6 Mergers and Acquisitions

1. 6 Mergers and Acquisitions • Mergers are usually categorized by closeness of markets that firms operate in • Horizontal merger • Merging firms operate in same relevant market, firms are directly competing • Market shares in relevant markets change as result of merger • Vertical merger • Merging firms operate at different stages of a production or distribution chain • Firms products belong to same relevant market do not compete horizontally • At least one firm can potentially be using the other firms' products as inputs in its production Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

2. 6 Mergers and Acquisitions • Conglomerate merger • Mergers not belonging to those above • Product extension • Products of the firms not competing but firms use close marketing channels or production processes • Market extension • Products are competing but relevant geographic markets are separate • Pure conglomerate mergers (none of those mentioned) Effects of Merger • Suppose duopoly which behaves competitively • Assume firms have identical cost functions and constant returns to scale prevail • MC1 = AC1, there are no fixed costs Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

3. 6 Mergers and Acquisitions • Profit maximization under perfect competition forces firms to price at marginal cost: pc = MC1 • Case 1: Merger to monopoly and costs stay at original level • Profit maximization rule (MC = MR) implies output Qm1 and price level pm1 so that deadweight loss DL1 takes place • DL = (Qc- Qm1)(pm1- pc)/2 • This is strict decrease in welfare • Also, merger means income transfer from consumers to owners of Newco • In this case, there would be reasons to block merger • Merger needs to be blocked for its deadweight loss creating effect, not because it means an income redistribution Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

4. 6 Mergers and Acquisitions • Case 2: Merger involves synergies • Assume cost savings occur through decrease in marginal costs • MC1 decreases to MC2 • Monopoly profit maximization implies price level pm2 which is lower than that without cost savings pm1 • Deadweight loss occurs, but it is smaller than that without cost savings • DL = (Qc- Qm2)(pm2- pc)/2 • There arwe now cost savings due to the decrease in MC • Amount is (pc-MC2)Qm2 • Efficiency is increased due to cost savings and decreased due to market power - deadweight loss Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

5. 6 Mergers and Acquisitions • Case 2 illustrates typical situation in antitrust • Many types of decisions and conduct by firms may be harmful for welfare while increasing it in other ways • From antitrust authority’s point of view, we face a trade-off • To determine whether a merger (or certain conduct ) is harmful on welfare, the authority should compare gains and losses to welfare • In US, this seems to be the case, efficiency defence • In EU, efficiency gains are more of reason to block merger, efficiency offense • Difference partly due to legislation? • Market dominance in EU • Significant lessening of competition in US Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

6. 6.1 Incentives to Merge Merger in Cournot market • Assume an industry structure characterized by: • n identical firms (cost functions are identical) • Cournot or capacity competition • Constant returns to scale: C(qi) = C(q) = cq, c > 0 • Linear demand is assumed linear: p(Q) = a - bQ, a,b > 0 • No possibilities for entry • Profit function of any firm is then • Firm i's Cournot-Nash equilibrium profit is Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

7. 6.1 Incentives to Merge • Merger between any two firms: there is one firm less in the industry than before • n firm industry changes into n-1 firm industry • Suppose m of n firms decide to merge (1 < m < n) • m firms have incentive to merge if being part of merged entity gives more profit than staying unmerged, that is, if • that is, if • Define LHS = A Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

8. 6.1 Incentives to Merge Case 1: m=1 • Notice that only if n=2, merger is profitable • This means we have monopoly being created • Hence, only if in duopoly both firms merge we have the merger being in all firms' interest Case 2: m=2 • Notice that only if n=3, merger is profitable • This again means we have a monopoly being created • Only if in triopoly all firms merge, merger is in all firms' interest Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

9. 6.1 Incentives to Merge Case 3: m=5 • If n=6, merger is profitable: monopoly is created • But now even with n=7 merging is profitable • Creation of a duopoly through merger is profitable • With n=8, merger is again unprofitable More generally • Notice that which is < 0 • Thus, A is decreasing in n, number of firms in industry • More there are firms before merger, other things equal, more difficult it is for merger to be profitable for merging firms Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

