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LOOKING AT MERGERS THE WAY FEDERAL REGULATORS DO

By Jim Romeo
CORPORATE FINANCE


What you’ll need to know if your company is in an acquisitive mood.

Looking at MERGERS
The Way Federal Regulators Do


BY JIM ROMEO


EXECUTIVE SUMMARY
  • WHEN A COMPANY CONSIDERS A MERGER, it’s important to understand what may trigger a regulatory challenge. CPAs are most likely to focus on financial data, but they must look at postmerger market implications, too.
  • FEDERAL REGULATORS SCRUTINIZE the relevant product market and the geographic market in each case. Such antitrust “watchdogs” assess a market by considering the likely consumer response to a “small but significant and nontransitory” price increase.
  • IN CONSIDERING THE GLOBAL MARKET a company’s location is not as important to federal regulators as how a merger or acquisition will affect competition within the United States.
  • COMPANIES THAT WAIT UNTIL they are in the midst of the Department of Justice’s approval process to bring in economic consultants who specialize in antitrust issues may be disappointed. A merger may get a thumbs-down if advisers are not familiar with antitrust economics.
JIM ROMEO is a freelance writer based in Chesapeake, Virginia.

t a time when mergers are proliferating in every business sector, federal regulators know that what’s good for a company is not always good for the consumer. If you’re a CFO or financial executive at a company that is seeking a more profitable position in the market through a merger or acquisition, it’s important to understand what antitrust issues regulators will look at and challenge. CPAs are most likely to focus on financial data, but it’s important that they consider postmerger market implications, too. Although it’s relatively easy to understand domestic market share, global market issues are complicating the merger process.

THE AGE OF MERGERS

The number of mergers reported in 1998 was 4,728, a 200% jump from 1991, with the year’s total volume exceeding $1 trillion. More mergers mean more regulatory activity and antitrust litigation. In 1998, the Federal Trade Commission’s Bureau of Competition spent more hours on merger litigation than in any previous year, expending over 40 person years.

Companies merge to boost market share, eliminate competitors or acquire important suppliers needed by competitors. A red flag for regulators appears if a newly merged company will dominate a market. In one example that took place in 1998, United States v . Lockheed Martin Corp. and Northrop Grumman Corp., regulators challenged the proposed acquisition of Northrop Grumman by Lockheed Martin, an $11.6-billion merger that was the largest ever objected to by federal officials. The complaint alleged that the merger would have created unprecedented vertical and horizontal concentration in the defense industry, which substantially would have lessened, and in several cases eliminated, competition in major product markets critical to the national defense. The merger was disallowed.

Merging can create market power, and regulators scrutinize deals in terms of product or service concentration, geography and the availability of substitute products within a market, to be sure the new entity does not overwhelm all competition.

CRUCIAL TESTS

According to the Department of Justice, an acquisition does not restrict competition if it meets at least two conditions:

  • The market is not concentrated after the merger.
  • New companies can easily enter the market in the near term and provide effective competition.

When the government scrutinizes mergers, “there are no laws about strict market shares or number of players. The laws discuss only market advantage and consumer choice,” says Nan Andrews Amish, a competitive strategy consultant with $ynergy, in El Granada, California.

Federal regulators look at the relevant product market and the geographic marke t in each case. To determine these markets, some methodology is required. Antitrust “watchdogs” assess a market by considering the likely consumer response to a “small but significant and nontransitory” price increase. If prices go up and customers wish to compensate by switching to a competitor’s product or to a comparable substitute product, the key questions are

  • Where can people find substitute products?
  • How many will do so?

The relevant product market was the subject of much rancor last year during two deals in the prescription drug wholesale market. At the time, McKesson was to merge with AmeriSource and Cardinal Health with Bergen-Brunswig. If the mergers had gone through, the two new entities would have controlled more than 80% of the market. Regulators said that would have significantly reduced competition in terms of price and services.

Regulators alleged that the relevant market consisted of the cluster of services—including warehousing, distribution and other value-added services—provided by drug wholesalers to institutional customers and retail pharmacies. The companies contended that they fell into a broader market that included other means of distribution, such as direct purchases from manufacturers and self-warehousing. Using this interpretation of the market, the merger would have accounted for a smaller percentage share, they argued.

When the case went to court, the key question was whether customers had reasonable alternate sources for buying their wholesale products. If so, then the mergers would not restrict market choices. The courts ruled that hospitals and independent drugstores would not substitute direct delivery and self-warehousing if an anticompetitive price increase occurred. The reasoning was that hospitals had been steadily increasing their reliance on wholesalers—to 80% of their needs in the previous year—and a price increase would have to be endured in this market. As a result, the merger was disallowed.

However, dominance of one market sector does not always spell the end of a deal. When the Gillette Co. and Parker Pen Holdings attempted to merge, regulators said the deal would restrict competition in the premium fountain pen market, since it would be possible for the merged company to raise prices with no alternative source available to consumers. The United States District Court deemed the regulators’ view of the alleged market too narrow, because premium fountain pens competed with other writing instruments. In other words, if premium pens became too expensive people could always buy cheaper types of pens. Given this broader market, it was determined that the merger would not significantly dampen competition.

