UK: The Impact of EU And US Antitrust Analysis On Hedge Funds

By Maria Regalado, Founder and Managing Director of Merger Antitrust Review, London

After a three-year period of low merger activity brought on by the slump in US economy, mergers and acquisitions are daily news again. The new boom in activity, with bids announced almost weekly (Linde/BOC, Mittal Steel/Arcelor, PSA/P&O), has turned the spotlight on hedge funds that use merger arbitrage investment techniques.

Deals that go as anticipated can result in profitability for hedge funds. In recent years, however, several mergers that showed great promise, involving companies that have businesses in the European Union, foundered when European Commission either prohibited or delayed them, even in cases where the US antitrust authorities had approved the same merger. GE/Honeywell is the most dramatic example.

These cases—GE/Honeywell being the most dramatic example—strongly suggest that a separate assessment of the EU antitrust implications of deals notified for approval in the US and the EU is essential in order to ascertain whether regulatory risks may prevent a deal from closing.

In an acquisition or merger situation, a merger arbitrage fund will analyze the announced merger/acquisition, and if it finds favourable risk/return factors, it will usually go long the stock of the company being acquired, and short the stock of the acquiring company. Most times, the stock of the target company will trade at a discount, since all mergers and acquisitions take time to close, and there is always a risk that the acquisition/merger will not be completed.

Prior to its closing, uncertainty about the outcome of an announced merger or acquisition results in a pricing disparity between the price of the acquiring company’s stock, and the price of the target company’s stock. Merger arbitrage hedge funds make investment profits when they successfully anticipate the outcome of an announced merger or acquisition, and capture the spread between the current market price, and the price at which the stock will be trading after the merger closes.

If the merger or acquisition closes in the way the hedge fund anticipates, profits will be made from the long position. On the other hand, if a merger encounters obstacles that prevent or substantially delay its closing (usually antitrust obstacles on both or either side of the Atlantic), then the profit opportunity is lost.

The profitability of a merger arbitrage hedge fund greatly depends on its ability to assess the probability of a merger’s success or failure, or of delays in completion. The law in the US and in the EU requires mergers involving companies with high turnover to be notified to the antitrust authorities for merger clearance, and it obliges the merging parties to suspend the deal until antitrust approval has been granted.

The risk analysis process followed by hedge funds leading to an investment decision involves examining in detail the regulatory antitrust issues in the US and the EU that could affect the timing (i.e., delays due to an antitrust in-depth investigation of the merger), or even the ultimate closing of the deal (i.e., an outright prohibition by the antitrust authorities banning the parties from closing the deal). The focus of this stage is to eliminate deals that are riskier for merger arbitrage funds in the sense that they are deals with a lower probability of being completed because of antitrust objections in the US and/or the EU. In addition, hedge funds need to be aware of the possibilities of delays in the grant of antitrust approval owing to the authorities’ need to investigate the antitrust impact in more detail and/or require the parties to offer divestitures as a condition of clearance.

Expert analysis by EU and US antitrust lawyers at an early stage (i.e., as soon as the merger is announced) will result in merger arbitrage hedge funds either making an investment (if the conclusion is that antitrust risks are low or nonexistent), or in "passing" on that particular merger because the identified problems or roadblocks with the grant of the necessary antitrust approvals.

Hedge funds and their antitrust counsel continually evaluate the risk level of each deal on a day-to-day basis. As a result, they may decide at any time to initiate, increase, reduce or eliminate an investment based on the risk assessment at that time. Sometimes hedge funds invest in a deal, only to decide later to sell the stock previously bought because new antitrust regulatory risks (e.g., third parties’ complaints against the merger based on antitrust grounds) pose a threat or a substantial delay in the closing of the deal.

Under the European Merger Regulation, the European Commission has the power to veto mergers that would significantly impede effective competition, in particular as a result of the strengthening of a dominant position (i.e., where the merging parties’ combined share would be 40% and above).

