale of Dynegy’s four natural gas plants were no different. The difference between pure financial buyers and strategic buyers, however, is that strategic buyers can often increase their bids by sharing a portion of the extra value they expect to derive from efficiencies unique to strategic buyers. But the involvement of a strategic buyer requires the private equity firm to assess and manage its antitrust risk accurately, an exercise that private equity firms have not had to conduct in most deals.
Blackstone’s choice of its strategic partner, NRG, reflected this analysis. Its ability to close on the main Dynegy transaction depended on its assessment that the concurrent sale of four natural gas plants to a rival with ownership interests in more than 40 power-generating plants in the U.S. would clear antitrust hurdles and not ensnare Blackstone’s acquisition of the remainder of Dynegy in a lengthy antitrust investigation. Antitrust due diligence also provided Blackstone essential context in its negotiations with Dynegy, including comfort that it could accept certain contractual conditions undoubtedly important to Dynegy, such as the $100 million it ultimately agreed to pay Dynegy as a break fee if it was unable to close the deal. Ultimately, Blackstone’s antitrust homework paid off as the federal antitrust authorities cleared both the Blackstone and NRG transactions by granting early termination, removing antitrust as an impediment to closing.
In order for other private equity firms to utilize this tactic, they will need to understand the implications for antitrust risk assessment of the New Merger Guidelines, which provide the primary blueprint for analyzing mergers and acquisitions under the antitrust laws. Although the federal enforcement agencies will investigate the same ultimate question as under the predecessor 1992 Horizontal Merger Guidelines (the “Old Merger Guidelines”)—whether the transaction is likely to substantially lessen competition and harm consumers—the New Merger Guidelines depart in significant respects from the Old Merger Guidelines. The New Merger Guidelines articulate a flexible approach to merger analysis and introduce new analytical tools and scores of new terms not found in the Old Merger Guidelines, a systematic analytical framework that had guided the business community for 18 years. And while it is too soon to predict the long-term effects of these changes, we can gain insight into the agencies’ future approach to merger enforcement by focusing on key thematic changes between the two versions.
Most significantly, the New Merger Guidelines attempt to curb the importance of defining the sphere of competition in which merging rivals operate, known as “market definition.” Market definition, which has both product/ service (the range of offerings that compete with those of the merging firms) and geographic (the geographic area in which competition occurs) dimensions, essentially played a gate-keeping function in merger analysis under the Old Merger Guidelines. In other words, in order to assess the competitive effects of a transaction, antitrust authorities have to first define the market in which the parties compete. The New Merger Guidelines—perhaps in response to frustration over losses in court that cast a spotlight on the agencies’ inability to define markets precisely (e.g., U.S. v. Oracle Corp., FTC v. Whole Foods Market, Inc.1)—renounce the notion that defining markets is a predicate to an evaluation of a transaction’s competitive effects. The agencies have effectively attempted to make market definition optional, proceeding directly to the analysis of whether the transaction leaves any customers vulnerable to higher prices or lower quality.
In place of market definition, the agencies now look more to “proximity” or closeness of competition between their products or services of the merging firms. Two products are proximate if one is the next-best substitute for the other. The evaluation of proximity will differ based on the competitive setting in which the merging firms participate. In settings involving differentiated products (i.e., products that are not perfect substitutes because they differ in performance, branding or some other dimension), a simple analysis of the attributes of the products of the merging firms, how the products are sold and a review of ordinary course of business documents such as marketing materials will provide a useful starting point. These views can be refined with an analysis of customer switching patterns, panel data and customer surveys. Agency economists will conduct systematic analyses of proximity by analyzing empirical evidence such as bidding or win/loss data, which reveal choices customers have exercised over time and incorporate them into new analytical tools (e.g., “diversion ratio” and “upward pricing pressure”) to predict whether the acquiring firm will be able to influence competition adversely after the merger.
In settings involving homogeneous or commodity products (products that are relatively uniform in composition and character), the agencies may determine proximity based on the relative location of the firms’ production or distribution centers to customers, particularly where transportation costs are high relative to delivered price. Although less clear in the New Merger Guidelines, the use of pricing zones and relative ranking found in company documents will also factor into the determination of proximity.
The New Merger Guidelines, however, offer no standards for evaluating proximity and determining when a merger between competing products may be anticompetitive. Under the Old Merger Guidelines, mergers resulting in shares in a properly defined market below 35% fell within safe harbors. Today, there are no presumptive zones of safety for transactions of any minimum combined share, which reduces predictability for the business community. And while the New Merger Guidelines raise concentration thresholds—measured using the Herfindahl-Hirschman Index (HHI), which is computed by taking the sum of the squares of each market participant’s market share— these new thresholds are unlikely to have a practical effect since they merely codify existing agency practice. In fact, the New Merger Guidelines now suggest that individual customers can form distinct relevant markets, a concept that the DOJ appears to be putting into practice in its first merger challenge under the Obama administration. See, e.g., United States v. Dean Foods Company, No. 10-cv-59 (E.D. Wis. Jan. 22, 2010), (complaint alleging that each school district in Wisconsin and the Upper Peninsula of Michigan is a separate geographic market).2
At least in the near term, the New Merger Guidelines should generate more investigations, result in increased focus on potentially targeted customers, prolong agency investigations and impose greater costs as the agencies wrestle with how to apply notions of proximity. Private equity firms, like the rest of the business community, can benefit by mastering these concepts and having an effective antitrust game plan for any transaction that involves a strategic partner. As Blackstone attempted to prove in its bid to acquire Dynegy, the returns literally could be infinite.