10. 6.1 Incentives to Merge • Notice also that which is > 0 • Thus, A is increasing in m, number of firms that decide to merge • More there are firms that take part in merger, other things equal, easier it is for merger to be profitable for merging firms • Irrespective of value of m or n, only if 80 % of firms in industry takes part in merger, merger is profitable • Merger to monopoly is always in firms' interest • Typical Cournot model where nothing but number of firms changes  price level increases after merger • This follows from quantity competition since quantities are strategic substitutes Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

11. 6.1 Incentives to Merge • Decrease in output by one firm is matched by an increase in output by rival firm • In Cournot model, once some firms merge, they decrease their total output, as they act as single firm • Firms not party to merger increase their output • Under many parameter values, firms which mostly benefit from merger are non-merging firms • Business stealing effect • Model says that mergers are not usually profitable • Then we should not usually observe mergers, assuming that firms are rationally behaving agents! • Not a good description of the real world where mergers are taking place in increasing numbers • Model misses some essential aspects of the phenomenon • Mergers occur endogenously, not exogenously • Cost savings needs be incorporated Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

12. 6.1 Incentives to Merge • Mergers not being profitable as due to strategic substitutes • Decrease in production of some firms is matched by an increase in production by the competitors • One way to overcome this effect is to assume U-shaped costs (strictly convex costs) • Rivals have less incentive for expansion of production as costs are increased • Mergers are more probable than in the Salant et al Mergers in Bertrand Market • Merger incentives under price competition? • Prices are strategic complements • Reaction functions are upward sloping • Price increase by some firms is matched by price increase of rival firms Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

13. 6.1 Incentives to Merge • In Bertrand model firms engage in price competition with differentiated products • Price increase by merged company is matched by price increase of rivals • Reaction of outsiders reinforces initial price increase that results from merger • Merger of any size is beneficial for merging firms • No business stealing effect • This model predicts industries would usually evolve into monopoly! • This, luckily, is not really what happens in the real world • There seems to be forces which prevents monopolization • These forces are not easily modelled and simple models do not descibe real world phenomena in satisfying way Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

14. 6.1 Incentives to Merge • Busines stealing effect is very much true in real world • Often, firms benefiting most from mergers are non-merging firms • Thus, usually Cournot competition best describes real world phenomena, this holds with merger theory as well • In preceding models acquiring and target firms were not differentiated • Firms were ”black boxes”, mere MC-functions • Only effect is reduction in number of (symmetric) firms • In real world acquisitions, there usually is buyer, seller and target in transaction • Transaction creates a larger entity • Seller sets price based on many factors • Asset value of the firm • Expected evolution of industry (expected profits) Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

15. 6.1 Incentives to Merge • Kamien & Zang (QJE 1990): In capacity competition, does monopolization take place when acquisition process is endogenous? • In quantity game, total industry profit increases with a decreasing number of firms • Any firm increases its profit as number of firms in industry diminishes • This follows from the nature of Cournot competition • Seller knows that it would gain in profits if it would sell later rather than sooner • Sellers want to ask more than buyers want to pay • Monopoly profit is maximum buyer can pay • In Cournot model, complete monopolization of an industry is possible only if originally there were only a few firms in industry Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

16. 6.2 Welfare Effects of Mergers • Merger without cost savings reduces welfare; if merger involves cost savings, we have trade-off • Farrell & Shapiro (AER 1990) is most thorough model on welfare implications of horizontal mergers • Quantity competition and general demand structures • Cost-savings due to consolidation are allowed • Mergers without synergies increase price and hurt consumers • Cost saving is assumed proportional to post-merger output • Then deadweight loss is proportional to output reduction • If cost saving outweigh the deadweight loss, net welfare effect of merger is positive Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

