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Water Island Capital Special Report: Global Competition Regulators Part II October 2016

Divestitures and the Regulatory Landscape

There has been a debate within regulatory agencies for some time now as to the best way to remedy anticompetitive mergers and acquisitions.1 On one end of the spectrum are those that favor divestitures (e.g. structural remedies) and on the other end are those that favor guidelines and conditions firms must follow for specified lengths of time after the merger completes (e.g. behavioral remedies). Independent research (such as the article referenced in footnote 1 below), as well as our own observations, lends credence to the fact that over the past few years, this debate has been largely confined to the realm of academia – theories and hypotheticals in research pieces and op-eds – as opposed to the halls of the various regulatory agencies. A sole reliance on divestitures was, and still continues to be, the favored remedial solution. However, 2015 saw the strengthening of a trend which began to materialize a few years prior: the use of divestitures as the sole means of remedy for anticompetitive mergers and acquisitions has continued to slowly recede in popularity, as non-structural approaches accounted for 37% (62% if we exclude the US) of total remedies imposed by global competition regulators. It seems the debate may have finally ventured outside the realm of academia and become something more – a precursor to the implementation of a concrete policy shift.

Source: Allen & Overy.2

1 (Heyer, 2012) 2 (Tolley & Bavasso, 2016)

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As market shares across industries (e.g. wireless providers, health care providers, and retail supermarkets in the US) becomes increasingly concentrated, the efficacy of divestitures will continue to be called into question. While our prior insights piece on global antitrust review3 provided an overview and introduction to the agencies which seek to regulate anticompetitive mergers and acquisitions, this piece will delve into how those regulators have sought to ensure competition. By exploring two high profile deals which highlight the shortcomings of the current regulatory approach, we aim to show that the status quo – a regulatory environment where a singular reliance on divestitures reigns supreme – could be set to change.

Case Study: Albertsons, Safeway, and Haggen

In March 2014, Safeway Inc., a US-based operator of food and drug retail stores, agreed to be acquired by Albertsons LLC, a US-based operator of drug stores, conventional supermarkets, and warehouse stores for approximately $8.3 billion. At the time, the two companies were structured as such:

• Albertsons LLC operated 630 supermarkets under the Albertsons banner in 15 states, and under the Market Street, Amigos, and United Supermarkets banners in Texas.

• New Albertson’s, Inc. (a subsidiary acquired in 2013 which was previously owned by SuperValu),

operated 445 supermarkets under the Jewel-Osco, ACME, Shaw’s, and Star Market banners, in the eastern United States.

• Safeway operated 1,332 supermarkets under the Safeway, Tom Thumb, Randall’s, Pak ’n Save, The

Market, Vons, Pavilions, and Genuardi’s banners located throughout the country.4 The sheer number of brands under which these companies operated should be a strong indicator of just how concentrated the industry had become, even prior to this deal being announced. As a result of this high industry concentration, and because the transaction met minimum deal value thresholds, Hart-Scot-Rodino (HSR) approval from the Federal Trade Commission (FTC) was required. In evaluating proposed mergers and acquisitions, US regulatory agencies typically utilize the Herfindahl-Hirschman Index (HHI), which measures industry concentration on a scale of 0-10,000 by squaring the market share of each firm competing in a market, and then summing the resulting numbers. Historically, the agencies have considered a market with a result of less than 1,000 to be a competitive marketplace; a result of 1,000-1,800 to be a moderately concentrated marketplace; and a result of 1,800 or greater to be a highly concentrated marketplace. Over the course of their investigation into the Albertsons / Safeway merger, the FTC found that “Post-acquisition HHI levels in the relevant geographic markets would range from 2,562 to 10,000, and the Acquisition would result in HHI increases ranging from 225 to 5,000” in addition to the finding that the “Acquisition would reduce the number of meaningful competitors from two to one in 13 relevant geographic markets, three to two in 42 relevant geographic markets, and 4 to 3 (or greater) in 75 relevant geographic markets.”5 In light of these findings, the companies agreed to divest a total of 168 stores in

