Antitrust Approaches to Partial Equity Investments

1. Antitrust Approaches to Partial Equity Investments Eric Emch AAI 9th Annual Energy Roundtable March 3, 2009 The views expressed here are not purported to reflect those of the U.S. Department of Justice

2. At Issue • What are the possible competitive impacts of partial equity investments in direct horizontal competitors? • How is this competitive impact, if any, addressed by antitrust authorities? • How does the approach in these situations relate to traditional antitrust merger analysis?

3. Control Limited Control Silent Financial Interest Control Traditional HMG Merger Analysis Unilateral Effects:Two-sided Coordinated Effects: Avenue A Avenue B Unilateral Effects:One-sided Coordinated Effects: Avenue B Limited Control Unilateral Effects:Two-sided Coordinated Effects: Avenue A Avenue B Unilateral Effects:One-sided Coordinated Effects: Avenue B Silent Financial Interest No Impact Matrix of Possible Effects Firm 1 Firm 2

4. Possible Unilateral Effects • Depends on financial stake in competitor, control elements only necessary on one side of the transaction. • Easy to understand basic intuition • Firm deciding whether or not to raise price weighs increase in profits from customers who stay versus lost profits from customers who leave • After acquiring a stake in competitor, some of those lost profits are returned to company via its partial ownership stake. • Cost of price rise goes down: yields higher price in most models of oligopolistic competition • Can be quantified by calculating a modified version of the HHI taking into account partial equity stakes; with differentiated products, by calculating a “price pressure index” which takes into account margins and diversion ratios between firms • For both, See O’Brien and Salop (2000) Antitrust Law Journal article

5. Possible Coordinated Effects: A • Focuses on control elements, not passive financial stakes • “Checklist” approach to identifying possible coordinated effects from mergers; examines factors which make collusion more likely or sustainable • The “checklist” factors vary a little depending on which list one looks at, but generally involve assessing whether the industry exhibits transparency (in prices, quantities, etc.), homogeneity (in firms, in products), certainty (of demand, supply), and whether it has a high concentration among sellers, and low concentration among buyers • These factors are related to three fundamental obstacles to the formation of a stable collusive agreement – reaching terms of agreement, monitoring compliance, and punishing deviations. • An entity acquiring an ownership stake in a competing firm can potentially change one or more of these checklist factors in a way that makes coordination more likely after the transaction

6. Possible Coordinated Effects: A • Reaching Agreement • Limited control can serve to align firm interests, leading to a greater homogeneity of firms • Perhaps provides an avenue for side payments • Relationship can provide a “cloak of legitimacy” over conversations relating to anticompetitive coordination • Monitoring agreement  • Increased access to competitively sensitive information • Ongoing “cloak of legitimacy” • Punishing deviations • Control elements may reveal more direct and less costly ways of punishing a deviator than a price war, which is damaging for the punisher as well as the target; for instance, • Punishing particular individuals in firm • Interfering with capital expenditures of firm

7. Possible Coordinated Effects: B • Focuses on financial stake and not control elements • Examines collusion as a model of repeated prisoner’s dilemma game; collusion can be sustained depending on relative payoffs from cooperating or defecting • Increased financial stake can decrease the payoff from cheating from a collusive agreement. On the other hand, it can also reduce the severity of the “punishment” phase. • These effects work in opposite directions and make the effect ambiguous in general • SeeMalueg (1992), International Journal of Industrial Organization • A recent model finds cross-ownership always making collusion more likely, under particular assumptions • See Gilo, et. al. (2006), RAND Journal of Economics.

8. Possible Efficiencies • Access to capital: Capital from inside an industry may not be hampered by information asymmetries that hinder capital being attracted from outside. By the same token, an investment from inside the industry may validate the value of an investment for outsiders. • Access to technology/expertise/scarce assets: Critical complementary resources for a firm may be available primarily from firms in nearby or related industries, or in some cases from firms within the same antitrust market. This may be particularly relevant in the case of two firms in a particular market that create a joint venture as a new competitor in that market.

9. Legal Context • Ex ante: Clayton Act Section 7 • But what about exemption for “solely for investment purposes”? • Courts and antitrust agencies have read this in different ways; sometimes read as a de facto exemption for completely passive investments below a certain size, sometimes not. • Ex post: Sherman Act Section 1 or Section 2?

10. Recent Example:Clear Channel (2008, DOJ) • U.S. v. Bain Capital and Thomas H. Lee Partners and Clear Channel Communications (2008) • DOJ sued to prevent the acquisition of a 70% interest in Clear Channel, the largest operator of radio stations in the United States, by two entities that either jointly or separately had some control over two Clear Channel competitors. • Bain and THL each had 25% equity stakes and had a right to appoint 2 of 8 board members in Cumulus Media Partners, which competed with Clear Channel in radio markets in Cincinnati and Houston; THL additionally had a 20% equity interest, a 14% voting interest, and the right to appoint 3 of 17 board members to Univision, which competed with Clear Channel in spanish-language radio in Houston, Las Vegas, and San Francisco

11. Recent Example:Clear Channel (2008, DOJ) • DOJ sues under Section 7 of the Clayton Act. DOJ alleges unilateral and coordinated avenues of harm from the transaction stemming from Bain/THL control or partial control of two direct competitors in well-defined product and geographic markets via • Governance rights/”influence” • Profit participation • Access to competitively sensitive information • DOJ consent decree resolved the problem directly by forcing divestures of radio stations in the market of concern, but they also gave parties the option of completely divesting all ownership and control of Univision or CMP in lieu of the divestitures. • Significantly, simply divesting control elements on one side of the competitive overlap is not an option under decree

12. Recent Example:Carlyle/Riverstone (2007, FTC) • Group of investors including Carlyle and Riverstone, two private equity firms, planned to acquire all outstanding shares of Kinder Morgan, Inc. (KMI), an energy transportation, storage, and distribution company. Investors also included KMI management, Goldman Sachs, and AIG. • Carlyle and Riverstone would jointly hold 11.3% of KMI through their CR III fund, along with the right to appoint a board member and to receive competitively sensitive information. In addition, Carlyle through another of its funds would own 11.3% of the equity of KMI with the same rights. • KMI owned or operated terminals and pipelines for natural gas and petroleum products. Carlyle/Riverstone CR-II fund also held a 50% interest in the general partner that controlled Magellan, a terminal and pipeline company that competed with KMI in various terminaling and pipeline operations. • This created a competitive overlap between KMI and Magellan, according to the FTC, in at least 11 terminal markets in the Southeastern United States.

13. Recent Example:Carlyle/Riverstone (2007, FTC) • FTC alleged anticompetitive unilateral and coordinated effects stemming from Carlyle/Riverstone having board representation and access to competitively sensitive information in competing entities. • Consent decree removed all elements of partial control of Magellan – it removed Carlyle/Riverstone board seats and access to competitively sensitive information from Magellan, and prohibited them from “influencing or attempting to influence Magellan’s business activities,” • Consent decree allowed current and future passive investments in Magellan, but no elements of control as long as Carlyle/Riverstone held any interest in KMI.