17. 6.3 Merger Simulation • Market definition is hard with differentiated goods and can be misleading • Market definition is {0,1} decision, good is either ”in” or ”out” • In reality goods belong to [0,1], they pose varying degree of competitive pressure to each other • Increase in market power is interesting, not market definition • Pure structural analysis of competitive effects can be misleading • Simulation uses economic models grounded in theory to predict effect of mergers on prices in relevant markets • Simulation allows direct measuring of changes in market power • Easier than measuring of market power • Simulation allows to evaluate likelihood of synergies offsetting price increases • Simulation requires estimation of demands • Own and cross-price elasticities or changes in residual demand Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

18. 6.3 Merger Simulation • Merger simulation: the big picture • Demand estimation • Create demand models • Get data and estimate demands • Calibrate demand model to pre-merger prices, quantities, and demand elasticities • Set parameters so that it exactly predicts pre-merger equilibrium • Plugging pre-merger prices into model must yield pre-merger shares • Predict post-merger marginal costs • Try to evaluate synergies • Use demand model & post-merger costs to compute post-merger prices • Idea: if post-merger prices are well above pre-merger level, transaction increases market power Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

19. 6.3 Merger Simulation • Measuring market power is hard in practice • Market power = L = (p-c)/p [0, 1/e] so that eL [0, 1] • Quality of market power measure depends on accuracy of estimates of marginal costs and demand elasticity • Data and estimation problems lead to biased measure of market power • Why would measuring changes in market power be easier? • Estimated price change reacts less to estimated MC or demand, as we use same instrument to measure pre and post-merger market power • Limitation of simulation: price increase predictions are sensitive to demand specification • Functional form of demand determines magnitude of price increases from merger Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

20. 6.3 Merger Simulation • One should use calibrated models in manner that makes them insensitive to functional form of demand • Compute compensating marginal cost reductions (CMCR) that exactly offsets price-increasing effects • CMCRs do not depend on functional form of demand as pre and post merger equilibrium prices and quantities are precisely same • If merger synergies appear likely to reduce merging firms’ cost as much as CMCRs, merger is unlikely to harm consumers • If merger synergies clearly fall well short, significant price increases are likely • Visit http://antitrust.org/simulation.html • Fool around with Linear Bertrand Merger • If you have access to Mathematica, take a look at SimMerger to get feeling of what simulation is about Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

21. 7 Predation • Predation = firm drives rival out of market by making it incur enough losses and then raises prises • Why would prey exit? • Why would prey stay out after price increased? • Can predator really recoup losses suffered during price war? Does predation make sense? • If predation is possible and profitable, how can we separate innocent aggressive competition from predation as restriction on competition? • Most cases apply so-called Areeda-Turner test:P < LRMC, P < LRAVC,or P < LRATC + some other indications predation • Costs are hard to define and measure • Predation rare in case law. But is it really that rare? Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

22. 7 Predation Financial market imperfections • Old ”deep pocket” theory: richly endowed predator would charge low prices to drive out poorly endowed rival • Ignores possibility that profit-seeking investors would finance prey • Relation between prey and its investors • Predator seeks to manipulate that relationship and drive prey out of market or deter expansion into new markets • Pedatory strategy viable because of capital market imperfections • Investors face agency or moral hazard problems • Managers may take excessive risks, shield assets from creditors, dilute outside equity, fail to exert sufficient effort, or otherwise fail to protect investors’ interests • Suppliers of capital can mitigate these agency problems by extending financing in staged commitments, imposing threat of termination in case of poor performance Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

23. 7 Predation • Debt-holders can threaten to liquidate firm or deny new credit • VCs can refuse to extend additional financing when early performance is poor • Shareholders can decline to purchase additional equity if expected returns are low due to disappointing initial performance • Predatory pricing in product markets becomes possible when predator exploits termination threats to dry up financing of rival firm • Agency problems are particularly acute in financing of new enterprises • Uncertainty about cash flow in early stages • Losses may be unavoidable start-up costs or due to agency abuse • Mitigate moral hazard by agreeing to extend financing only when firms’ initial performance is adequate Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