3 (Dibble, 2016) 4 (Federal Trade Commission, 2015) 5 (In the Matter of Cerberus Institutional Partners V, L.P. a limited partnership; AB Acquisition LLC, a limited liability company; and Safeway Inc., a corporation., 2015)

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areas of high concentration to four separate companies – eight stores to Associated Food Stores Inc., 12 stores to Associated Wholesale Grocers Inc., two stores to SuperValu Inc., and the vast majority, 146 stores, to Haggen Inc. Subsequently, they received FTC approval and the deal ultimately closed on January 30, 2015. Post-Merger Prior to the Albertons divestiture, Haggen was an independent grocery retailer in the Pacific Northwest with 18 locations and 2,000 employees. Haggen’s purchase of the Albertsons divestiture in December 2014 for an undisclosed sum (estimated to be more than $300 million) ballooned those numbers to 164 locations and over 10,000 employees.6 Debbie Feinstein, director of the Bureau of Competition for the FTC stated that in determining the suitability of Haggen to adequately adapt to a nearly 800% increase in locations and a nearly 400% increase in employees, the FTC “brought Haggen in and looked at their business plan, their finances, their management plan, their future plans to invest in stores, plans for stores that aren’t performing as well, their distribution capabilities, marketing plans, their pro forma, etc. We do our due diligence before we recommend to the Commission that they accept the consent for public comment.”7 With the FTC’s blessing, Haggen completed their acquisition and began their plan to expand from a little-known, regional grocery retailer to a national powerhouse with locations throughout the western United States. Had the story ended there, this would have been a case study on how to successfully complete and integrate a large scale divestiture. Unfortunately for both Haggen and the FTC, this was not to be. A Haggen lawsuit filed in September 2015 outlined the chaos that unfolded almost immediately following the decision. According to the lawsuit, days before handing over the keys to the store, Albertsons raised the prices on all of its goods in addition to updating the electronic point-of-sales (POS) system to reflect these higher prices. As many of Haggen’s new stores were located in extremely price-sensitive markets, this inaccurate pricing information led to Haggen being ill-prepared to compete in these new markets. Additionally, Haggen claimed that Albertsons had instructed employees to remove all of the inventory from the stores and replace it with items that were already past, or close to passing, their expiration date – leading to product shortages, delays in rebranding and reopening the new stores, and expenditures on unforeseen costs. While the accuracy of the lawsuit can be questioned (Haggen had initially sued for $1 billion in damages but settled in January 2016 for $14 million)8, the troubles Haggen faced were far less opaque.

After the finalization of Albertsons’ 146 store divestiture in February 2015, Haggen spent the next five months rushing to bring their new stores online. However, by August 17, 2015, Haggen had announced that it would close and pursue a sale of 27 of its newly acquired stores. By September 9, the company had declared Chapter 11 bankruptcy. September 25 brought with it the announcement that Haggen would pursue the closure and sale of 100 more stores (in addition to the aforementioned 27). Finally, on November 7, Haggen announced that it would seek buyers for all of its stores. The graphic below outlines the finalized plans for the Haggen stores:

6 (Kendall & Brinkely, 2015) 7 (Adkins, 2015) 8 (Brickley, 2016)

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Source: Coupons in the News.9 *”Other” includes small, generally single-store, divestitures to 13 other companies.

As difficult as it is to believe, at the end of this fiasco the FTC allowed Albertsons to repurchase over 40% of the stores they divested to Haggen just 10 months prior. As Haggen began the process of closing or selling its assets, there emerged only a few buyers – none of which were capable of taking on more than a few dozen stores. At the risk of the complete shuttering of these assets and the potential unemployment of thousands of workers, the FTC waived their divestiture conditions on Albertsons and allowed them to step in to both purchase the stores and hire the employees. On November 24, 2015, Albertsons received approval to buy back 33 divested stores (one of these stores was a pharmacy not included in the above graphic) for $14 million dollars. According to the Wall Street Journal, “Albertsons’ successful bid price for more than a half dozen of the stores was $1 each, though the company will also assume financial liabilities that go along with the properties”.10 Additionally, on March 29, 2016, a judge approved Albertsons’ plan to take over the 29 remaining Haggen “core” stores (essentially, the 18 stores Haggen began with in addition to the divested stores that Haggen was able to successfully integrate) for $106 million.11 All told, by the end of this ordeal, Albertsons was not only able to buy back a portion of their assets at lower prices than they originally sold them, they were also able to acquire a competitor at fire-sale prices with virtually no strings attached. Albertsons did allow one small consolation, however – they agreed to keep the Haggen name on 15 of their newly acquired stores. Present Implications and Future Predictions The Haggen ordeal was a massive blunder for the FTC and could be a catalyst for US competition regulators to begin a pivot away from their overreliance on divestitures as a means by which to address

