Antitrust and Food M&A: Lessons Learned and a Look Ahead

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By Eleanor Tyler

A tsunami of proposed food, beverages and agriculture mergers in recent years has not resulted in increased antitrust scrutiny by federal regulators but the percentage of deals being challenged may increase as industry consolidation spreads.

The Federal Trade Commission and the Department of Justice, the two agencies tasked with reviewing mergers to ensure active market competition, have reviewed fewer than a dozen of these proposed deals in the past five years.

The most basic measure the antitrust agencies use to gauge whether a tie-up will reduce competition in a given market requires a look at the number of competitors remaining in the market and the market share they could collectively wield against the proposed combined firm.

The more companies combine, the greater the likelihood that any two merging companies will overlap in some market that could draw regulatory scrutiny. If market conditions are already “highly concentrated,” regulators are likely to be even more concerned about each incremental merger.

Number of public deals

What factors are most important in the antitrust analysis of a proposed merger? What can merging firms do to reduce the risk their deal will meet resistance at the FTC or DOJ?

Some hints about regulators' current concerns can be gleaned by looking at deals challenged in the past.

A look at current merger trends may provide some insights into issues that could affect regulators' view of future mergers.

Merger Review

According to the Food Institute, the food industry alone saw 410 deals in 2015—fewer deals than in 2014, but with more emphasis on large deals with direct competitors.

Of course, it is exactly those deals that face mandatory review at DOJ or the FTC under the Hart-Scott-Rodino Act, 15 U.S.C. §18a. Under the HSR Act, the agencies review deals that meet adjusted thresholds based on size of the deal or size of the parties to the deal.

The HSR is, at its heart, a waiting period: The parties notify the antitrust agencies of the proposed deal and cannot make moves to consummate the deal until the agencies terminate the waiting period early or the waiting period expires. Technically the waiting period is 30 days. If the agencies ask for more information on a merger, however, they can get an extension of time to review it. That “second request” for information on a merger signals a concern about the merger.

In practice, merger review can last months if a company receives a second request: oilfield services companies Halliburton Co. and Baker Hughes Inc. announced their proposed merger in November 2014; the Department of Justice sued to block the $28 billion merger after more than a year of negotiation with the companies on April 6, 2016. A judge blocked Sysco Corp.’s planned takeover of US Foods Inc. on June 23, 2015—a year-and-a-half after the parties announced the proposed deal in December 2013.

Section 7 of the Clayton Act, 15 U.S.C. §18, prohibits mergers if “in any line of commerce or in any activity affecting commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly.” The agencies' bottom line is “that mergers should not be permitted to create, enhance, or entrench market power or to facilitate its exercise.”

A number of factors are involved in the agencies’ analysis of market power and the types of competitive conditions that facilitate its exercise. The agencies look at market shares for the merging companies, market shares for rivals, how easy it is for new competitors to enter each market where the two merging companies compete and what alternatives exist for customers pushed by rising prices.

This is an inherently fact-intensive inquiry. The agencies decide in each case the specific products that constitute each market, and the geographic scope of distribution for those markets. The agencies’ Horizontal Merger Guidelines, published in 2010, provide an exhaustive overview of that process.

In recent challenged food and beverage mergers, several points of contention in how the companies view their mergers and how the agencies view them stood out.

Public Deals
Sysco/US Foods: Markets Matter

Sysco's proposed merger with US Foods is a poster child for a challenged merger involving two dominant competitors with a nationwide scope of operations. Sysco announced in December 2013 that it would buy US Foods for $3.5 billion in cash and stock and take on $4.7 billion in debt from US Foods, for a total purchase price of $8.2 billion. They expected to close in the third quarter of 2014.

Sysco maintained that the market in which it and US Foods operated was highly competitive, and that the new combined company, with roughly 30 percent of that overall market, would not be able to raise prices. “The foodservice distribution industry is highly competitive and is a mature industry characterized by slowing revenue growth,” Sysco said in securities filings. “Increased competition from nontraditional sources, such as club stores and commercial wholesale outlets with lower cost structures, group purchasing organizations or consolidations among competitors have served to further increase pressure on the industry’s profit margins. … We expect these trends to continue for the foreseeable future.”