The companies were required to create a product portfolio that included lower- and higher-priced writing instruments if they wanted the merger to occur. This meant that the management team of the merging companies was required to develop and introduce low-end, inexpensive writing instruments, which would provide alternative choices to consumers. When asked to create a new portfolio, companies may acquire such a product line, or develop one from scratch and show proof and plans to regulators of what they will offer and how they will offer it.

In other cases, divestiture of a few products can help win approval. In the proposed $1.125-billion acquisition by S. C. Johnson & Son, Inc., of the home care and home food management businesses of DowBrands, Inc., regulators determined that the merger would shrink competition substantially in the research, development, manufacture and sale of soil and stain removers and glass cleaners within the United States. S. C. Johnson had to sell several DowBrands product lines to a third company before the acquisition got the okay.

MAPPING OUT A DEAL

In viewing a geographic market, regulators look at an identified region and test to see how a small price increase will affect the region. Here’s an example of how the geographic market came into play: In the proposed 1998 merger of two hospitals in Poplar Bluff, Missouri, Tenet Healthcare Corp. sought to acquire Doctors’ Regional Medical Center, a physician-owned, for-profit hospital. The market consisted of 31 ZIP code zones in southeastern Missouri from which the two hospitals drew 90% of their patients, an area with a radius of about 50 miles.

To seek merger approval, the companies pointed to alternative hospitals in the region that were more than an hour’s drive from Poplar Bluff. When the merger was challenged, the courts considered the critical issue to be “whether the surrounding hospitals [were] ’practical alternatives’ to which patients would turn if the merged entity raised prices.” The courts ruled that a consumer was unlikely to travel far to get routine primary care, even after a price increase. Thus, a merger would tighten the local geographic market, making it too narrow and limiting the patient’s options. As it was proposed, the merger was disallowed.

The geographic market can change as the product market changes. Whether a market is deemed regional or global depends on the product and the market. “In the petrochemical industry, ethylene and its derivatives are typically characterized as global businesses,” says Joe Coote, a vice-president with Charles River Associates in Cambridge, Massachusetts, who specializes in antitrust issues for the chemical industry. “Ethylene gas, however, is not traded on a worldwide basis, but on a regional basis. Polyethylene, on the other hand, is a derivative of ethylene and is traded worldwide.”

A product traded on a regional market has a limited number of buyers and sellers. A product traded on a worldwide basis is on another playing field, with many more buyers and sellers. For approval of a merger involving companies that produce ethylene or a derivative product, regulators would examine how the product is traded and what the effect would be on “substitutability” and price for buyers in the market. A worldwide market may not be as concentrated as a regional one. A merger of companies with products traded on a regional basis may mean a concentrated market with dominance by one firm—thus offering no choice or substitutability in the event of a price increase. In some cases, the nature of a product can determine the geographic market. The new geographic market of the merged company’s product can pose risk to the substitutability and adequate competition available to buyers. If this risk is too high, regulators may disapprove a merger or acquisition.

Surfing the Web for Antitrust Information

American Bar Association—Antitrust Law Section

www.abanet.org/antitrust/

Antitrust Case Summary Browser

www.stolaf.edu/people/becker/antitrust/antitrust.html

Antitrust Law and Economics Review

webpages.metrolink.net/~cmueller/

Antitrust Policy

www.antitrust.org

Department of Justice: Antitrust Division Home Page

www.usdoj.gov/atr/index.html

Federal Trade Commission’s Antitrust Web Site

www.ftc.gov/ftc/antitrust.htm

Florida Bar Antitrust Site

www.flabuslaw.org

THE HHI

To determine if a merged company will have excessive market power, the increase of market concentration must be measured. This is done by using the Herfindahl-Hirschman Index (HHI; see below), which is calculated by squaring the percentage of the market share of each company in a specific industry, then summing the squares. The HHI can range from a high of 10,000, for an industry in which one company has a 100% market share, to a low of near 0, for an industry in which many businesses each have a very small market share. Because the index uses the sum of squares, businesses with larger market shares carry greater weight in the calculations that determine market concentration.

How do regulators use the HHI? “The Department of Justice considers an HHI above 1,200 to be a sign of concentration and an HHI above 1,800 to be evidence of high concentration,” says Scott Hakala of Business Valuation Services. “Any merger that increases the HHI above, say, 1,000 points would be subject to more scrutiny—and to a challenge if the HHI is above 1,200—and especially if it is above 1,800.”

Hakala explains the HHI best with a hypothetical case of the DallasFort Worth air travel market. “If American Airlines controls 50% of the flights out of DallasFort Worth, Delta controls 15%, Southwest controls 15% and the remaining carriers are relatively insignificant, then the HHI would be (50 X 50) + (15 X 15) + (15 X 15) + e [a small additional factor for the other carriers] = 2,500 + 225 + 225 + e = 2,950 + e,” according to Hakala.