9 (Coupons in the News, 2015) 10 (Kendall & Brinkely, 2015) 11 (González, 2016)

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anticompetitive mergers and acquisitions. But what about non-US competition regulators who have not been impacted by Haggen in the same way their US counterparts were? Globally, divestitures are currently the favored method for resolving antitrust concerns and, absent a Haggen-sized misstep, there isn’t a clear reason as to why that should change. The ultimate outcome of the ongoing SABMiller / Anheuser-Busch InBev transaction (which spans multiple jurisdictions and global regulatory agencies), however, could prove to be the Haggen-like catalyst for the rest of the major global competition regulators.

Case Study: SABMiller / Anheuser-Busch InBev

On October 7, 2015, Anheuser-Busch InBev SA/NV (ABI) – a Belgian producer and distributor of beer, soft drinks and mineral water – submitted a proposal to acquire SABMiller PLC (SAB), a UK manufacturer of beer and soft drinks, for $113 billion12. If completed, the resulting company is expected to generate $64 billion in annual revenue and have a world-wide post-divestiture market share of nearly 30% (including a 46% market share in the US, 57% market share in Mexico, 33% market share in Africa, 63% market share in Brazil, and 62% market share in Latin America).13 The estimated market concentrations prior to divestitures are an even more stark representation of the veritable omnipresence of these companies and their brands:

Source: DataMoniter. Note: This chart does not include every country in which AB InBev and/or SABMiller have/has market share.

12 At the time of announcement and including net debt. The latest and final offer is worth approximately $125 billion. 13 (Mickle, 2015)

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As a result of this deal’s size and scope, the number of regions from which the companies need to obtain regulatory approval is substantial – the European Union, the US, South Africa, China, Colombia, Ecuador, Australia, India, and Canada. Given the information above, global regulators are unlikely to give this deal their approval without significant concessions – the most prominent of which are the large divestiture packages. In that regard, both SAB and ABI have been busy:

Sources: Dealogic, Water Island Capital.

It’s clear from the pre-divestiture concentration chart that regulators were going to push hard for concessions, and based on the above map, they certainly received them. In the US, SAB’s 58% stake in the MillerCoors venture amounts to roughly 17% of the total US market share. In the EU, the companies are divesting eight separate brands with a combined worth of $7.9 billion – including the popular Peroni and Grolsch brands. In China, SAB is divesting its stake in CR Snow, which is not only the largest brewery in the country by market share, but also the brewer of Snow – the most popular beer in the world (in terms of sales by volume). In South Africa, Distell is one of the leading producers of fine wines, spirits, and ciders on the entire continent. Should this deal take on Haggen-like characteristics down the road, regulators may point to these divestitures as evidence of them taking a firm stance (despite these actions leading to an even more concentrated industry). However, while more than $22 billion worth of divestitures may seem excessive, SAB and ABI benefit from this scenario just as much as the regulators (and consumers) on the other side of the table.