After the FTC started analyzing the merger, however, Sysco announced that it was prepared to divest 11 U.S. food distribution centers to the third-largest foodservice company, Performance Foods Group. Performance had 5 percent of the market in the broader foodservice sector in the year preceding the merger, and Sysco considered Performance a viable owner for any assets that the antitrust regulators required Sysco/US Foods to shed. The assets Sysco proposed to divest were worth $4.6 billion in sales, according to Sysco.

By February 2015, the FTC and 11 state attorneys general sued to block the deal. The FTC proposed defining the impacted market as nationwide broadline foodservice distribution, a definition based on what specific customers in that market need in a distributor. The FTC argued that Sysco and US Foods are the only broadline foodservice distributors with nationwide coverage. It estimated that, post-merger, Sysco would have 75 percent of sales of broadline foodservice distribution to national customers, with the next largest competitor weighing in at 11 percent. Such a concentration is generally viewed as prohibitively high by the agencies, and the FTC here saw no possible remedy to the anticompetitive effects of the deal.

The national scope of the definition doomed Sysco's proposed divestitures because they only affected smaller, regional markets. The divestitures were intended to beef up the next competitor in foodservice sales in local or regional markets where Sysco and US Foods were the main competitors. But by focusing on the scale of Sysco’s operations nationwide, and the fact that only US Foods had something close to comparable scale, the FTC proposed a market in which only truly massive, systemwide divestitures would create a viable competitor.

Sysco fought that market definition in court, but in June 2015 the U.S. District Court for the District of Columbia agreed with the FTC’s analysis and enjoined the merger pending the FTC’s administrative challenge. See FTC v. Sysco Corp., 113 F. Supp. 3d 1, 2015 BL 205410 (D.D.C. 2015). Sysco abandoned the deal shortly thereafter, paying millions of dollars in break-up fees to both US Foods and Performance Foods Group for the terminated deals.

What went wrong? Sysco came into the deal prepared to shed assets, and had found and locked in a viable purchaser. Under the normal model of getting a merger through antitrust scrutiny, this was very sensible preparation. Sysco and US Foods looked at their business and saw where they had overlapping facilities and no real competitors post-merger. They were prepared to sell assets to someone who could step into the competing role in those discrete locations.

In most mergers this would have been enough: For example, DOJ on March 31 agreed to approve the merger of records management companies Iron Mountain Inc. and Recall Holdings Ltd. after the companies agreed to sell Recall's document storage facilities in 15 cities to some to-be-determined purchaser.

Supply and Demand

There are at least three important insights in the Sysco saga for competitors looking to merge.

First, the FTC defines markets fundamentally differently than a business might. Just because a company books revenue from different regions or profit centers does not mean that the antitrust agencies will view the market in the same segments.

The FTC will look at substitutability between products: that is, they look at what a customer will buy if the price on its preferred product goes up too much. That inquiry is about how the customer views the market and the shape of customer demand, not about supply. The FTC's normal investigation includes sending detailed questionnaires to merging companies' customers and rivals. If the agency gets information about how customers view the company's products that the company did not foresee, the company can get blindsided by the agencies' take on the market impacts of its merger.

Public Deals

When breaking out market segments, therefore, it helps to consider different price points and order bundles that various customers enjoy. The market segment the FTC focused on in this merger—and then in its current challenge of a proposed merger between Staples Inc. and Office Depot Inc.—involves sophisticated customers that aggressively negotiate their supply contracts. Antitrust analysis might not focus on smaller customers seemingly most at risk of a higher price for lack of bargaining power: “Competition” includes a business's most powerful customers and the lowest price they can negotiate.

Second, are the two merging companies the first and second largest in a given market or is the relevant market going from three main competitors to two? Expect a challenge. Because of the basic math behind reviewing a merger for anticompetitive impacts, some mergers will always appear more potentially damaging to competition than others. Some markets are already highly concentrated before the merger, and other mergers create a sudden jump in the concentration of a given market that will draw antitrust scrutiny.

