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DG ECFIN

European Commission

N° 2 June 2005

In this issue :

Editorial p. 1

M&A overview p. 2

“Efficiency defence” in merger control

p. 10

This six-monthly note is issued

by Directorate E, Economic evaluation service

Board of editors for this issue: J.H. Schmidt, F. Ilzkovitz, R. Meiklejohn, G. Garnier, M. Johnson, S. Vitiello, C. Buelens For more info : gaelle.garnier@cec.eu.int © European Commission 2005

Editorial By Klaus Regling, Director General, DG ECFIN In January 2004, the Council of Ministers adopted a new merger regulation. One of the major changes it introduces is a policy explicitly allowing efficiency gains to be taken into consideration when analysing the competitive effect of mergers on the basis that, while mergers may have anti-competitive effects, they may also lead to cost savings and an increased ability to innovate that may counteract the potential harm to consumers. Today’s debate sets those who believe that the EU competition policy is too restrictive and hinders the emergence of European champions against those who consider that a highly competitive environment on the EU markets is essential to increase efficiency. I clearly belong to the second group. It is clear that European companies will not become more successful at the world level if competition policy is not effective. Effective competition on domestic markets spurs companies to make the efficiency improvements needed to ensure success on international markets. It is the disciplining force of strong competition at home that leads to greater global success. Mergers and acquisitions need therefore to be controlled by an effective competition policy as they may lead to excessive market concentration and anti-competitive behaviour. However, let us not forget that the ultimate aim of European competition policy is to maximise economic welfare. To do so, it is essential to encourage firms to search for efficiency-enhancing production processes to the benefit of European consumers. This requires a regulatory system that, while guaranteeing effective competition, does not impose unnecessary restrictions on companies’ ability to adapt and innovate. It therefore makes sense for competition policy to include the possibility of an “efficiency defence”, in other words to make clear provision for weighing up potential positive and negative effects in cases where a merger threatens to result in a lessening of competition but may also yield efficiency gains. This note explains and evaluates the reasons for an “efficiency defence” as defined in the horizontal merger guidelines. However, it also shows that the policy is not easy to implement. Some suggestions as to how this could be done are outlined in the note. The note also gives an overview of M&A activity. The number of worldwide mergers and acquisitions increased between 2003 and 2004. Within the enlarged EU, M&A activity is still predominantly taking place in the EU-15, but is increasing in the new Member States. A sectoral analysis reveals that the proportion of worldwide M&A operations occurring in the services sector has been rising steadily and now accounts for around two thirds of transactions in both the EU and the US.

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M&A overview 1. Overall M&A activity Following a worldwide peak at the beginning of 2000, the number of merger and acquisition operations (M&A) fell in 2001 and 2002, before increasing in 2003. Taking 2004 as a whole, at the world level the total number of M&A operations was 33 500, up from 31 600 in 2003. However recent figures show that world M&A activity fell during the course of 2004 (See Graph 1a below). The evolution of merger activity in the EU and USA since 2000 has followed a similar pattern to the world as a whole. In 2004 there were 9 000 operations where EU companies were the target, an increase of just 0.1% since 2003. Operations where US firms were the target increased from 8 100 in 2003 to 9 100 in 2004, an increase of 12.5%. However, the evolution of activity within 2004 gives a slightly different picture. The number of operations in which EU firms were the target fell between the first quarter (Q1) and the second (Q2) before rising between Q2 and Q4. By contrast the number of operations featuring US firms as target in 2004 remained broadly unchanged between Q1 and Q3 before falling between Q3 and Q4. On casual observation the in-year results run contrary to the assertion that the strengthening of the euro and weakening of the dollar towards the end of 2004 would have made US companies a more attractive target for foreign bidders and eurozone companies less attractive (a recent article in the Wall Street Journal, “Deal Making in Europe Outpaces Activity in US”, 6 June 2005, suggests that Western Europe was ahead of the USA in terms of the number of M&A deals in the first five months of 2005). However M&A operations are driven by a wide range of factors of which exchange rate considerations are only one. Section 4 of this note discusses in more detail the issue of links between exchange rates and M&A activity.

Graph 1a: Evolution of the number of M&A as target

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As a source of bidders (i.e. acquiring companies) in M&A operations, the EU led the USA between 2000 and 2003. In 2004 the USA took the lead with 9 600 US companies involved in M&A operations as bidder, an increase of 14.5% on the previous year. Over the same period the increase in operations involving an EU company as bidder increased by just 0.1%, to 8 500.

Box 1 : Important differences between M&A and FDI statistics Broadly speaking, Foreign Direct Investment (FDI) includes M&A statistics, greenfield investments, reinvested earnings and intra-company loans. However, the following issues should be noted. Firstly, M&As record capital transactions without deducting disinvestment while FDI data deduct disinvestment. Second, cross-border M&A may be financed by external and domestic settlements while FDI are financed by external settlements and reinvested earnings. Third, while M&As record all acquisitions of shareholdings of 5% or more, only acquisitions of holdings of more than 10% of the capital qualify as FDI.