24. 7 Predation • Predator may slash price to drain prey of sufficient funds to meet its loan commitments, forcing default • Predator can lower prey’s earnings to impair prey’s debt capacity by limiting collateral it can put up • Lower earnings may cause lenders to wrongly believe that firms’ profits are likely to be lower or riskier in future and therefore to stiffen their lending terms • Contract that minimizes agency problems will maximize incentive to prey Reputation • Predator lowers prices to mislead prey and potential entrants into believing that market conditions are unfavorable • Decision to enter or exit is based on evaluation of expected future revenues and costs • Most firms contemplating entry or exit do not have all information to determine future revenues and costs Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

25. 7 Predation • If incumbent firm is better informed than others about cost or other market conditions, it may be able to influence the expectations • Incumbent firm can manipulate and distort market signals about profitability, and influence the expectations through pricing decisions or other actions • Predator seeks to establish reputation as price cutter, based on some perceived special advantage or characteristic • Reputation effects may be present when predator sells in two or more markets or in successive time periods within same market • One market or period serves as demonstration market with predatory conduct, and the other market or time period provides recoupment market, where predator reaps benefits • Reputation-induced belief reduces future entrant’s expected return and may deter entry Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

26. 7 Predation Signaling • Better informed predator reduces price to convince prey that market conditions are unfavorable • Aggregate demand is too low to justify presence of both firms in market or expansion by prey • Prey inferring weak demand from low price may be deterred from expanding or induced to leave market • Less plausible than previous predatory strategies • Test market and signal jamming theories plausible • Victim lacks knowledge and experience in market • Introduce new product or brand to probe market response by entering a limited “test market” • Predator may attempt to frustrate this market test by either of two predatory strategies Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

27. 7 Predation • Test market predation • Predator secretly cuts price to reduce entrant’s sales in test market • Induce entrant to believe that demand is low • Entrant abandons entry or enters on smaller scale • Signal jamming • Predator openly cuts price to distort test market results • Entrant can observe demand for its product only under exceptional circumstance of an ongoing price war • Market test is foiled, and entrant is unable to determine whether market demand for its product is sufficient to support entry • Cost signaling • Predator drastically reduces price to mislead prey to believe that she has lower costs • Predator trying to establish a reputation for low cost cuts price below the short run profit-maximizing level Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

28. 7 Predation • Observing predator’s low price, prey rationally believes there is at least probability that predator has lower costs • Lowers prey's expected return and causes prey to exit • Limiting factor in applying cost signaling theory is possible inconsistency between low price, predatory bluffing and subsequent recoupment • Attempt to raise price risks revealing signaling to prey and other potential entrants, causing them to upgrade estimates of market profitability Policy • Proof of scheme of predation only establishess that identified strategy is plausible • Need to show • Below cost pricing: avoidable or incremental cost, not AVC • Recoupment • Business justification? Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

29. 7 Predation • Financial market predation • Prey depends on external financing • Financing depends on its initial performance • Predation reduces initial performance and threatens preys financing and viability • Predator can finance predation internally or has better access to external finance as prey • Reputation • Multimarket predator faces localized competition • Predator faces threat of sequential entry • Reputation reinforces predatory strategy or increases probalility of future price cuts • Entrant observes previous exit or other adverse experiences Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

30. 7 Predation • Test market predation • Predator observes prey’s attempt to experiment on limited basis • Predator cuts price below following or anticipating entry • Price cut prevents prey from learning true demand conditions • Cost signaling • Predator might have lower or reduced costs • Predator reduces price • Prey believes that predator has lower costs • Possible cost reduction is sufficient to exit, deter entry or limit expansion Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

