Merger Arbitrage Hedge Funds

Trans-Atlantic antitrust risk analysis

Maria Regalado, Solicitor and Managing Director of Merger Antitrust Review
Originally published in the December 2005 issue

In this article Merger Antitrust Review analyses the impact that merger antitrust analysis by the US and the EU authorities has on the profitability of merger arbitrage hedge funds' strategies. The article reviews the disagreement between the US and EU merger authorities in one of the largest trans-Atlantic failed mergers of the last few years, the GE/Honeywell case, and it provides an outline of the main tools that the EU authorities use in their decision to approve or block mergers following the adoption in 2004 of the new European Merger Regulation (Council Regulation (EC) No 1392004 of 20 January 2004)

Merger Arbitrage; the role of antitrust analysis

Mergers and acquisitions are heating up again, after a three-year period of low activity brought on by the slump in US economy. The new boom in activity in Europe as company profits soar, has turned the spotlight on hedge funds that use merger arbitrage investment techniques. Merger arbitrage fund managers invest in companies involved in a merger or an acquisition. In an acquisition or merger situation, a merger arbitrage fund will analyse 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. The stock of the target company will most times trade at a discount, since all mergers and acquisitions take time to complete, and there is always a risk that the acquisition/merger will not be completed.

When a merger or an acquisition is pending, uncertainty about its outcome 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 is completed. If the merger or acquisition completes in the way the arbitrageur anticipates, profits will be made from the long position; if a merger encounters obstacles that prevent or substantially delay its closing (usually antitrust obstacles), the profit opportunity will be lost. It is important for merger arbitrageurs to decide at a very early stage (sometimes as early as the news about an anticipated merger or acquisition are made public) whether or not they are to make an investment on a merger or acquisition.

The performance of a merger arbitrage hedge fund greatly depends on its ability to assess the probability of a merger or acquisition success or failure, or of delays in completion. The risk analysis process followed by arbitrageurs leading to an investment decision involves examining in detail the regulatory antitrust issues in the US and in 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 informed of the possibilities of delays in the grant of antitrust approval due 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. In this last regard, sometimes divestitures required by the antitrust authorities may be so draconian that the parties may opt for abandoning the merger.

An informed analysis at an early stage (i.e as soon as the merger is announced) of the most likely view to be adopted by the antitrust authorities will result in merger arbitrage hedge funds either making an investment (if the antitrust risks are low or non-existent), or in 'passing' on that particular merger because of the identified problems or roadblocks with the grant of the necessary antitrust approvals. Arbitrageurs continually evaluate the risk level of each deal on a day-to-day basis. As a result, at any time, they may decide to initiate, increase, reduce or eliminate an investment based on the risk assessment at that time. Sometimes merger arbitrageurs 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.

The GE/Honeywell case: a trans-Atlantic merger that failed due to antitrust prohibition in the EU

It is clear that antitrust risks in the US and/or in the EU are critical for merger arbitrage hedge funds, since the profit opportunity may vanish if the US and/or EU antitrust authorities deny or delay the necessary authorisation to complete the deal. It is important to note in this regard that US antitrust approval of a deal does not guarantee that the same deal will be approved by the EU antitrust authorities (the European Commission). Some merger arbitrage funds learnt 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 United States Department of Justice announced that it had reached an agreement with General Electric Company 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

"such integration [i.e GE/Honeywell] would enable the merged entity to leverage the respective market power of the two companies in the products of one another. This would have the effect of foreclosing competitors, thereby eliminating competition in these markets, ultimately affecting adversely product quality, service and consumers' prices".
Jack Welch, then CEO of General Electric, said, "The European regulators' demands exceeded anything I imagined and differed sharply from antitrust counterparts in the US and Canada."

How could merger arbitrageurs have figured out in 2001 that a merger already approved in the US would not only face antitrust obstacles in the EU, but it would be blocked by the European Commission? First and foremost, despite existing co-operation agreements between the US and EU antitrust authorities in relation to review of mergers notified for clearance in both jurisdictions (Agreement 1995 OJL 9547), 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 United States and the EU merger regimes. In particular, whilst the EU antitrust regulators are more likely to block deals that they fear will cause market leading firms to become even more effective competitors, on the other hand and in contrast, in the United States lower prices resulting from mergers are welcome, even in those cases in which the merging parties are market leaders and they are likely to gain market share as a result of the merger.

After GE/Honeywell: the new European Merger Regulation. A real change in merger antitrust analysis in the EU?

On May 1 2004, the original EU Merger Regulation applied to GE/Honeywell (Regulation 406489) was replaced by EU Regulation 1392004 (the new European Merger Regulation). The question that this legislative change raises for merger arbitrage hedge funds is whether under the new EU Merger Regulation, the antitrust standard to be applied by the European Commission to mergers differed from the standard applied to block GE/Honeywell, and whether the risks of conflicting merger decisions in the US and the EU still require a separate and isolated analysis of EU antitrust risks.

As with Regulation 406489, under the new Merger Regulation a merger or acquisition involving parties whose turnover is above relevant thresholds (regardless of the companies' nationality) has to be notified to the European Commission, and cannot be completed before clearance is obtained. Failure to notify a merger or acquisition, or closing of the transaction before a clearance decision, or breach of a prohibition decision, can result in fines imposed by the European Commission of up to 10% of the aggregate world-wide turnover of the parties involved.

Once the merger is notified, the European Commission conducts 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 writing to 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 during this initial phase 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 either be 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 even more, with the subsequent negative effect on the spread of the deal.

One of the main changes introduced by the new European Merger Regulation is a new test that the European Commission now applies to the appraisal of mergers and acquisitions. Whilst the 'old test' was whether a merger would create or strengthen a dominant position, the new Merger Regulation provides that mergers which would significantly impede effective competition, in particular as a result of the creation or strengthening of a dominant position, shall be declared incompatible with the European Common Market and prohibited. This new standard is based on an economic analysis of how the markets operate, and it should bring the EU merger test closer to the US standard, which prohibits mergers when the effect "may be substantially to lessen competition, or to tend to create a monopoly". It has been said on the other hand that this new test is intended to empower the EU to block more mergers, such as those involving an oligopolistic market, even if the merged company would not be truly dominant or necessarily even much larger than the remaining competitors.

What merger arbitrage hedge funds can expect from the EU antitrust authorities in 2006

Whilst the European Commission has used the new standard to block a merger involving EU companies (acquisition of Gas de Portugal by EDP and ENI, on December 9 2004), it has still to be seen what the effect will be of the application of the new EU test to a merger already approved in the US, which may raise antitrust objections in the EU. The acquisition of Reebok by Adidas, approved by the US authorities in October 2005 and yet to be assessed by the European Commission, is likely to test whether in practice the new EU regime is now closer to the US antitrust analysis of mergers and acquisitions.

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.

Merger Antitrust Review is a consultancy providing unique expert EU antitrust analysis and counselling to risk arbitrage fund managers and third parties, for whom antitrust analysis is key in the success of their investment and trading strategies. Merger Antitrust Review's analysis and counselling services embody perspectives from senior EU antitrust lawyers with years of experience in making merger notifications to EU and national antitrust authorities, and in advising risk arbitrage managers at a large law firm in London.