Worldwide M&A operations increased between 2003 and 2004…

…but quarterly figures reveal a within-year decline

In 2004 the USA overtook the EU as the largest source of M&A bids

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The total value of mergers at the world, EU and US levels increased markedly towards the end of 2004

Graph 1b: Evolution of number of M&A as bidder

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After declining in 2000 and 2001, total merger value at the world, EU and US level remained relatively constant before rising during 2003 and peaking in Q1 2004. Following declines in early 2004, values increased markedly towards the end of 2004 (See Graph 2 below). Looking at 2004 as a whole, the worldwide value of mergers was 1 900 billion euros, an increase of 32% on 2003. The value of mergers where an

Graph 2: Evolution of total value of M&A as target

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Box 2: Notes on the data base and conventions M&A statistics in this note are based on data provided by Thomson Financial Services (TFS). The database covers all acquisitions of shareholdings of 5% or more and with a value over US$1 million as well as acquisitions for which the value is unknown. It endeavours to collect and present information which is as complete as possible. However, although major operations affecting publicly listed companies are often officially published, the numerous purchases of smaller or unlisted companies are more difficult to identify, making the coverage somewhat arbitrary. Also, subjective assessments are often inevitable e.g. as regards the date and sectoral classifications of a merger and acquisition operation. In addition a number of conventions have been established when drafting this M&A note. We take account of both completed and pending deals. We use the TFS classification for the sectoral aspects of M&A (SIC classification, different from NACE classification). Moreover, sectoral activities are defined according to the target’s main activity, as this is the activity most likely to interest the bidder and also because the targeted sector is the one in which the effects of an operation are likely to be the greatest. Finally it is important to note that the database does not contain value data for a significant number of deals. However, these are mostly small deals since the value of large operations can usually be ascertained. The value data are therefore underestimated, though not by a large amount.

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EU company was the target also increased by 32%; for the USA, the increase was higher at 44%. It is clear from the graph that in terms of total value the world picture is strongly driven by EU and US, reflecting the fact that higher value mergers tend to involve US and EU25 firms. In the USA in particular, the combination of a fall in the number of M&A operations at the end of 2004 combined with an increase in the total value, shows that the average value of M&A operations increased. 2. M&A activity in the EU-25 countries The mid-term review of the EU’s Lisbon Strategy emphasised the need to make Europe an attractive place to invest. Graph 3 shows Member States ranked by the level of total inward M&A between 2001 and 2004. As the value of inward M&A is likely to be affected by a country’s size, as well as other factors, the figures in the graph have been adjusted by dividing each country's total inward M&A by its GDP. For the period 2001 -

2004 the five most important M&A targets in the EU-25 were the UK, Germany, France, the Netherlands, and Italy. The graph shows that after GDP is taken into account, only the UK and the Netherlands remain in the top 5. Among the new EU Member States, the value of inward M&A relative to GDP is highest in the Slovak Republic - placing it in the 6th position overall. This contrasts with the other new EU Member States, in which the value of inward M&A is generally low compared to EU-15 countries. A recent journal article raised the issue of how in some countries, restrictive national merger regulations may create a disincentive for transnational mergers involving firms located in those countries.1 The countries cited as having particularly restrictive laws

were Austria, Denmark, Finland, Germany, Greece, Ireland, the Netherlands, and Sweden. Of these, the Nordic countries and the Netherlands score well in the chart, but the others do less well. Further investigation may reveal whether the low ranking can be attributed in part to the restrictive merger regulations in these countries.

The five most important EU targets for M&A are the UK, Germany, France, the Netherlands, and Italy… …but taking GDP into account reveals a very different picture Restrictive merger controls in some countries may reduce incentives to invest

1 CESifo Forum, Winter 2004

Graph 3: GDP adjusted value of M&A targeted on current EU member states 2001-2004

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Around two thirds of M&A operations are targeted on the combined services sectors While the proportion of worldwide M&A transactions in services rises steadily… …manufacturing still remains the most targeted sector in the EU

3. Sectoral comparisons In the EU, the combined services sectors have been increasingly contributing to GDP, and now represent its largest component. This shift towards services is also apparent in the composition of M&A transactions. Graph 4 displays the number of M&A transactions in 2004 for non-service sectors (SIC Divisions A-D2) and the combined services sectors3 (SIC Divisions E-I) at the world, EU and US level. Looking at worldwide M&A operations, 63% took place in all service sectors combined. The proportions for the EU and the USA were slightly higher at 64% and 69% respectively.

Graph 4: Sectoral breakdown of M&A targets (2004)

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Looking at the sectors in more detail, it can be seen that, in terms of worldwide M&A transactions, manufacturing was the most targeted sector (see table 2). However, its share in overall M&A transactions has declined from 34% in 1995 to 28% in 2004. Conversely, the proportion of transactions in the services sector (SIC Division I) increased from 17% to 25% in the same period, after peaking at 31% in 2000. The rate of M&A transaction activity in other sectors has remained relatively stable over the period analysed. The evolution of M&A transactions in the EU is comparable to, but slightly more pronounced than, that observed at the global level. Indeed, the share of M&A transactions in manufacturing dropped from 40% to 31% between 1995 and 2004, while the equivalent values for services jumped from 14% to 26%. In the US, the strong rise in the proportion of M&A transactions in the services sector from 23% in 1995 to 35% in 2004 came at the expense primarily of manufacturing but also of finance and insurance. It is noteworthy that the highest number of M&A transactions in the US occur in the services sector, which contrasts with the EU (and the world as a whole), where manufacturing is still the predominant target sector.

2 See table 2 for a definition of the respective sectors. 3 The combined service sectors encompass the traditional services sector (SIC Division I, i.e. hotels, personal services, business services etc.), as

well as Transportation, Communications, Electric, Gas & Sanitary Services (SIC Division E), Wholesale Trade (SIC Division F), Retail Trade (SIC Division G), Finance, Insurance & Real Estate (SIC Division H) and Public Administration (SIC Division J).

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Table 2: Evolution of the sectoral breakdown by aggregates (targeted sectors)

World EU-25 US Sector (SIC Division) 1995 2000 2004 1995 2000 2004 1995 2000 2004 Agriculture, Forestry & Fishing (A) 0.8% 0.8% 0.8% 0.7% 0.7% 0.6% 0.4% 0.4% 0.4%

Mining (B) 5.5% 3.6% 6.7% 2.0% 1.0% 1.5% 3.6% 1.9% 4.3%

Construction (C) 2.0% 1.7% 1.8% 3.4% 2.0% 2.4% 1.0% 1.4% 0.9%

Manufacturing (D) 34.4% 27.1% 28.2% 40.2% 29.7% 31.4% 29.6% 24.3% 25.5%

Transportation, Communications, Electric, Gas & Sanitary Services (E)

10.7% 11.3% 10.6% 11.1% 11.1% 12.3% 9.6% 9.8% 9.1%

Wholesale Trade (F) 5.9% 4.5% 4.4% 7.5% 5.8% 4.7% 5.6% 3.6% 3.5%

Retail Trade (G) 4.8% 4.7% 4.7% 5.7% 5.1% 5.6% 5.0% 5.4% 5.0%

Finance, Insurance & Real Estate (H) 18.8% 14.9% 17.9% 14.8% 13.3% 15.6% 22.1% 14.4% 16.5%

Services (I) 16.8% 31.3% 24.8% 14.3% 31.3% 25.7% 22.9% 38.5% 34.6%

Public Administration (J) 0.2% 0.2% 0.2% 0.2% 0.1% 0.2% 0.1% 0.2% 0.2%

Total 100% 100% 100% 100% 100% 100% 100% 100% 100%

4. Cross-border operations

The share of domestic operations relative to cross-border operations has always been high in the EU-25. Within the category of cross-border operations, the share of mergers between the EU-25 and the rest of the world is larger than the share of intra-EU-25 M&A (see Table 3 below). Latest figures for 2004 indicate an upturn in the proportion of international M&A, from 21% to 24% of operations involving EU companies.

Table 3: Breakdown of total EU M&A transactions into domestic,

community and international operations

Domestic Community International Bidder

unknown Total

1995 58% 14% 20% 8% 100% 1996 56% 14% 23% 7% 100% 1997 56% 15% 24% 4% 100% 1998 54% 15% 26% 4% 100% 1999 56% 16% 23% 4% 100% 2000 55% 17% 22% 6% 100% 2001 56% 17% 21% 7% 100% 2002 59% 16% 20% 5% 100% 2003 59% 14% 21% 6% 100% 2004 57% 14% 24% 5% 100%

Ten new countries joined the EU in may 2004, and there has been speculation over what effect the new entrants will have on investments in existing EU countries. A recent business survey suggests that investors from the USA are increasingly attracted by Eastern Europe as a production location and are consequently turning away from previously popular EU countries such as Germany, which nonetheless retain their attractiveness in other segments such as marketing and R&D. 4 For 26% of the surveyed firms, Eastern Europe has now become the main investment target.

The proportion of EU mergers that were purely domestic fell slightly between 2003 and 2004

4 “AmCham Business Questionnaire 2004”, American Chamber of Commerce and Boston Consulting Group, March 2005.

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The proportion of US-based M&A operations which targeted the new EU Member States increased between 2003 and 2004 but remains relatively small

The proportion of intra-EU M&A targeting the new Member States fell in the run-up to EU membership

Table 4a shows that whilst the results of the survey are not strongly borne out by the data on M&A, there was certainly a jump in the proportion of US M&A activity which was targeted on the new Member States between 2003 and 2004, from 1.2% of the total to 2.0%. However it is clear from the data that US M&A targeted towards the new Member States continues to represent a very small proportion of the total US M&A activity which is targeted in the EU.

Table 4a: Value of US mergers targeting EU-25 firms (€ million) 2000 2001 2002 2003 2004

Old Member States 95 833 48 779 35 508 49 658 54 428 % of total 97.8% 99.0% 98.9% 98.8% 98.0%

New Member States 2 120 483 392 615 1 123 % of total 2.2% 1.0% 1.1% 1.2% 2.0%

Table 4b shows the proportion of cross-border intra-EU M&A activity that was targeted on the new Member States. In 2001 and 2002 M&A targeting the new Member States accounted for nearly 10% of all intra-EU M&A. Perhaps surprisingly this proportion dropped by more than half in the years immediately prior to accession.

Table 4b: Value of EU cross-border mergers targeting EU-25 firms (€ million)

2000 2001 2002 2003 2004 Old Member States 333 443 143 381 105 470 53 932 143 337

% of total 96.5% 90.8% 90.8% 95.9% 96.0% New Member States 12 210 14 494 10 632 2 332 5 952

% of total 3.5% 9.2% 9.2% 4.1% 4.0%

As discussed in Mergers & Acquisitions Note N°1, which looked at international M&A activity and discussed the impact of globalisation, EU-15 countries mainly invest in the new Member States while North American firms invest more in Asian countries such as China. The rapid growth of the Chinese economy in 2004 was accompanied by a number of high-profile M&A operations, including the purchase of the computer manufacturing business of US firm IBM by the Chinese computer manufacturer Lenovo. Table 5 shows the main sources of, and targets for, cross-border M&A with China in 2003 and 2004. Despite a number of high-profile M&A where Chinese companies appeared as the bidder, the majority of cross-border operations featured Chinese companies as targets. Indeed, in 2004, 677 Chinese companies were involved in M&A transactions as targets, compared to 101 firms that acted as bidders – twice as many as in 2003. The table also reveals a strong regional dimension in Chinese M&A. While half of the 10 main bidder countries were Asian, Chinese firms’ main targets were located in Hong Kong and Singapore. A strong increase in merger activity within China can also be seen. Outside Asia, US firms are both the main bidders and the main targets for Chinese firms. With only the UK and Germany represented in the top 10, EU firms do not feature strongly as bidders for Chinese companies. Firms in Germany, the UK and France were among the most targeted in 2004, together accounting for more targeted firms than the US. Despite the strong relative increase in targeted EU firms between 2003 and 2004, the absolute numbers of merger cases remain low, suggesting that Chinese outward M&A activity is still in its initial stages.

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Table 5: Chinese cross-border M&A transactions

Top 10 Bidders 2003 2004 Top 10 Targets 2003 2004 Hong Kong 186 203 Hong Kong 23 49 United States 81 122 Singapore 2 7 Singapore 33 67 United States 7 7 Canada 23 28 Australia 4 5 Japan 33 25 Germany 0 5 United Kingdom 15 22 South Korea 2 3 Taiwan 11 17 United Kingdom 0 3 Malaysia 6 14 Brazil 0 2 Australia 10 12 Canada 1 2 Germany 16 10 France 0 2 Total inward M&A 528 677 Total outward M&A 59 101 China 1165 1664 China 1165 1664

Finally in this section, the increasing weakness of the dollar was an important financial news story in the second half of 2004, with possible implications for growth in the EU. It has also been suggested that the relative weakness of the dollar has made US companies more attractive as merger targets and non-US firms have become relatively more expensive as targets for US firms. However, as Graph 5 below shows, there does not appear to be any obvious relationship between the exchange rate and M&A in the US, either as target or bidder. M&A operations where US companies targeted firms outside the US rose slightly during 2003-2004, as did the number of operations where US firms were the target of bids from non-US firms. A more sophisticated econometric analysis of the relationship could control for other factors affecting M&A in order to isolate any possible exchange rate effect. However such in-depth analysis is beyond the scope of this note.

Graph 5 : United States foreign exchange rate and cross-border M&A

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5. Largest M&A operations in 2004

Table 6 shows the five largest completed and pending M&A operations in 2004. All except one (Santander Central Hispano and Abbey National) were domestic mergers. Two of the mergers were in the banking sector and two were in the area of pharmaceuticals.

While it is still low compared to inward M&A, Chinese outward M&A is picking up

We find no obvious effect of the falling US dollar on cross-border M&A operations featuring US firms

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Four out the five largest M&A transactions in 2004 were domestic mergers

Table 6: Top 5 M&A operations at world level

Date Name Nation Industrial Classification Amount (€ million)

26/01/2004 Target Aventis SA France Pharmaceutical

Preparations 49 989.9

Bidder Sanofi-Synthelabo SA France Pharmaceutical

Preparations

14/01/2004 Target BANK ONE Corp. USA National Commercial Banks 46 015.4

Bidder JP Morgan Chase & Co USA National Commercial Banks

15/12/2004 Target Guidant Corp USA Surgical and Medical

Instruments 19 268

Bidder Johnson & Johnson USA Pharmaceutical

Preparations

23/07/2004 Target Abbey National PLC UK National Commercial Banks 12 994.6

Bidder Santander Central Hispano Spain National Commercial Banks

20/08/2004 Target Rouse Co USA Real Estate Investment

Trusts 10 221.9

Bidder General Growth Properties Inc USA Real Estate Investment

Trusts

***

10

“Efficiency defence” in merger control

By Gaëlle Garnier 1. Introduction Rapid economic and technological changes as well as globalisation are resulting in major corporate reorganisations around the world as companies search for efficiency-enhancing production processes and seek access to new customers in wider markets. Sometimes a merger between firms may be a precondition for effective adaptation to these changes. Some commentators have argued that European firms’ competitiveness has been hindered by the European merger control system because it has not made sufficient allowance for the creation of European champions better able to face world competition and achieve global market positions. However, effective competition on domestic markets spurs companies to make the efficiency improvements needed to ensure success on international markets. Therefore, a competitive environment is essential to improve the export performance of European firms and an efficient competition policy can contribute to this. Recently the Council of Ministers introduced an explicit “efficiency defence” into the European Merger Regulation. In cases where a merger threatens to result in a lessening of competition but may also yield efficiency gains, the merger control system now makes clear provision for weighing the positive effects against the negative ones, so as to assess the net impact on competition. This article discusses the usefulness of policy that explicitly endorses the consideration of efficiencies in merger control. The first section explains the reasons that justify the introduction of an “efficiency defence”. The second section describes how efficiencies are taken into account in the European merger control system, and how the Commission proposes to evaluate them. The third section discusses what can be learnt from the implementation of the “efficiency defence” in other jurisdictions. The fourth section proposes a methodology in order to ensure that the cases where important economic impacts may be expected are not overlooked.

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A need to balance anti-competitive effects and efficiencies

2. Reasons for an efficiency defence There are both economic and other arguments in favour of an explicit consideration of efficiencies in merger control. 2.1 Economic reasons In circumstances of imperfect competition, market processes do not result in society’s resources being allocated to their highest value use among all competing uses. Allocative efficiency is further reduced by mergers which lead to a weakening of competition. For example, when the industry is concentrated, entry is difficult, scale economies are significant and market shares are sticky, a merger may lead to an increase in market power, thereby decreasing allocative efficiency. M&A may also facilitate anti-competitive behaviour such as market foreclosure or efforts to hamper rivals’ innovation capability. Consequently, M&A may lead to a reduction in economic welfare. The raison d’être of merger control is to block large-scale mergers that would have a welfare-reducing effect by depriving customers of the benefits brought about by effective competition such as low prices, high-quality products, a wide selection of goods and services, and innovation. However, the potential detrimental effect of less competition may sometimes not materialise due to the beneficial effect of greater internal efficiency of the merged company (See Box 1 on the link between M&A and efficiencies). Even if a merger threatens to lead to increased market power and hence to possible allocative inefficiencies, it may also create opportunities for reducing costs of production, marketing and distribution or for developing innovative products and services. Such internal efficiency gains are often referred to as productive efficiencies, to distinguish them from the allocative efficiency of the market. Within productive efficiencies, one can distinguish between static and dynamic gains (See Box1). This “trade-off” is at the origin of the introduction of efficiency defences in many national jurisdictions, such as Canada, the USA and, more recently, the EU.

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Box 1: The link between M&A and efficiencies Mergers create new combinations of tangible and intangible assets which, if successful, may yield efficiencies in several ways5. Short-term economies of scale may result from the elimination of a duplication of fixed costs or reallocation of production between plants. Long-run economies of scale may arise in production, R&D and marketing activities if the formerly separate firms’ investments in physical capital are combined and integrated. Economies of scope arise when the cost of producing two products together is lower than the sum of the costs of producing them separately because they require a common input. Learning effects are the reduction in unit cost due to accumulated experience. Some purchasing economies may occur after a merger, for example when the merged entity increases its bargaining power and obtains a quantity discount. A merger may also lead to a lower cost of capital, especially for a small firm that joins a large corporation. Mergers may reduce transaction costs (transactional efficiencies) when cooperation between independent firms is hampered by incomplete contracts, i.e. when it is not possible to foresee all the circumstances in which the contract may have to be applied, when the incentives of the two parties are not fully aligned or when monitoring is difficult. The above-mentioned types of efficiency are usually static efficiencies. A merger may, however, also yield dynamic efficiencies, enhancing technological progress by fostering the diffusion of know-how or increasing the incentives for R&D activities among the merging firms. While static efficiencies are achieved by producing goods at lower cost or of enhanced quality using existing technology, dynamic efficiencies are benefits from new products, or product enhancement gains achieved from the innovation, development or diffusion of new technology. It is often argued that dynamic efficiencies are likely to have the largest impact on the social welfare of the economy6. Furthermore, it is possible that a merger is more likely to be a necessary condition for the achievement of dynamic efficiencies; static efficiency gains can more often be attained by alternative means. 2.2 Other reasons The introduction of an explicit provision for an efficiency defence in the Merger Regulation reflects the evolution of the merger control system from the intermediate objective of preventing strong market positions towards a more “effects-based approach” assessing the likely net impact of mergers on consumers. Since 1990, the European Commission has had specific powers to control mergers with a Community dimension. This system of merger control at the Community level was created because globalisation and the dismantling of non-tariff barriers in the single market resulted in major corporate reorganisations in the Community, particularly in the form of cross-border mergers. Such restructuring was welcomed if it was motivated by the desire to exploit new opportunities created by a wider market and the search for efficiency7. Although the Merger Regulation included "technical and economic progress" amongst the criteria to be considered, there was general agreement that the scope for taking efficiencies into account was, in practice, limited. Until the entry into force of the new Merger Regulation in 2004, mergers tended to be judged on the basis of their potential anti-competitive effects alone, not on their pro-competitive benefits.

An efficiency defence reflects the evolution of merger control towards an approach assessing the likely net impact of mergers on consumers

5 For a full discussion, see Ilzkovitz, F. and R. Meiklejohn (eds), forthcoming, "European merger control: do we need an efficiency defence?",

Edward Elgar, Cheltenham, UK. 6 J. Farrell and C. Shapiro, 2001, Scale Economies and Synergies in Horizontal Merger Analysis, Antitrust Law Journal.

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The introduction of an efficiency defence demonstrates that “there is a widening consensus that the basic objective of competition policies is to encourage economic efficiency; so that while competition is the process, economic efficiency is the ultimate goal”8. If there is still enough competition on the market, greater internal efficiency of the merged company should be translated into lower costs and prices and thus be beneficial to consumers. The new approach could contribute to increased consistency between competition policy and the Lisbon objective of increased competitiveness as it improves the clarity and transparency of the decision-making procedure and the rigour of the analysis in a number of ways9. First, the formal inclusion of an efficiency defence will lead to a more sophisticated assessment of efficiencies and hence greater understanding of their impact. Although there are problems associated with the implementation of an efficiency defence, since the links between M&A and economic efficiencies are not always easy to understand, “once economies are admitted as a defence, the tools for assessing these effects may be expected progressively to be refined”10. Second, the introduction of an explicit efficiency defence in the European merger control process may increase companies’ incentives to identify and present efficiency gains and to do so in more organised and realistic ways11, again giving the European Commission a better understanding of the issue. The knowledge that the rationale for a merger will be scrutinised by a competition authority may also induce managers to think more carefully before embarking on a course of action which entails substantial risks. 3. Efficiencies in European merger control In 2004 the Council of Ministers adopted a new Merger Regulation which explicitly indicated that efficiencies are taken into account in the analysis of mergers12. Several conditions have to be fulfilled, however, in order to do so: the efficiencies need to benefit consumers and to be merger-specific, verifiable and timely.

7 Ilzkovitz F. and R. Meiklejohn, 2003, European Merger Control: Do we need an efficiency defence? Journal of Industry, Competition and

Trade, 3:1/2, pp. 57-85. 8 OECD, 1994, Interim Report on Convergence of Competition Policies. 9 Buigues P., Jacquemin A., Sapir A., European policies on competition, trade and industry: conflict and complementarities, 1995, Edward Elgar,

Aldershot, UK. The authors show that, in certain sectors, industrial policy, competition policy and trade policy are not in line with the prescription of economic theory and therefore do not sufficiently encourage efficiency. They also criticise the insufficient transparency of the links between the three policies.

10 O. Williamson, 1968, "Economies as an antitrust defense: the welfare trade-offs", American Economic Review, vol. 58, pp. 18-36. 11 See Robert Pitofsky, 1998, ‘Efficiencies in Defence of Mergers: 18 Months After’. 12 Article 2(1)(b) of the old Merger Regulation (4046/89), however, already allowed the Commission to take into account “the development of

technical and economic progress provided that it is to consumers’ advantage and does not form an obstacle to competition”. Some commentators on the Merger Regulation were of the opinion that this meant that the Commission could take efficiencies into account in its assessment of the competitive effect of the merger.

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3.1 General principle The Commission determines, pursuant to Article 2 of the new Merger Regulation, “whether the merger would significantly impede effective competition, in particular through the creation or the strengthening of a dominant position”, and should therefore be declared incompatible with the common market. The 2004 guidelines on the assessment of horizontal mergers state that efficiencies may justify a merger that would otherwise be considered anti-competitive: “it is possible that efficiencies brought about by a merger counteract the effects on competition and in particular the potential harm to consumers that it might otherwise have”. In practical terms, the Commission compares the competitive conditions that would result from the merger with the conditions that would have prevailed without the merger. This is done in all markets identified where the merger could potentially harm competition, namely the “relevant markets”13. In order to evaluate the foreseeable impact of a merger on the relevant markets, the Commission analyses its possible anti-competitive effects and the relevant countervailing factors such as buyer power, the possibilities for new competitors to enter the market and possible efficiencies put forward by the parties. 3.2 Benefit to consumers Efficiencies such as cost savings or gains associated with increased R&D will be taken into account only to the extent that they are passed on to consumers. “The relevant benchmark in assessing efficiency claims is that consumers will not be worse off as a result of the merger”14. The guidelines on the assessment of horizontal mergers distinguish two main types of efficiency gains which may benefit consumers15. The first type of efficiency is cost savings, for example in production or distribution. Variable and marginal cost reductions are more likely to be taken into account in the assessment of efficiencies than fixed costs because they are more likely to result in lower prices for consumers and to be achieved in a shorter period of time. In a footnote the guidelines explain that “fixed cost savings are not given such a weight as the relationship between fixed costs and consumer prices is normally less direct, at least in the short run”. The second type of efficiency relates to innovation resulting in new or improved products. A product innovation is the introduction of a good or service that is new or significantly improved with respect to its characteristics or uses. This has to be distinguished from a process innovation, which is the implementation of a new or significantly improved production, delivery or distribution method. This includes significant changes in techniques, equipment and/or software.

Efficiencies may be an integral part of the analysis of mergers

Lower prices and a wider selection of better products are efficiencies

13 Affected markets consist of product markets where the parties have a combined market share of 15% or more for horizontal relationships and

25% or more for vertical relationships. 14 European Commission, 2004, "Guidelines on the assessment of horizontal mergers under the Council Regulation on the control of concentrations

between undertakings", Official Journal C 31, 05.02.2004, pp. 5-18. 15 Consumers may be end-consumers or producers using goods.

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Efficiencies will be taken into account only if they benefit consumers Efficiency gains must be merger-specific, verifiable, and timely The merging parties must demonstrate the merger-specificity of the claimed efficiencies

Customers will however in all cases benefit from increased choice, lower prices, or higher quality of goods and services. Efficiencies that are likely to benefit the merged company, but not its customers, would not be recognised as a countervailing factor to the negative impact of the merger. The guidelines state that efficiencies are more likely to be passed on to consumers if there is sufficient competitive pressure from the remaining firms in the market and from potential entry. This is based upon the principle that competition in the market is the best method for protecting consumers. Efficiencies will probably never justify a merger to monopoly or near-monopoly. The greater the possible negative effects on competition of the merger, the larger the efficiency gains have to be in order to counteract those effects. Finally, the guidelines clearly state that efficiency gains may counteract a potential anti-competitive effect only if they arise in the same market where the merger is likely to lead to competition concerns. In other words, efficiency gains in one market cannot compensate for an anti-competitive effect in another. 3.3 Merger-specificity, verifiability and timeliness The efficiencies need to be merger-specific. This means that they first need to be proved to be effectively caused by the merger and unlikely to be realised in the absence of the proposed merger. Efficiency gains will only be taken into account if it is proved that they could not be achieved by less anti-competitive alternatives. This last requirement comes from the fact that efficiency gains may also be made through many types of business arrangement, including not only mergers but also, for example, joint ventures, licensing, and strategic alliances. M&A usually represent the most “restrictive” type of arrangement as they effectively remove one competitor from the marketplace entirely. The efficiencies are therefore not considered merger-specific if they could be achieved by another type of business arrangement. For this reason, merger-specific efficiencies are viewed by some economists as those cost savings or technological advances which flow from the close or intimate integration of hard-to-trade assets16. Examples may be improving the inter-operability of complementary products or sharing complementary skills. According to this definition, efficiencies will only be merger-specific if they cannot be achieved by internal expansion or through less restrictive transactions. The merging parties must provide all the relevant information in order to demonstrate that the claimed efficiencies are merger-specific. In addition, the onus is on them to show that efficiencies are likely to be realised and to counteract any adverse effect on consumers that might otherwise result from the merger. Efficiencies which are vague or speculative will not be taken into account. Efficiencies have to be verifiable by the Commission in order to provide enough certainty that they are likely to materialise.

