Potential competitors are firms that currently do not exert competitive pressure but might do so in the future. The acquisition of these firms is a widespread phenomenon. As Figure 1 shows, since the mid-1990s there has been a dramatic shift in the exit strategy of start-ups backed by venture capital, from IPOs towards acquisitions (obviously, not all the targets of such acquisitions are potential competitors). In the digital economy alone, hundreds of start-ups have been bought in the last few years by incumbents such as Alphabet (Google), Amazon, Apple, Meta (Facebook) and Microsoft, but this phenomenon extends beyond the digital industries. Similar patterns prevail in other industries such as, among others, the healthcare and pharmaceutical industries, as documented by Eliason et al. (2020) and Cunningham et al. (2021), respectively.
Source: Pellegrino (2021).
Note: The figure plots the number of successful exits of start-ups backed by venture capital in the US by year and type (Initial Public Offerings vs. Acquisitions).
In most cases, such acquisitions did not trigger mandatory pre-merger notification requirements, leading to stealth consolidation (Wollmann 2019). When antitrust agencies did open an investigation, the acquisitions were authorised (except for the recent Facebook/Giphy decision by the UK's Competition and Markets Authority, the first time a merger by one of the Big Tech companies has ever been blocked). As a result, many have asked for stricter antitrust action, alarmed by the possible anti-competitive consequences arising from the elimination of future competition (Cremer et al. 2019, Furman et al. 2019, Scott Morton et al. 2019, Lemley and McCreary 2020, Motta and Peitz 2021).
Much of the emphasis in this debate has been on such acquisitions having anti-competitive effects when they take the form of so-called ‘killer acquisitions’, as documented by Cunningham et al. (2021) in the pharma industry: incumbents acquire a start-up to then shelve the start-up's project, to avoid cannibalisation of existing profits. However, one must recognise that such acquisitions may allow for the development of projects that would otherwise never reach the market. This may happen because the incumbent has an availability of resources that the target firm lacks. In a recent paper (Fumagalli et al. 2020), we focus on financial resources as the key asset that start-ups may be short of and acquirers can complement, based on evidence showing financial constraints are an important impediment to the start-ups' growth.
In this context where both anti- and pro-competitive effects may in principle arise, the objective of our paper is to identify optimal policy towards acquisitions of potential competitors. Perhaps surprisingly, despite the potential upside of such acquisitions, we find that antitrust agencies should enforce merger control in a ‘strict’ way, as we explain below.
In our model, a start-up owns a project with positive net present value that, if developed, will allow it to compete with an incumbent firm. To cover the cost of development, the start-up needs to raise external funds. It may be either able to do so, and hence would succeed as an independent company in the market, or it may be financially constrained, and it will not be able to become an actual competitor. Neither the incumbent nor the antitrust agency knows the type (i.e. financially constrained or not) of the start-up. The price of the takeover is determined in a non-cooperative bargaining game with asymmetric information. If the incumbent and the start-up finalise an acquisition, the antitrust agency authorises or blocks the deal based on pre-committed standards of review.
We show that the takeover game can feature two types of equilibrium offers: either a high takeover price, such that any start-up would sell at that price, irrespective of its type; or a low takeover price, at which only financially constrained start-ups would be willing to sell.
Which price arises at the equilibrium depends on the decision of the antitrust agency on the proposed deal and on the probability for the incumbent to pay a high price. More precisely, if a low price is accepted, the antitrust agency infers that the start-up is financially constrained and will authorise the deal. This is the case in which the acquisition is (weakly) beneficial: if the incumbent develops, a new product will reach the market; if it shelves, nothing changes since the start-up would not have been able to succeed independently. A high price, instead, does not reveal additional information on the type of start-up to the incumbent and the antitrust agency. By paying a high price, the incumbent is certain to appropriate the project and avoid product market competition, but it may end up overpaying for a constrained start-up. This is a risk worth taking only when the prior probability that the start-up is unconstrained is high enough. However, the antitrust agency needs to authorise the deal for the high-price takeover to occur. It will do so if the prior probability that the start-up is unconstrained is low enough. In that case, the scenario in which the early takeover is welfare detrimental, because of the suppression of product market competition and, when the incumbent shelves, also of project development, is sufficiently unlikely.
There are situations, therefore, in which a high-price offer is profitable for the incumbent, but the anticipation that the deal will be blocked leaves no other option than offering a low price. In this case, the merger policy exerts a ‘selection effect’: it pushes towards acquisitions that target only constrained start-ups and are thus preferable in terms of welfare. Moreover, the more stringent the standards of review, the stronger the selection effect and the more likely that a low-price takeover replaces a high-price takeover at the equilibrium.
For this reason, the optimal merger policy commits to standards of review that are sufficiently strict to prohibit high-price takeovers. Indeed, it is optimal to do so even when the high-price takeovers might increase expected welfare. By forcing the switch to a low-price takeover, such a merger policy makes expected welfare even higher. The optimal merger policy, though, would not block all acquisitions of potential competitors: low-price transactions involve only start-ups which would not have access to credit, and hence would not be able to become independent competitors. Such takeovers would be approved.
This is the main message of our paper: despite the possible pro-competitive effect, the optimal merger policy should not be lenient towards acquisitions of potential competitors.
