It’s interesting to see that the Biden Administration is planning to take the private equity industry down a peg or two by going after some of its strategies to gain market power by engaging in consolidation plays, also known as roll-ups. The Department of Justice intends to lodge more anti-trust challenges, as Jonathan Kanter, head of that unit, told the Financial Times.
We’ll turn to what Kanter said shortly, but the article was not as clear as it could have been on how consolidations increase the profits of the merged companies at the expense of consumers. Some methods are legal or at least don’t run afoul of anti-trust laws. Cutting costs, lowering headcount, or reducing product quality are all kosher unless the expense reduction came about via some sort of collusion or bid-rigging with other buyers (think the Silicon Valley wage-fixing case). But rollups don’t produce benefits only on the outlay side of the ledger. They can also produce pricing power. We’ve seen many examples of this, such as private equity coming to dominate certain kinds of veterinary products and supplies and jacking up their prices.
The Federal government has been asleep at the switch in antitrust enforcement for years, so it’s not clear how well this effort to implement new and more creative enforcement strategies will go. When an agency is trying to cut new ground, sometimes due to changes in commercial practices or technology, the courts can be slow to catch up. And lawyers often have to lose a few cases before they figure out the strategies and arguments that have the best shot at prevailing.
So a cynic might say that even though the private equity industry could get mighty offended by being called bad names by the Biden Administration (the firms take umbrage at mere slights)
So there’s a second question here: whether the DoJ has the support of the Administration, as well as a long enough runway, to start to make progress. 2024 is a long way away, but the odds of Team Dem hanging on to the White House do not look good. So private equity firms may simply need to wage a war of delay (not hard since big cases tend not to move quickly) since they may be bailed out by regime change.
Another issue is that antitrust case have historically revolved around measures of industry concentration, with a lot of fighting about what the boundaries of the industry actually are. Kanter’s ideas sound awfully far afield. But perhaps he is hoping to surmount summary judgement/motion to dismiss and then root around in acquirers’ files. I am sure there are lots of damning admission, both in marketing materials to investors and in analyses presented to lenders, about profit improvement strategies that depend on what the law would deem to be price fixing and/or market manipulation.
Key sections from the Financial Times piece:
“Sometimes [the motive of a private equity firm is] designed to hollow out or roll up an industry and essentially cash out,” Jonathan Kanter, head of the DoJ’s antitrust unit said in an interview with the Financial Times. “That business model is often very much at odds with the law and very much at odds with the competition we’re trying to protect.”
Let’s stop here. Kanter seems to be objecting to leveraged buyouts as well as consolidation plays. Sadly mere asset-stripping is not illegal, even though it’s a common approach. At a 50,000 foot level, the larger deals, which consume the majority of capital commitments, are leveraged buyouts, in which the investor returns come mainly from the use of leverage, cost reduction (even to the point of damaging the franchise), selective asset sales, and other financial engineering. At the other end of the spectrum, private equity firms buy smaller companies and profess to add value in helping them grow faster, say by giving them capital or access to other resources so they can expand (think a regional product going national).
However, industry contacts say that the apparent success of smaller company growth plays comes less from the private equity buyer improving the operation of the company, and more from them simply being good at buying “growth-y” companies. Financial Times reader Heavy Hearted American provided confirmation:
I do work on many P/E deals. P/E firms are nothing more than an intermediary between actual owners. In 15 years, I’ve never seen a P/E firm take an underperforming company and make it profitable again. That’s just a fantasy. Most P/E targets already have strong cash flows and low debt. Plus most “finance guys” have no idea how to run the operations of a real business.
Generally, I see P/E firms take out large debt with a balloon payment, usually 5 years out. The added interest and goodwill amortization costs makes all of them unprofitable from a GAAP accounting standpoint. Even rarer is to see cost cutting and efficiency gains offset the added interest burden. Any free cash flow, which is usually very little, is sucked up in management fees and distributions. The hope is that in 5 years when the bills come due from the bank, their is a deeper pocked buyer waiting in the wings. with a higher valuation in mind.
A later section from the story:
In one of his first speeches following his appointment, Kanter warned the DoJ would seek to block more anti-competitive deals rather than pursue complex settlements and lamented a “dearth” of lawsuits addressing monopolistic behaviour, counting a 20-year gap between big cases….
One area of focus for the agency is “interlocking directorates”, where executives from a buyout group sit on the boards of multiple, competing companies they own or control. Such governance arrangements could violate a section of the 1914 Clayton Antitrust Act, Kanter said, adding: “We’re going to enforce that.”
He also said the DoJ would pay closer attention to private equity’s role as a buyer of assets when the agency orders companies that are merging to divest assets in order to preserve competition. Kanter has said such a solution is often less effective than blocking the deal outright…
Antitrust agencies are looking for ways to increase scrutiny of private equity. For instance, the DoJ and the FTC are in the process of changing pre-merger notification forms to toughen up disclosure requirements. “[We’re] making sure that we get more information upfront to help us understand . . . the full competitive picture,” Kanter said.
Despite my skepticism, these ideas have merit. Moderately sizeable deals and bigger are subject to Hart Scott Rodino pre-merger filings, and the FTC can object to or oppose deals it view as anti-competitive. The normal remedy for a deal that has HSR problem is usually the divestiture of an offending bit or two, but the new sheriffs are inclined to be less accommodating. So this approach could make a difference. The Clayton Act angle could also give private equity firms heartburn.
However, here is where a new DoJ/FTC approach could fall short:
Experts said applying existing antitrust laws to private equity could be challenging given they are largely tailored to bilateral tie-ups. That is often incompatible with the private equity model, which involves building portfolios with a string of companies that relate to each other in a multitude of ways.
If the Feds block a merger based on an argument of coordinated activities and a private equity firm sues, the Feds would be asking a court to make new law. That’s the concern I expressed above, that it often takes several attempts to perfect a legal argument and also find a good fact set. And agencies can lose their nerve if they suffer a high-profile early defeat. We saw this in the financial crisis where the SEC and DoJ chickened out when their first big case, against the managers of two Bear Stearns subprime hedge funds that imploded, went splat. First, they failed to understand that these funds were victims, basically stuffees of bad subprime paper, and not perps. Second, they tried to force fit the prosecution into what the SEC knew how to do, insider trading cases. Yes, the senior guys did sell their own stakes down at various points when the market was unraveling. But there were other days when they were more confident about their sector coming back. To a jury, their actions looked more like trader panic than an effort to defraud their investors.
Of course, the other reason to harbor doubts is the private equity industry already spends enormous amounts on legal fees and has ready access to the best partners at the toniest firms. Their weight of money means they can bury an opponent in motions practice. However, one slight offset is that antitrust has been so dead as a practice area for so long that it’s not as if there’s a deep bench of private sector attorneys to engage.
So even though any fight against private equity is a big uphill battle, this one might make a bit of headway. Keep your fingers crossed.