As markets become more concentrated, the agencies challenge more deals. And markets are broadly more concentrated than they have been in the past, according to the White House Council of Economic Advisers. Measured in revenue share for the top 50 firms, the council found that wholesale trade and upstream agricultural supply industries became substantially more concentrated between 1997 and 2012. For example, the Council pointed to economic census data showing that the largest 50 firms in wholesale trade earned $2.183 trillion collectively in 2012, a 27.6 percent share of the overall market and 7.3 percent more than the share they held from 1997 to 2012.

Although Sysco looked at its broader market and saw itself with a 30 percent post-merger market share, it apparently failed to take into account both the broader competitive market in which it operates, which might overall have become less competitive, and discrete markets within its service range in which it is a dominant player. The antitrust agencies, pursuant to the Clayton Act, are looking at the possibility of reduced competition “in any line of commerce or in any activity affecting commerce in any section of the country.” They will take multiple markets into account in their analysis and may also consider upstream and downstream effects from a proposed deal.

Also, the agencies are increasingly challenging deals in markets that are already concentrated. According to Northeastern University Professor John Kwoka, proposed mergers in markets going from five players to four were challenged about 64 percent of the time between 1996 and 2011, but the risk went up slightly as the years progressed. From 2008 to 2011, mergers that reduced competition from four players to three were challenged 90 percent of the time, whereas that rate was closer to 70 percent from 2004 to 2007, Kwoka told Bloomberg News in April 2016.

Finally, if Sysco could have predicted a high level of antitrust scrutiny, it could have taken precautions by better defining the parties' risks and obligations in the asset purchase and sale agreements. While explicitly laying out risk shifting raises a concern about giving regulators a “roadmap” to problem business lines or assets that the parties are prepared to divest, parsing the risks prior to a formal challenge can be valuable enough to outweigh any potential costs.

If the antitrust regulators reject the parties' negotiated divestitures, as they did with Sysco, other provisions of the agreement need to reflect that potential risk. Obviously, the termination clause and any “ticking fees” should take into account the risks to both parties of having to wait more than a year to close or not closing at all. There might be benefits to explicitly allocating the risk of various stages of the review process, from the high costs of responding to a second request, to the costs of delaying the merger, to the litigation costs involved in fighting to save the deal in the face of an antitrust challenge. Parties also should be careful to define “best efforts” in complying with any regulatory hurdles.

Parties also increasingly include reverse termination fees, which pay the target if the deal fails on regulatory review, in their agreements. Sysco paid $300 million, or roughly 8.5 percent of the $3.5 billion stock and cash portion of the deal, to US Foods as a reverse termination fee when the deal collapsed. While details of the negotiation process aren't available, that high of a fee may imply that Sysco didn't adequately foresee headwinds to the deal. Indeed, Sysco paid a $12.5 million fee to Performance Food Group when the divestiture deal they negotiated fell through.

Trends to Watch

Along with increased concentration in many industries, there are a few trends specific to the food and agriculture industry worth watching.

Private equity has been very active in food and agriculture in the few past years, and experts expect the trend to continue. According to Bloomberg analysis, the average premium for sellers in food industry deals over the past five years has been around 43 percent. Worldwide, the premium is 24 percent. While premiums are rich, smaller companies that are innovating in the healthier foods space often have an overall low price tag, and private equity funds are looking at projected growth in those areas and seeing profit.

But PE firms are also snapping up large food companies. Warren Buffett's Berkshire Hathaway Inc. bought H.J. Heinz Co. with 3G Capital in 2013 and then, in the largest food industry merger of 2015, combined it with Kraft Food Group Inc. Bloomberg Gadfly reported in March 2016 that 3G may be looking to purchase Mondelez International Inc., which split from Kraft in 2012, or General Mills Inc. Apollo Global Management LLC announced plans to buy grocer The Fresh Market Inc. for $1.4 billion in March 2016.

On May 3, 2016, the FTC cleared Peak Rock Capital Fund LP's purchase of Diamond Crystal Brands Inc. from Hormel Foods Corp., in Peak Rock's fourth recent food-related investment. It already owns Natural American Foods, a honey producer; Berner Food & Beverage, which makes dairy-based shelf-stable snacks and beverages; and Highline Mushrooms.