From a policy perspective, our analysis questions the current laissez-faire approach towards acquisitions of potential competitors and supports the proposals towards stricter enforcement of these mergers. Legislative initiatives as well as changes in enforcement standards are being considered in several jurisdictions. For instance, the US agencies have announced the review of the Horizontal Merger Guidelines1 and that they may challenge acquisitions of potential competitors – a departure from previous policy.2 In the UK, the Competition and Markets Authority issued revised merger guidelines in July 2021,3 announcing a stricter merger enforcement across sectors.4
Moreover, our analysis suggests that antitrust agencies should use the information conveyed by the takeover price when reviewing acquisitions of potential competitors. In our setting, a high takeover price signals that the takeover may not be indispensable for the success of the start-up and that, therefore, is likely to raise anti-competitive concerns. This insight can be applied more broadly: in our model one can interpret as synergies the fact that incumbent's assets, by complementing the assets of the start-up, may enable development, but acquisitions might produce synergies of different nature, for instance because the start-up is short of managerial skills or market opportunities. Also in those cases, a high transaction price may reflect that the start-up does not need those synergies to grow and have success in the market, and that the takeover may harm competition.
This insight supports the use of a transaction value threshold as an additional test to identify mergers that are potentially anti-competitive and that deserve a closer look.5 This echoes the proposals made by various antitrust agencies to revise their approach towards mergers in digital markets (Competition and Markets Authority 2021). However, the validity of this approach can also be applied to screen any merger involving a potential competitor.
Our results also suggest that the information conveyed by a high transaction value should be used not only for the initial screening but also for the assessment of the counterfactual to the mergers that are investigated and of their effects on competition.
Argentesi, E, P Buccirossi, E Calvano and T Duso (2020), “Tech-over: Mergers and merger policy in digital markets”, VoxEU.org, 4 March.
Bryan, K A and E Hovenkamp (2020), “Antitrust Limits on Startup Acquisitions”, Review of Industrial Organization 56: 615-636.
Caffarra, C and F Scott Morton (2021), “The European Commission Digital Markets Act: A translation”, VoxEU.org, 5 January.
Competition and Markets Authority (2021), “A new pro-competition regime for digital markets”, presented to Parliament by the Secretary of State for Digital, Culture, Media & Sport and the Secretary of State for Business, Energy and Industrial Strategy.
Cremer, J, Y de Montjoye and H Schweitzer (2019), Competition policy for the digital era, Report prepared for the European Commission.
Cunningham, C, F Ederer and S Ma (2021),“Killer Acquisitions”, Journal of Political Economy 129(3): 649-702.
Eliason, P J, B Heebsh, R C McDevitt and J W Roberts (2020), “How Acquisitions Affect Firm Behavior and Performance: Evidence from the Dialysis Industry”, Quarterly Journal of Economics 135(1): 221-267.
Fumagalli, C, M Motta and E Tarantino (2020), “Shelving or developing? The acquisition of potential competitors under financial constraints”, Economics Working Papers 1735, Department of Economics and Business, Universitat Pompeu Fabra.
Furman, J, D Coyle, A Fletcher, P Marsden and D McAuley (2019), Unlocking digital competition. Report of the Digital Competition Expert Panel.
Lemley, A M, and A McCreary (2020), “Exit Strategy”, Stanford Law and Economics Olin Working Paper 542.
Motta, M and M Peitz (2021), “Big Tech Mergers”, Information Economics and Policy 54.
Pellegrino, B (2021), “Product Differentiation and Oligopoly: A Network Approach”, University of Maryland, Mimeo.
Prat, A and T Valletti (2018), “Merger Policy in the Age of Facebook”, VoxEU.org, 26 July.
Scott Morton, F, P Bouvier, A Ezrachi, B Jullien, R Katz, G Kimmelman, A D Melamed and J Morgenstern (2019), Market Structure and Antitrust Subcommittee Report, George J. Stigler Center for the Study of the Economy and the State, The University of Chicago Booth School of Business, Committee for the Study of Digital Platforms.
The Economist (2018), “American tech giants are making life tough for startups”, 2 June.
The New York Times (2020), “Big Tech’s Takeovers Finally Get Scrutiny”, 14 February.
The Wall Street Journal (2019), “How ‘Stealth’ Consolidation Is Undermining Competition”, 19 June.
Wollmann, T G (2019), “Stealth Consolidation: Evidence from an Amendment to the Hart-Scott-Rodino Act”, American Economic Review: Insights 1(1): 77-94.
1 See, for example, https://www.ftc.gov/news-events/press-releases/2022/01/ftc-and-justice-department-seek-to-strengthen-enforcement-against-illegal-mergers.
2 See, for example, the speech delivered by AAG Vanita Gupta at Georgetown Law's 15th Annual Global Antitrust Enforcement Symposium Washington, DC, September 14, 2021.
3 Competition and Markets Authority, “Merger Assessment Guidelines”, 18 March 2021.
4 See Prat and Valletti (2018), Argentesi et al. (2020) and Caffarra and Scott Morton (2021), for discussions on merger policy in digital markets.
5 The current notification thresholds are mostly based on both merger parties having a sufficiently high turnover and prevent antitrust agencies from investigating the vast majority of mergers involving potential competitors.