31. 8 Merger Case Airtours / First Choice merger • Commisson case No IV/M.1524, available through course web site www.cea.fi/joe.htm • Airtours and First Choice supply leisure travel services (package tours) in UK and Ireland • Vertically integrated into upstream (airline operation) and downstream (travel agency) businesses • Relevant market: short-haul foreign package holidays in UK • European beach, ski and city destinations • Long-haul (Florida, Caribbean, Thailand etc) is not substitute for short-haul • Different aircaft • Less rotation of aircraft -> higher crew and catering costs • Operating cost per passenger/mile Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

32. 8 Merger Case • Sufficient demand to fill large aircraft -> match fleet composition closely to mix of passengers between larger (long-haul) and smaller (short-haul) • Different image for consumers • Longer flight time and jet–lag can reduce ’usable’ holiday time • Short-haul holiday typically much cheaper than comparable long-haul • Market shares • Airtours 19.4 % • First C. 15.0 % • NewCo 34.4 % • Thomson 30.7 % • Thomas Cook 20.4 % • Cosmos 2.9 % Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

33. 8 Merger Case • Surprise prohibition decision • Three firm ”oligopoly” 85.5 % market share • In past, much fluctuation in market shares, and exit and entry • Package holidays differentiated, branded, consumer products • UK MMC incuiry few years earlier concluded market was quite competitive despite increased concentration • Low barriers to entry • Is collusion really sustainable? • Court of First Instance overturned Commission’s decision because of lack of evidence, treatment of facts • CFI seemed to accept Commission’s general policy Could commission be right? • ”Oligopolists” are now vertical integrated, ”competitive fringe” not • Competitive fringe less able to challenge oligopoly • Raises entry costs as entrants need to enter all stages of production and distribution Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

34. 8 Merger Case • Two-stage competition: 1) reserve capacity 12-18 months in advance, 2) price competition • Firms have strong incentive to sell full capacity • Steep discounts when departure dates are approaching • Temptation to deviate from collusive price are strong, and threat of punishment within selling period not credible • Package holidays heterogenous good • Less likely to reach collusive prices • Commission: collusion on capacity rather than prices • Firms choose low levels of capacity • Deviation: set high level of capacity • Punishment: choice of high levels of capacity for one or more period Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

35. 8 Merger Case • Unlikely in many sectors, capacity decisions constrain firms for long periods • Punishments costly and delayed • In this industry, capacity decisions are reviewed periodically • Semicollusion: collude on some variables, compete on others • Could lead to more intense competition than Cournot or Bertrand behavior • Firms might observe each others’ capacity decisions • Collusion on capacities can be consistent with economics • But is collusion likely? • Demand is volatile: • Hard to separate demand shock from deviation • What demand are rivals’ predicting? Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

36. 8 Merger Case • Even if ”oligopolists” collude, competition from outsiders and entry to increase capacity • Court: Commission was wrong • Joint dominance: • Market must be sufficiently transparent for members of oligopoly to monitor each other • Punishment mechanism that ensures ‘common policy’ is sustainable as there is a need to counter the incentive to cheat • Reaction of competitors and customers does not undermine benefits expected from ‘common policy’ • Commission must produce convincing evidence that all three conditions would be met in particular case • Firms have ‘right to adapt themselves intelligently to the existing and anticipated conduct of their competitors’ • Commission had confused ‘acceptable’ oligopolistic interaction with tacit coordination in the decision Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede

37. 8 Merger Case • No credible punishment mechanism • Commission did not prove that market was sufficiently transparent for oligopolists to monitor capacity when capacity decisions were taken • Analyses of demand growth and demand volatility were fundamentally flawed • Commission failed to give weight to responses of fringe players and consumers to postulated reduction in output and increase in prices • My interpretation: Commission tried to increase scope of dominance concept • In US, merger might have been blocked • With new EU rules and more careful analysis, merger might have been blocked Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede