CMA scrutiny of high-leverage PE divestment purchases expected to increase

In a 2021 study on children's social care market, the CMA highlighted concerns around PE investors and highly leveraged businesses in the sector, citing "disorderly failure" which could result in the business being considered less attractive to a new proprietor and causing market disruptions.

According to the report, the CMA's concern is that PE-owned providers in aggregate, net debt exceeded their fixed assets, in comparison to non-PE-owned assets. PE owners can exit the market at any time, and the high levels of debt raise concerns about the resilience of the market, the report said.

Specific scrutiny by the CMA is likely to be seen in a divesture context, where merging parties need to divest a business to earn approval, Ruchit Patel, partner at Ropes & Gray, said. The CMA will look at whether the buyer can run a divested business and this will merit scrutiny, Patel said. A highly leveraged model will attract attention from the regulator, he said.

The CMA will want to ensure there is enough cash for the divested business to compete on an ongoing basis, Patel added. "You need to look at whether the leverage allows you to deliver on business plans, R&D, product development, and innovation. And you need to look at whether forecaster price increases of services and products are driven by disproportionately leveraged financing, the absence of competition, or any other factor" said Patel.

Speaking at a recent conference, CMA mergers director Timothy Geer cited agency guidance outlining that "a highly-leveraged acquisition of the divestiture package which left little scope for competitive levels of capital expenditure or product development is unlikely to satisfy the CMA".

"PE firms portfolio approach to investment and potential shareholdings in other businesses in the same industry could affect the firm's incentives to compete and thus influence the CMA's decisions in a divestment purchase scenario," said Geer.

In any auction processes, PE was traditionally favoured due to a lack of regulatory baggage, commented Michael Okkonen, partner at Dechert. However, if the CMA does introduce more scrutiny, then PE will be competing on a more leveled playing field, he added. Additionally, sellers will be heavily scrutinising PE to avoid potential delays, said Okkonen.

This may shift the auction dynamic as sellers may prefer a lower leveraged strategic buyer over a highly leveraged PE buyer, Patel said. In an auction process, strategic buyers typically offer better prices but PE bidders are chosen in many instances as they carry less regulatory risk, echoed Okkonen. "The sellers tend to prefer the higher price that strategic buyers often offer over private equity buyers, he added.

"When investing in a divestiture business in the UK, the [proprietors] focus must be on having a deliverable and executable business plan with sufficient funding. So, if available, funding a business with more cash than leverage could mitigate concerns," Patel added. The CMA's primary concern is that the acquirer is independent and has a viable investment plan, echoed Veronica Roberts, partner at Herbert Smith Freehills. Further theories of harm may be developed which include a focus on leverage, that would be factored into decision-making, she said.

The CMA can investigate highly leveraged deals and take this into account for a substantive assessment, Okkonen said. However, it may be difficult to assess if the level of debt will decrease the level of competitiveness and to what degree. "In situations where PE acquires a divesture asset, typically the [CMA] requires the new owner to have the ability to keep the target competitive. One could see the CMA considering the level of debt which could lower the competitiveness of a target post-closing," he added.

"The transaction would have to be highly leveraged to have an impact on the CMA's conclusion on the deal," Okkonen said.

Concerns around leverage of a firm's position from one market to another can be considered in merger control, according to David Little, partner at Latham & Watkins. The CMA has indicated it will continue to explore these theories in merger cases, including those involving PE, he said.

Most CMA merger control intervention is based on traditional horizontal theories of harm, which look at whether PE has overlapping holdings with the target, he added. In a divestment context, the nature of the analysis lends itself to broader consideration of a buyer's business model – for example, the debt profile of a buyer, including a PE buyer, could be evaluated to assess how financing might impact the profitability of the divestment business, Little said.

Any overcorrection by an authority, or any change in enforcement, which is not explained on the specific facts, could chill investment appetite and deal flow, Little said. This doesn't serve anyone's interest: buyers need predictability around when intervention is more likely to occur and sellers want a competitive auction – unpredictability or changes by authorities that are not grounded in evidence could depress interest, he said.

Although any potential CMA concerns around highly indebted businesses would be industry-agnostic, the CMA may focus on sensitive consumer-heavy sectors such as life sciences, Okkonen said.

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