While initial purchases in the food and beverages sector clear antitrust hurdles easily, funds may face resistance as they increase their holdings. The antitrust agencies will look at overlap in all markets served by each company, as well as overlaps in control and management, and the added complexity of multiple holdings in the same industry can add time to the analysis even with no potential problems.

The antitrust agencies have done this before. In 2006, the FTC challenged The Carlyle Group and Riverstone Holdings LLC's plan to take energy services company Kinder Morgan Inc. private. The FTC alleged the $22 billion deal would threaten competition between Kinder Morgan and Magellan GP LLC, a competing midstream energy company that Carlyle and Riverstone already controlled. The parties reached a consent order with the FTC in early 2007 allowing the deal, but the PE funds had to become passive investors in Magellan, ceding control of the company to another principal investor and removing their representatives from the Magellan board.

Another trend that bears watching is vertical integration, which presents different challenges at the antitrust clearance stage than horizontal integration.

Vertical mergers, which involve companies in a buyer-seller relationship, are challenged less often than horizontal mergers. Such deals don't usually remove a competitor from the market, and often they yield real efficiencies that can translate to lower prices in the market.

But vertical mergers in the food and agriculture industry have added dimensions. In addition to securing access to potentially scarce resources, vertical integration may also be used to control food safety along supply and distribution chains. In an environment of short supply, antitrust regulators will take a hard look at whether a merger will give the buyer the “ability and incentive to limit its rivals' access to key inputs or outlets.” When too many players are scrambling for the same resources, eventually a market power problem can develop.

A recent example is Tyson Foods Inc.'s $8.5 billion purchase of Hillshire Brands Co. in July 2014. Both companies make processed, packaged meat products. But the Department of Justice's antitrust review of the merger focused not on retail competition where the two companies face each other head-to-head, but on supply and distribution of sows.

DOJ filed a complaint by August 24, 2014. It focused on where Tyson and Hillshire compete against each other to buy sows from U.S. farmers. Tyson bought sows and resold them to packers, including Hillshire, through its Heinold Hog Markets division. Hillshire purchased most of its sows directly from farmers and, instead of reselling them, used them to make sausage. Hillshire was, therefore, both a customer and a competitor of Heinold's. It also meant that Heinold and Hillshire technically have a vertical relationship.

But Heinold and Hillshire combined would be buying so many sows they would be able to drive down the price to farmers, who would have fewer outlets for sows post-merger, DOJ said. Sausage makers don't buy from farmers directly because they value the sorting and weighing services marketers like Heinold provide at buying stations. It would be time-consuming and costly for an entrant to establish new buying stations, the DOJ said. As a result, other sausage makers couldn't turn elsewhere if Heinold raised the price it offered.

In short, the DOJ complaint implied that, not only could the combined entity push down the prices it paid to farmers for sows, but Heinold could also charge sausage makers supracompetitive prices that wouldn't similarly affect Hillshire because of its direct supply of sows. Heinold could, therefore, pocket outsized profits by squeezing farmers on one hand and its slaughtering customers on the other. As a solution, DOJ required Tyson to divest the entire Heinold division in order to purchase Hillshire.

As companies look to sew up a dedicated source of supply for critical agricultural inputs, or to own their distributors to control quality, DOJ and the FTC might see the same potential for squeezing competitors in other mergers.

Conclusion

Many U.S. industries are becoming more concentrated, and the food and beverages industry is no different.

As concentration increases, each successive merger in a market draws more scrutiny. Even if past mergers in a given market have sailed through regulatory review, parties to a purchase and sale agreement should carefully consider what they will do if they encounter antitrust resistance and negotiate those risks in the deal.

Understanding potential pitfalls of the process involves knowing both the business and its customers' needs. Of course, that is valuable knowledge without the spectre of a regulatory review when two companies look to merge or buy or sell assets.

To contact the reporter on this story: Eleanor Tyler in Washington at etyler@bna.com

To contact the editor responsible for this story: Tiffany Friesen Milone at tmilone@bna.com