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It’s important to note that, except for the Distell stake, every single one of the divestitures listed above were offered up by SAB/ABI voluntarily (either prior to the respective region’s regulatory review process beginning or during the initial submission phase) as opposed to being requested by regulators. Further exploration of the global alcohol industry suggests that, far from being simply structural remedies to address anti-competitiveness, these divestitures are both purposeful and strategic in nature and were designed so as to allow the companies to shed assets in low or negative growth areas and reposition into markets with the largest promise for the future. In developed markets, beer consumption has slowed so much that the global beer market is expected to shrink this year by 0.1% (the first time the market has shrunk in 30 years). In the U.S. (where production has dropped 11% since ABI’s 2008 Anheuser-Busch acquisition) and Brazil, which together account for half of ABI’s total sales, beer volumes fell 3.9% over the first half of the year.14 Given this context, the divestitures in Europe and the US look both logical and self-serving – the companies are able to appease regulators while simultaneously transitioning out of markets that are either slowing down or in decline. Conversely, the highest growth areas for beer consumption are Latin America, Africa, and Asia – all areas in which SAB has a fairly compelling market share. In Africa as a whole, where volumes are expected to rise by 2.6%, SAB has a 34% market share. The company also offers ABI access to fast-growing markets in Latin America like Peru and Colombia, which helped SAB deliver a 6% increase in beverage volume over the first half of the year.15 In Africa and China, however, it initially seems difficult to count the divestitures of the Distell and CR Snow stakes as wins for the companies – the path towards regional hegemony doesn’t often begin with divestitures of the most popular regional players. While this could simply be chalked up to the costs necessary to receive the required regulatory approvals, looking at ABI’s prior history of expansion into new markets offers an alternative explanation. As noted in the Wall Street Journal, “AB InBev has a history of using acquisitions to boost profitability by cutting costs and steering consumers toward more expensive beers. CLSA analyst Caroline Levy said AB InBev has bought regional brewers in China, eliminated the regional beers, and then guided consumers toward Budweiser, which is about three times as expensive as Chinese beers, and its own higher-priced Chinese beer, Harbin.”16 Despite the setbacks incurred in the divestitures, ABI could easily begin replicating this strategy in Africa (while continuing the practice in China) by buying up the small regional breweries (which can be acquired at much lower costs and, given their size, are unlikely to require divestitures as a part of the regulatory approval process), eliminating their product offerings, and shifting their consumers to the higher priced SAB/ABI brands. In fact, ABI already has ample experience in positioning their beers as upscale alternatives. When the UK artificially increased the price of Stella Artois by imposing a higher duty tax (as a result of the beer’s 5.2% alcohol by volume, which was stronger than similar lagers at the time), the company developed one of the most famous beer marketing campaigns in history. By fully embracing the price increases, the “Reassuringly Expensive” campaign (which lasted from 1981 to 2007) saw Stella ascend from relative obscurity to one of the most popular brands in the UK with taglines such as “Come along, gentleman. Haven’t you got mansions to go to?” and sponsorships at the Queen’s Tennis Championships and major film festivals. The campaign was so successful that company executives decided to market the

14 (Mickle, 2015) 15 (Mickle, 2015) 16 (Mickle, 2015)

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beer as a sophisticated, upscale alternative in the rest of the regions in which it was sold, despite not being subjected to the same duty taxes in those areas.17 If ABI can successfully position their brands as upscale alternatives to Distell and CR Snow, history shows they are capable of capturing an increased market share while simultaneously charging more for their products. Coupled with a strategy of acquiring smaller regional brewers (and therefore eliminating competition in the faster growing craft beers segment) a plan begins to emerge as to how the company can dampen, or even negate, the impacts of its divestitures. As far as the high-growth regions go, the two companies already (for all intents and purposes) dominate the Latin American market. Provided the Chinese government doesn’t get involved, through regulatory means or otherwise, ABI can very easily leverage SAB’s experience operating in the region, as well as their experience in the areas previously mentioned, to aggressively compete for market share – and in Africa, it’s more or less the same story. Overall, it’s highly unlikely that any of the divestitures made in the pursuit of this deal (including the CR Snow and Distell stakes) will have a material impact on the companies’ aggressive push for market share in these high-growth regions. Present Implications and Future Predictions It is, of course, true that SAB/ABI’s business plan will take years to play out and success is not guaranteed. The ultimate outcome could very well be that global regulators successfully upheld competition while allowing a megamerger to complete. However, the eagerness with which the companies offered up their stakes in some of the most popular and successful breweries in the world should at least give rise to the question of whether or not these divestitures will ultimately accomplish their intended purpose. While the market share in the EU countries and the US will certainly become more equitable (at least in the short term), Latin America, Asia, and Africa could see the pendulum swing strongly into SAB/ABI’s favor in just a few years. Additionally, with the combination of SAB and ABI’s potent global distribution networks, the companies are well positioned to aggressively compete in the US and the EU should those regions reverse their growth predictions.