The HHI also can be used to determine the number of effective competitors in a market. This can be calculated by taking 10,000 and dividing by the HHI. For example, 10,000/2,950 = 3.39 effective competitors in this air travel market. In the life-reinsurance industry after Swiss Re acquired Mercantile & General, the index rose to 875, from 715. Dividing 10,000 by either index figure shows that there are plenty of effective contributors in the market and that the deal would not be challenged by regulators.

 

 

INTERNATIONAL CONSIDERATIONS

The reach of the U.S. antitrust laws is not limited to conduct and transactions that occur within the boundaries of the United States. A company’s location is not as important as how a merger or acquisition will affect competition in the United States. This is the key to understanding the implications of a merger between a foreign-based international business and a domestic company.

Market shares are assigned to foreign competitors in the same way in which they are assigned to domestic competitors. However, if exchange rates fluctuate significantly, so that comparable dollar calculations on an annual basis may be unrepresentative, the regulatory agency may measure market shares over a period longer than one year.

International market share can change the balance when a company presents market data to regulators. If it can be shown that the product’s market is truly international in nature, then some companies may be able to reduce the HHI by making a case that competition within the broader scope of the international market is sufficient to allow for a merger.

In considering international market share, many variables can muddy the waters. First, international market share is difficult to define and measure and, once measured, it’s hard to determine whether it is part of the relevant market. “Clearly, there are certain industries, such as pharmaceuticals, large-scale engineering and construction and automobiles that have international markets,” says Hakala. “However, even in pharmaceuticals and autos, the ability to sell cars or drugs internationally may not translate into being a competitive force in the U.S. market because of failure to meet U.S. standards or to have an adequate U.S. retail presence.” For example, despite the seeming magnitude of the deal, the Daimler-Benz Chrysler merger went largely unchallenged by regulators, as it did not appear to restrict the availability of automobiles to consumers in the United States.

Herfindahl-Hirschman Index Guidelines

W hat is a company’s share of the market after a merger? That figure is one of the components of the Herfindahl-Hirschman Index (HHI), which regulators and others use to evaluate market share. The HHI is the sum of squares of the market shares of constituents of a postmerger market. In simpler terms, consider a market in which companies A, B, C and D are the key players and their shares of the market are 10%, 20%, 15%, and 25%. The HHI would be (10 X 10) + (20 X 20) + (15 X 15) + (25 X 25) = 1,350.

Postmerger HHI below 1,000. The Department of Justice regards markets with HHIs below 1,000 as unconcentrated. Mergers resulting in unconcentrated markets are not likely to have adverse competitive effects and ordinarily require no further analysis or a court challenge.

Postmerger HHI between 1,000 and 1,800. The Department of Justice regards this range to be moderately concentrated and open to scrutiny. A merger that produces an increase in the HHI of less than 100 points in a moderately concentrated market would be unlikely to have adverse competitive consequences and ordinarily require no further analysis. Mergers producing an increase in the HHI of more than 100 points in moderately concentrated markets potentially raise significant competitive concerns.

Postmerger HHI above 1,800. The Department of Justice regards markets in this range to be highly concentrated. However, if the merger pushes up the HHI less than 50 points, even in a highly concentrated postmerger market, it is unlikely to have adverse competitive consequences and ordinarily requires no further analysis. Mergers producing an increase in the HHI of more than 50 points in highly concentrated postmerger markets potentially raise significant competitive concerns. In cases where the postmerger HHI exceeds 1,800, mergers producing an increase in the HHI of more than 100 points are likely to overwhelm the market.

WHAT’S A COMPANY TO DO?

So why does it seem that nearly every day we read of regulators challenging a merger? It may be that many companies don’t consider the economics and legalities of antitrust until after the deal is done. It’s not until the merger comes up for approval that much of the probing starts. “The extent of analysis that happens before the deal is usually pretty limited,” says Arnold Lowenstein, a vice-president and economist at Charles River Associates. “It is common that dealmakers don’t properly analyze the up-front antitrust issues in the same depth that they look at the financials. They’ll beat the financials to death. They’ll think about synergies and technology assessments and all kinds of business analysis. But when it comes to the antitrust side of it, it’s basically, ’My attorney says it’s okay.’”

Antitrust issues can be complicated and may be outside the realm of some financial and legal advisers. Companies sometimes spend many millions of dollars to acquire or merge with another company only to find that their deal created an anticompetitive situation that their financial or legal advisers failed to recognize. Companies that wait until they are in the midst of the Department of Justice’s approval process to bring in economic consultants who specialize in antitrust issues may find themselves disappointed. A merger may get a quick thumbs-down simply because the investment banker and attorneys were not familiar with the economics of antitrust.

Looking forward, antitrust market-share issues will become more important as industries concentrate. “It’s not because the antitrust rules are changing,” says Lowenstein. However, once an industry has shrunk from several players to a few, when the next deal will shrink it even further, “it’s going to run into roadblocks.” If a deal is not given sufficient forethought, Department of Justice approval may be contingent on restructuring of the newly proposed merger or divestiture of certain product lines. This can result in 10% to 20% increases in the cost of the merger. A smart company planning to merge or acquire will work with economic and legal counsel to ensure compliance at the outset of the deal. Solid economic advice up front can save money down the road.

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