Once a merger is notified in the EU, the European Commission will conduct a "Phase I" enquiry (lasting a maximum of 35 working days), during which it will consider the arguments proposed by the companies involved in the merger, and "market test" them with third parties. This involves seeking views from customers, competitors, trade associations and suppliers.

Should the Commission’s assessment reveal that the merger is compatible with the EU market, it will clear the transaction after 25 working days. If on the other hand the Commission identifies antitrust concerns that it considers can be resolved with divestitures, an additional 10 working days will be added to Phase I, and during this extended period the Commission and the parties will negotiate the divestments required to solve the Commission’s concerns.

The outcome of that extension will be either a clearance decision, or if negotiations between the Commission and the parties fail, the opening of an in-depth "Phase II" investigation by the Commission, which may last six months or longer, with the attendant negative effect on the spread of the deal.

US antitrust approval of a deal does not guarantee that the same deal will be approved by the European Commission. Some hedge funds learned that lesson the hard way in the failed merger between GE and Honeywell, a well-known example of trans-Atlantic antitrust divergence in the analysis of trans-Atlantic mergers.

On May 2 2001, the Antitrust Division of the US Department of Justice announced that it had reached an agreement with General Electric Co and Honeywell International Inc that resolved the US antitrust concerns with the companies’ proposed merger. On July 3 2001, the European Commission announced that it had determined to prohibit the transaction. According to the European Commission’s press release announcing its prohibition decision:

Jack Welch, then chief executive of GE, said, "The European regulators’ demands exceeded anything I imagined and differed sharply from antitrust counterparts in the US and Canada."

How could hedge funds have figured out in advance that a merger already approved in the US would not only face antitrust obstacles in the EU, but also be blocked by the European Commission? First and foremost, despite existing cooperation agreements between the US and EU antitrust authorities in relation to review of mergers notified for clearance in both jurisdictions, the divergence in the antitrust authorities’ views exposed in GE/Honeywell in 2001 was rooted in fundamental substantive and economic differences in antitrust analysis between the US and the EU merger regimes.

In particular, while EU antitrust regulators are more likely to block deals that they fear will cause market leading firms to become even more effective competitors, their US counterparts in contrast welcome lower prices resulting from mergers, even in those cases in which the merging parties are market leaders and are likely to gain market share as a result of the merger.

On December 14 2005, the European Court of First Instance ruled on GE’s appeal against the Commission prohibition decision in 2001. Although the Court upheld the Commission’s decision on the grounds that a dominant position would have been created (in fact the merged GE/Honeywell would have been a monopolist in certain markets given that both parties had high market shares in these overlapping markets), the Court stated that the Commission made manifest errors of assessment with regard to the effects of the merger on particular markets, especially in its analysis of conglomerate effects resulting from the concentration.

The theory of conglomerate effects used by the Commission to show dominance, has two aspects to consider in the assessment of a merger:

• Vertical integration. This theory seeks to establish the dominance of a merged entity by arguing that market strength held by company A party to the merger in one market can be used to "leverage" market strength of the other party, company B, in another market. The problem with this argument, according to the Court, was that it involves guesswork on the part of the Commission as to what the merged company may or may not do in the future and how markets will evolve.
• Bundling. Here the argument is that after the merger, the company could make the sale of a product produced by company A dependent on the buying of a related company B product—producing dominance. 

The Court stated that on the facts of the case, there was not enough evidence to prove that the merged GE/Honeywell would have behaved in this manner in the future and it ruled that the Commission was wrong to prohibit the merger on these grounds.

The December 2005 judgment is likely to make it difficult for the European Commission to use the conglomerate effects theory against future mergers.

In addition, it is important to note that the European Court addressed in its judgment the issue of why antitrust authorities in the EU and the US had come to different conclusions. The Court found that the fact that US authorities had approved the GE/Honeywell merger with only minor remedies was not relevant for the purposes of the EU analysis of the same deal. The Court said:

Against this background, given the extent to which EU antitrust risks can affect the spread, it is absolutely essential for merger arbitrage hedge funds to be informed at an early stage of the risk of an antitrust prohibition, or a delay in the closing of the deal caused by EU antitrust objections.

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