Conclusion

In light of the above cases, it may be difficult to argue for the efficacy and effectiveness of a singular reliance on divestitures in the future. While it is entirely possible that regulators may begin to lean more heavily upon them (perhaps in addition to expanding their breadth), whether or not divestitures will actually sustain and/or improve market competitiveness remains to be seen. Regardless, based on the two case studies presented in this piece, it is clear that divestitures are not a regulatory panacea. For industries where only small regional competitors can absorb the divestitures, regulators run the risk of repeating the Haggen fiasco. For industries where the divestors begin with a substantial market share advantage, regulators run the risk of the companies quickly reestablishing pre-divestiture market share levels through the strength of their already established operations.

17 It should be noted, however, that Stella’s image in the UK has been somewhat volatile. As a result of increased demand, in the early ‘90s ABI allowed the beer to be sold in supermarkets which, in turn, discounted the beer with various price promotions. Coupled with its higher alcohol content, the cheaper price made this the lager of choice for binge-drinking, and the beer began to be associated with violent crime and hooliganism. The company launched a new “she is a thing of beauty” campaign in 2007 in order to restore the upscale image and has had some success in that regard. However, the brand’s popular nickname, “Wife Beater”, has been more difficult to expunge.

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Unfortunately, we aren’t ready to make a call as to how this situation will ultimately play out for arbitrageurs. It’s clear that should difficulties and blowbacks continue to accumulate, regulators are unlikely to remain content with the status quo. However, they seem just as likely to lessen their reliance on divestitures (in favor of behavioral remedies, hybrid remedies, or a rejection of the combinations altogether) as they are to double down on divestitures by imposing more stringent requirements. While we believe that a shift towards behavioral or hybrid remedies would be the most beneficial path for both companies undergoing M&A activity as well as arbitrageurs (as these remedies would allow companies more latitude in determining how to address regulatory concerns, in turn decreasing the likelihood of a deal break as a result of burdensome requirements) we concede that regulators generally don’t make changes to policy for the benefit of investors. Regardless of the way the regulatory winds blow, however, we at Water Island Capital will be diligently monitoring and adapting to the changing regulatory environment as we seek to meet our mandate of protecting client capital while delivering superior risk adjusted returns.

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References

Adkins, J. (2015, November). Q&A with the FTC on Haggen Acquisition. Retrieved June 20, 2016, from Santa Clarita Valley Business Journal: http://static.signalscv.com/flipbook/SCVBJ/2015/11/files/assets/basic-html/page5.html

Brickley, P. (2016, January 22). Albertsons Settles Litigation Over Haggen Troubles. Retrieved June 20, 2016, from The Wall Street Journal: http://www.wsj.com/articles/albertsons-settles-litigation-over-haggen-troubles-1453501613

Coupons in the News. (2015, November 6). What Will Become of Your Haggen Store? The Latest List. Retrieved July 3, 2016, from http://couponsinthenews.com/2015/11/06/what-will-become-of-your-haggen-store-the-latest-list/

Dibble, B. (2016, April). Water Island Capital Special Report: Global Competition Regulators. New York, New York, United States of America: Water Island Capital. Retrieved from https://arbitragefunds.com/restricted/get/WIC_Global_Competition_Regulators.pdf

Federal Trade Commission. (2015, January 27). FTC Requires Albertsons and Safeway to Sell 168 Stores as a Condition of Merger. Washington, DC, United States of America. Retrieved June 24, 2016, from https://www.ftc.gov/news-events/press-releases/2015/01/ftc-requires-albertsons-safeway-sell-168-stores-condition-merger

González, Á. (2016, March 29). Judge approves sale of Haggen to Albertsons. Retrieved June 21, 2016, from The Seattle Times: http://www.seattletimes.com/business/retail/judge-approves-sale-of-haggen-to-albertsons/

