It’s time to get back in the swing of the merger analysis fundamentals thing, so I thought I’d turn back to the subject of defenses. The fact that I already spent three posts discussing efficiences as a merger defense probably gives you some indication of its relative importance, but there are other ways to defend your potentially anticompetitive merger too.
But before I get into the specifics, let’s talk a little about what it means to have a defense in this context. In my mind, anyway, it’s a little different from what you typically think of as a defense (which can perhaps be summed up as, “sure, I did it, but it was justified for X reason”). For the most part, merger defenses are really arguments that the transaction will not substantially lessen competition. So rather than a justification for having broken the law, they are really arguments that the transaction doesn’t break the law because certain factors demonstrate that there will be no lessening of competition. Which is reflected in the fact that the Merger Guidelines don’t actually refer to these things as “defenses” even if they are often colloquially labeled that way.
In that sense, they aren’t really that different than arguing that the product market should be broader and thus reduce the parties’ combined market share, or that the geographic market should be narrower and thus there is no overlap between the parties. Both argument of that type and the substantive “defenses” are a way to show that the transaction won’t reduce competition.
So, other than efficiencies, what “defenses” are there?
The notion of why powerful buyers might be a defense is pretty straightforward. If your customers are powerful enough, you won’t be able to impose a price increase via unilateral effects and you won’t be able to coordinate with your competitors to reduce competition. Perhaps the powerful buyers will be able to credibly threaten to vertically integrate and no longer need the products or services sold by the merger parties. Or perhaps they have the resources and sufficient individual demand to credibly sponsor a new entrant. Ultimately, the idea is that powerful buyers will have other choices available to them that would prevent the merger from leading to anticompetitive effects.
But, obviously, power buyers can only be so powerful. If the transaction results in 100% market share for the combined firm, there’s not much chance of convincing the agencies that will be offset by powerful customers. Perhaps a good way of thinking about it is that there must be some sort of inverse relationship between the combined share of the parties and the usefulness of power buyers as a defense.
Finally, the existence of a few large, powerful buyers isn’t a get out of jail free card. The Guidelines are pretty explicit about the agencies still considering whether other, smaller customers might be harmed by the transaction.
I could probably write a whole post just about entry, and in particular my views about the extent to which entry is sometimes undervalued in merger analysis. But let’s stick to the basics here.
The idea of entry as a merger defense is really one of the fundamental basics of free market economics. Even if the transaction leads to higher prices (via reduced ouput), those higher prices represent an increased profit opportunity, which will attract new competitors to the market. In theory, it’s entry that prevents the accumulation of market power, keeps competition alive and drives prices down to marginal costs. If there is money to be made, new competitors are going to want to get into the game.
Of course reality doesn’t perfectly reflect theory and in the real world there are actual barriers to entry, like start up costs, regulatory approvals, learning curves, customer relationships, intellectual property and the like.
Which is why the Guidelines impose three requirements for viewing entry as a merger defense. To be credited, entry must be (1) timely, (2) likely, and (3) sufficient.
To be considered timely, entry must be “rapid enough to make unprofitable overall the actions causing those effects and thus leading to entry,” in the oh-so-clear words of the 2010 Merger Guidelines. Honestly, I don’t know exactly what that means. What’s clear is that an insignificant amount of anticompetitive harm that happens prior to entry can be tolerated and that in revising away from the two year standard that was part of the 1997 Guidelines, the agencies wanted to reserve the right to demand faster entry. But that’s about it. My take away would be that entry analysis is, like the rest of merger analysis, highly fact-specific but that you should expect that it needs to happen in two years or less.
To be likely, entry has to be profitable considering the costs and risks involved. If it’s going to take seven years, four environmental reviews and an investment of $3 billion for the entrant to start competing for a small sliver of the available market, it’s a safe bet the agencies are unlikely to find entry to be likely. In other words, likelihood is about the barriers involved and the potential payout for attempting to hurdle them.
Finally, potential entry must be sufficient even where it’s timely and likely. What does it mean to be sufficient? Well, that’s hard to describe in the abstract, which is why the Guidelines instead give examples of where it may be insufficient. Entry into a market characterized by differentiated products, for example, may be insufficient because the new product may be an insufficiently close substitute for the two existing products (alternatively, one might argue that the brand loyalty that’s necessary for a differentiated product is a barrier that makes entry less likely or timely as well). More generically, entry might be insufficient because the capacity, quality or other competitively significant capability of the new entrant would be too minimal to undo the projected anticompetitive effects.
As you can tell, evaluating the credibility of entry or expansion and its ability to counter anticompetitive effects is necessarily forward looking, and therefore, necessarily speculative. It can be quite difficult for merger parties to convincingly argue that yes, new competitor X is poised to enter the market. A history of entry and exit can help, for example, if there are fringe players who have the capability to produce the product or have done so in the past. There also is certainly a role for econometrics, especially if there have been small but non-transitory increases in margins in the industry in the past. Your entry case will be strong if such increases have sparked entry in the past, and weak if they have not.
This post is getting kind of long and I’m temped to deal with this with a semi-sarcastic, “this one doesn’t really exists so just ignore it.”
But my underlying compulsion to be of service (what’s up with that?) won’t allow me to be quit that glib (I said glib, not Gibb, so banish those thoughts of 1970s feathered hair).
Okay, so the idea here is that a merger isn’t going to create or enhance market power if the seller was going to be leaving the market anyway. The notion being that the target isn’t really of any competitive significance if its assets were about to leave the market, so why not allow a merger to salvage some of their value?
Naturally, parties get excited about the possibility of a failing firm defense anytime one party to a transaction has been struggling. But struggling isn’t really enough. It can help to show that the struggling firm’s competitive significance is less than its market share would otherwise suggest, but to qualify for a failing firm defense you have to convince the agencies that the failing firm (1) would not be able to meet its financial obligations in the near future, (2) wouldn’t be able to reorganize under Chapter 11, and (3) has made unsuccessful good-faith efforts to find alternatives that would result in less harm to competition.
That last one’s really a kicker. If you’re the leading firm in the market and the allegedly failing firm could sell to one of your smaller competitors, you’re doing to have a hard time establishing a failing firm defense.
There is something a bit misleading about presenting each of these ideas separately. It’s the rare case that would rely only on one of these concepts in the hope of getting the deal done. In a difficult case, you would want to try to employ all of these arguments (and more).
You might, for example, have a case in which you’re combining manufacturers of durable consumer goods with strong brand recognition and perceived high combined shares.
In order to overcome the inherent concerns about such a transaction, you would probably want to show that the handful of retailers that sell those products to consumers each account for a substantial portion of overall sales and have a history of successfully sponsoring new entrants. You’d also love to show that among those new entrants are growing manufactures in China that stand ready to expand in the face of increased domestic opportunities. Further, while the target may not actually be failing, the higher costs and recent failed product launches it has experienced make it less competitively significant than its historic market share would suggest.
Wrap that up with a nice bow of significant cost savings that can easily be achieved by better utilization of the buyer’s more efficient manufacturing facilities and you might even manage to get your deal cleared without a divestiture or challenge.