16 J. Farrell and C. Shapiro, 2001, Scale Economies and Synergies in Horizontal Merger Analysis, Antitrust Law Journal.

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Finally, the Commission will only take into account efficiencies which are timely. The later efficiencies are expected to materialise, the less weight the Commission assigns to them, so as to ensure proper assessment of the probability that they will materialise. 4. What can we learn from the experience of other jurisdictions? This section discusses what can be learnt from the practices of jurisdictions which have an explicit policy of taking efficiencies into account. It shows that it has not been applied very often, partly because of difficulties of implementation. In addition there is still a great deal of debate as to what the right welfare standard is and which types of efficiencies are relevant to the analysis of mergers. 4.1 Implementation can be difficult The efficiency defence has not been applied very often in practice. This is not very surprising, as empirical evidence seems to indicate that mergers generally have modest effects on profitability but that in a limited number of cases M&A efficiencies may be very large17. Furthermore, efficiency analysis should normally only play a role in those merger cases that give rise to some concern. An efficiency defence is therefore unlikely to be decisive in many cases. However this is also explained by the difficulties in integrating efficiencies into the analysis of mergers for three main reasons. First of all, “while in most jurisdictions there is now a highly-developed paradigm for the analysis of anti-competitive effects (i.e. assessing the relevant markets, market shares and barriers to entry), the paradigm for considering specific merger efficiencies is rejected or relatively undeveloped in many countries. Accordingly, competition authorities may seek to discount the magnitude of predicted efficiencies” 18. The USA, Canada, the EU, the UK and Australia are examples of jurisdictions that have explicit policies in favour of the consideration of efficiencies in merger control. However the number of cases where efficiencies have been taken into account are very limited. While efficiencies have been at the origin of certain decisions not to challenge some merger cases, for example in the USA, in the EU system there have not been any cases since the issuance of the 2004 guidelines. Efficiencies, and in particular dynamic efficiencies, are uncertain by their nature as their magnitude, likelihood and timing are difficult to ascertain. Without the benefit of hindsight, it is difficult to quantify such benefits. The parties must define and demonstrate the size and nature of anticipated efficiencies, often at a preliminary stage in their due diligence and business planning, and certainly before they have the opportunity to fully assess the reality of the integration challenges they may face.

Efficiencies are difficult to integrate in the assessment of mergers

17 For a full discussion, see Ilzkovitz, F. and R. Meiklejohn (eds), "European merger control: do we need an efficiency defence?", Edward Elgar,

Cheltenham, UK. 18 ICN, 2004, ICN Merger Guidelines Project, Chapter 6.

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The "dynamic consumer standard"

While the US competition authorities recognise the potentially vital role of R&D and innovation efficiencies19, they explain that these efficiencies are generally less susceptible to verification than static efficiencies and are therefore given less weight. Commissioner Leary of the Federal Trade Commission (FTC) actually acknowledged in a speech given in 2002 that, while innovation or managerial efficiencies are probably the most significant variable in determining whether companies succeed or fail, the FTC tends to ignore them in the formal decision-making process because it does not know how to weigh them. Finally, while it seems easy from a theoretical point of view to make a cost-benefit analysis of mergers, in practice this analysis is not simple as there are complex interactions between competition and efficiency effects. For example, efficiencies are more likely to be achieved in a competitive environment but the achievement of efficiencies may also have a feedback effect on competition.

4.2 Welfare criteria applied by different jurisdictions Competition authorities do not treat every type of efficiency equally. This is partly due to a different choice of welfare standards. Under the consumer surplus standard, efficiencies must eliminate the consumer losses associated with the lessening of competition. Under the total welfare standard, producer gains may also compensate for consumer losses. The Canadian system follows an intermediate approach, taking account of both consumer and producer welfare but allowing a greater weight to be assigned to the former. Some commentators on the efficiency defence approach in the USA20, which resembles that of the EU, interpret this approach as a hybrid consumer welfare/total welfare approach21, also sometimes called a dynamic consumer standard. The idea is that, although efficiencies that are immediately passed on to consumers receive the most weight, other efficiencies can also be considered if they will ultimately benefit consumers. The dynamic consumer standard sees the main significance of efficiencies as lying in how likely they are to contribute to post-merger competition22. For example, in a concentrated sector with four companies, a merger between two of them may lead to a significant impediment to effective competition. However in a high-tech industry such as data processing software, the merger may create efficiencies by combining complementary R&D capabilities which could lead to higher quality and a greater number of varieties of the software if the integration of activities has been well thought through in advance. As a result, the merged company could become a better competitor against the two other companies and the transaction would therefore lead to more competition and efficiencies in the market.

19 T.B. Leary, Commissioner FTC, ‘Efficiencies and Antitrust: A Story of Ongoing Evolution’, 2002, ABA Section of Antitrust Law 2002 Fall

Forum. 20 The 1968 merger guidelines already included a “narrow efficiency defence” based on the work of Oliver Williamson. However, it is the 1984

and 1997 merger guidelines which really defined the tools and methodology used by US courts and competition agencies. 21 See W. J. Kolasky and A. R. Dick, 2003, ‘The merger guidelines and the integration of efficiencies into antitrust review of horizontal mergers’,

Antitrust LJ Vol.71, N°1. 22 Susan DeSanti, Director, Policy Planning Federal Trade Commission, 1996, Competition and efficiencies in Merger Analysis, the 1996 Annual

Meeting Section of Antitrust Law, American Bar Association.

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Another example might be an industry with three players where the technology is in the process of being updated. While the market leader is relatively certain to survive the transition to the next generation of the technology, the two smaller players lose customers, who increasingly doubt the firms’ capacity to update their technology. The two companies can no longer invest in R&D as they are left with excess capacity and rising unit costs. Merging their manufacturing facilities would allow them to achieve economies of scale, reduce their unit cost of production and update their technology, something they could not achieve alone. As a result the level of competition would be increased. While merger-specific efficiencies are intrinsically hard to replicate, they may involve positive external effects for competitors of the merged entity, thereby increasing competition. For example, the development of a new product or production process may be too risky for firms to undertake unless the costs can be spread over a very large volume of production. In such circumstances, a merger may be a necessary precondition for technological progress. Although the immediate effect of the merger would be an increase in market power and some short-term consumer detriment, it may be that the new product or process can be imitated by rivals once it has been developed. For this reason Roberts and Salop23 propose a further development of the US approach, consisting of “a dynamic version of the pure consumer welfare standard which would balance any consumer harms flowing from short-run price increases with consumer benefits from price decreases in the longer run resulting from diffusion of the merger-induced cost reductions to other competitors.” They add that “application of an appropriate discount rate to future time periods ensures that greater weight is given to relatively more certain, short-run effect”. The approach of a dynamic consumer standard could perhaps help to reconcile competition authorities’ views on the types of efficiencies which may be considered in their analysis. Some efficiency improvements may increase firms’ profits without benefiting consumers in the short run. This would be the expected outcome when savings are made in fixed costs, since such savings do not necessarily lead to lower consumer prices, at least in the short term. Fixed cost savings are therefore not usually considered to be relevant efficiencies in jurisdictions which have chosen the consumer standard. However, if it appears that they are likely to improve competition, they would be taken into account under the dynamic consumer standard approach. While most economists would be more in favour of a “total welfare”24 approach, as all resource savings benefit society, and producers are also consumers, the welfare standard presented by the EC Merger Regulation is the consumer standard. Efficiencies will only be taken into account if they benefit consumers. This allows for a dynamic perspective whereby the Commission’s Merger Guidelines do not exclude consideration of efficiencies that may occur in the longer term. However, naturally, they indicate that the later the efficiencies are expected to materialise, the less weight the Commission can assign to them.