Heyer, K. (2012). Optimal Remedies for Anticompetitive Mergers. Antitrust, pp. 26-31. Retrieved June 15, 2016, from http://www.americanbar.org/content/dam/aba/publications/antitrust_magazine/spring_2012_heyer.authcheckdam.pdf

In the Matter of Cerberus Institutional Partners V, L.P. a limited partnership; AB Acquisition LLC, a limited liability company; and Safeway Inc., a corporation., C-4504 (Federal Trade Commission January 27, 2015). Retrieved June 15, 2016, from https://www.ftc.gov/system/files/documents/cases/150127cereberuscmpt.pdf

Kendall, B., & Brinkely, P. (2015, November 24). Albertsons to Buy Back 33 Stores It Sold as Part of Merger With Safeway. (Dow Jones & Company) Retrieved June 20, 2016, from Wall Street Journal: http://www.wsj.com/articles/albertsons-to-buy-back-33-stores-it-sold-as-part-of-merger-with-safeway-1448411193

Mickle, T. (2015, October 14). AB InBev Takeover of SABMiller Would Realign Global Beer Industry. New York, New York, United States of America: Dow Jones & Company. Retrieved June 29, 2016, from http://www.wsj.com/articles/ab-inbev-takeover-of-sabmiller-would-reshuffle-global-beer-industry-1444743235

Tolley, L., & Bavasso, A. (2016, February). Global trends in merger control enforcement. Allen & Overy. Retrieved August 17, 2016, from http://www.allenovery.com/SiteCollectionDocuments/Global%20trends%20in%20merger%20control%20enforcement%202016.pdf

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Glossary:

Chapter 11 Bankruptcy: A form of bankruptcy that involves a reorganization of a debtor's business affairs, debts and assets. Named after the U.S. bankruptcy code 11, Chapter 11 is generally filed by corporations that require time to restructure their debts, and it gives the debtor a fresh start, subject to the debtor's fulfillment of his obligations under the plan of reorganization. Divestiture: The action or process of selling off subsidiary business interests or investments.

Important Information:

All materials have been prepared for general information purposes only to permit you to learn more about our firm. The information presented is not legal advice, is not to be acted on as such, may not be current, is not an exhaustive discussion of all regulatory requirements pertaining to a merger, and is subject to change without notice.

Communication of information by, in, to or through this piece and your receipt or use of it (1) is not intended as a solicitation, (2) is not intended to convey or constitute legal advice, and (3) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any such information without first seeking qualified professional counsel on your specific matter.

FUND OBJECTIVE: The Arbitrage Fund seeks to achieve capital growth by engaging in merger arbitrage.

An investor should consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. The current prospectus contains this and other information about the Fund. You may obtain a copy of the Fund’s prospectus at http://arbitragefunds.com or by calling (800) 295-4485. Please read the prospectus carefully before investing.

We are making this research available to you for your information and education. Any references in this research to specific holdings are not to be considered recommendations by the Arbitrage Fund (the “Fund”) or Water Island Capital (the “Advisor”), the Fund’s advisor. Any discussion of specific securities is intended to help readers understand the Advisor’s investment management style vis-à-vis the current deal environment, and should not be regarded as a recommendation of any security or of the Fund.

RISKS: The Fund uses investment techniques that are different from the risks ordinarily associated with equity investments. Such techniques and strategies include merger arbitrage risks, high portfolio turnover risks, options risks, borrowing risks, short sale risks, and foreign investment risks, which may increase volatility and may increase costs and lower performance. Past performance is not a guarantee of future results.

Top 10 holdings as of 6/30/16: AGL Resources Inc, Starwood Hotels & Resorts Worldwide Inc, ITC Holdings Corp, TECO Energy Inc, Questar Corp, FirstMerit Corp, TransCanada Corp, Qlik Technologies Inc, Cvent Inc, SABMiller PLC. Top 10 holdings represent 40.4% of the portfolio. Holdings are subject to change. Current and future holdings are subject to risk.

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