23 C. Salop, 1995, FTC hearing on global and innovation-based competition, efficiencies in dynamic merger analysis. Emphasis added. 24 Total welfare means the sum of consumer and producer surpluses.

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The Guidelines also do not exclude as a matter of principle consideration of fixed costs savings, although they underline that reductions in marginal costs are more likely to result in lower prices for consumers. Finally, it is also made clear that dynamic efficiencies may be taken into account if the relevant conditions are met. In all circumstances, the objective of EU merger control is to prevent consumers being harmed for a substantial period of time. 5. Implementation of an efficiency defence As the cases where an efficiency defence is relevant may include some mergers that yield large economic efficiencies, it is important to have the right methodology for identifying them. However, since the magnitude of the information costs required for an efficiency defence is high, an in-depth investigation of efficiency gains should be carried out only in those cases where the merger might otherwise be blocked and where significant efficiencies are claimed by the parties. Ilzkovitz and Meiklejohn25, inspired by Röller, Stennek and Verboven, propose a sequential approach distinguishing three stages: the screening tests, a qualitative analysis of efficiencies and a quantitative cost-benefit analysis. In the first stage there is no explicit analysis of efficiencies. For mergers that only reduce competition insignificantly or not at all, efficiency gains are presumed to be more important than anti-competitive effects and these mergers will be automatically accepted. Similarly, general presumptions are used to define a threshold above which anti-competitive effects are presumed to dominate. Thus, both a low and a high threshold are defined and a more detailed investigation, including an explicit efficiency defence, is made only in intermediate cases. This would leave room to exclude efficiencies from detailed analysis both when the merger raises no serious competition problems and where the claimed efficiencies are small in comparison with the high anti-competitive effects. Essentially, the screening tests are the same as the existing Phase I procedure of the Merger Regulation, with the difference that the Commission might indicate to the notifying parties that an efficiency defence would be unlikely to succeed if the market power effects of the merger were perceived to be very large or if the claimed efficiencies were small or implausible. The information provided by the parties at the screening stage should already enable the Commission to indicate whether an efficiency defence has a chance of succeeding. If the parties fail to provide any plausible reasons to expect significant efficiency gains, they can be discouraged from pursuing this line of defence in the rest of the procedure. If the merger passes the screening tests and the parties claim that it will create efficiencies, a comprehensive qualitative analysis of efficiencies is made on the basis of information given by the parties.

25 F. Ilzkovitz and R. Meiklejohn, forthcoming, "European merger control: do we need an efficiency defence?", Edward Elgar, Cheltenham, UK.

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This information would include an explanation of the nature of the expected efficiency gains (economies of scale and scope, rationalisation of research and development, improvement in management etc); their possible effects on costs, prices, the quality of products and innovation, and the time horizon for these positive effects to be realised26. At the final stage of this process, if relevant information is available, a more complex analysis might be carried out to quantify the net effects of the merger, taking account of both the anti-competitive effects due to the increase in market power and the efficiencies expected from the merger. 6. Conclusion As competition policy aims to promote economic efficiency, an explicit efficiency defence is justified for both economic and other reasons. Some mergers combine anti-competitive features with the potential for appreciable efficiency gains which may be sufficient to counteract the harm to competition. Furthermore, an efficiency defence can contribute to developing greater coherence between European economic policies designed to improve competitiveness. In particular, it shifts the focus of the merger control system from the intermediate objective of preventing strong market positions towards a more effects-based approach assessing the likely net impact of mergers on consumers. If there is still enough competition on the market, greater internal efficiency of the merged company should be translated into lower costs and prices and thus be beneficial to consumers. The European Commission’s 2004 guidelines on the assessment of horizontal mergers seek to clarify the way in which the analysis of the impact on competition of such mergers is carried out. As part of this, efficiencies are now explicitly included in the analysis as countervailing factors against the anti-competitive effect of mergers. In order to be taken into account, however, the efficiencies need to benefit consumers and be merger-specific, verifiable, and timely. The practice of other jurisdictions shows that the number of merger cases in which an efficiency defence has been applied is very limited. This is partly because the number of mergers actually causing some competition concerns while yielding efficiencies is limited. Furthermore, implementation has often proved difficult as efficiencies are uncertain in nature and difficult to verify. The dynamic consumer standard as suggested by some economists provides an interesting perspective for improving our understanding of what constitute relevant efficiencies. Although the efficiency defence has only been applied in a very limited number of cases, the economic implications may be very large. A methodology is therefore proposed in order to ensure that those mergers would be allowed by competition authorities: first, a screening test to identify the cases for which an efficiency defence should be applied; second, a comprehensive qualitative analysis; and finally – where possible – a quantitative analysis.

26 Neven and Seabright (in Ilzkovitz and Meiklejohn op. cit.) suggest that efficiency claims are not really credible unless the notifying parties can

support their claims by showing evidence that they have planned the necessary reorganisations of their management structure, production facilities, marketing and R&D departments and designed appropriate incentive structures for their staff.