This Focusing on Funds is topical for fund managers and investors as merger control enforcement continues to strengthen around the world and the number of jurisdictions where the issue is relevant continues to increase. It is essential that if a transaction does raise merger control questions, that these are identified early. This maximises the flexibility that parties will have to address any concerns - for example, by structuring the fund or transaction to take it out of merger control jurisdiction, or by planning a delay in completion to allow time for a required clearance.
This topic is international and in Parts 1 and 2 of this edition of Focusing on Funds we take a look at key issues to consider with respect to merger control, either when forming fund vehicles or joint ventures, or when acquiring real assets.
In this Part 1 we will consider:
- transactions where merger control can typically have an impact; and
- the EU Merger Regulation.
In Part 2 we will consider:
- the UK and the impact of Brexit;
- the United States;
- South Korea;
- jurisdictions that can surprise; and
- practical tips to prepare for merger control.
Which transactions are caught by merger control?
The vast majority of fund investments involving real asset do not require merger control clearances. Yet the ongoing internationalisation of real asset ownership, together with increasing numbers of joint venture investments means that a growing number of transactions are being caught by merger control rules.
Whilst the number of transactions where merger control notifications need to be made are relatively small, deal makers need to remain vigilant as the consequences of a misstep can be serious:
- If a compulsory merger control filing is missed, the non-filing party can be fined up to 10 per cent of its global turnover.
- An unexpected merger control filing can delay deal completion by several weeks.
- For investments that result in concentrations of market power, the authorities have sweeping powers to prohibit transactions or order asset divestments, in order to remedy any concerns.
Buyers who find themselves making unexpected merger filings will often be those purchasing minority investments to which significant veto rights are attached; or those entering into joint ventures to hold investments – for example, by purchasing a 50 per cent stake in assets such as large businesses including real estate assets or portfolios. Sovereign wealth funds and pension funds can be particularly likely to trigger jurisdictional thresholds for filings due to the significant sums they have under management.
The EU merger regulation
Under the EU's "one stop shop" principle, national competition law regulators within the EU 27, such as the German Federal Cartel Office, have jurisdiction to review a transaction only where the EU does not. Note that the UK forms part of the EU merger control regime only until 31 December 2020.
A transaction may need to be approved pre-completion by the European Commission under the EU Merger Regulation if three conditions are met:
- The transaction concerns a "business".
- There is a "change in control" over that business.
- The transaction meets relevant jurisdictional thresholds.
1. Is the subject of the transaction a "business"?
The transfer of companies and of assets can both comprise a "change in control" of a "business". For example, the target could be an investment company that manages a real estate portfolio, or the holding company of an estate. Equally, the target could be assets such as an office block, a shopping centre or a mixed-use development.
The key question is whether the target has a so-called ‘market presence’ that generates turnover (i.e. generally rental income). This excludes sites or properties with no sitting occupiers or tenants such as vacant development plots or greenfield sites.
Bearing rent alone might not instinctively be considered to turn an asset into a "business", but Commission guidance is limited on the point. There may be an argument that rent which is not at a proper market rate (eg ‘peppercorn’ rent) or very long leases, do not have a market presence. However in recent years, we have observed parties becoming more cautious such as, for example, to consider notifying transactions where residual tenants of buildings to be redeveloped are paying rent.
Usually in a transaction involving funds there will tend to be a network of management and operational agreements which are all considered to form part of the activities of the ‘business’ being acquired such that there is clearly the acquisition of a business.
2. Is there a "change in control"?
Once it is established that the transaction concerns a "business", there will be a change in control where the buyer acquires either sole control or joint control.
Examples of a buyer taking sole control:
- Purchasing a controlling interest in a target real estate company.
- Purchasing a freehold or long leasehold interest in a tenanted building.
- A JV party buys out its JV partners' stake in a portfolio of real estate assets (a move from joint control to sole control).
Examples of a buyer taking joint control:
- An asset is acquired jointly by two JV partners (e.g. 50:50).
- An interest is acquired in a shopping centre which confers decisive influence (for example, because the shareholder agreement gives each shareholder veto rights over the business plan, key investment decisions or senior appointments).
- No single party controls an office estate, but two or more of the shareholders have sufficiently aligned interests to mean that they routinely vote the majority of the shares together.
A merger filing cannot be avoided by splitting the acquisition of control into a series of incremental transactions. The Commission will consider the economic purpose of all transactions between any two parties within a two-year period to determine whether each transaction would have happened without the others.
3. Jurisdictional thresholds must be met
A transaction must be filed with the European Commission if either the First Threshold or the Second Threshold is met.
- Combined aggregate worldwide turnover of all parties to a transaction exceeds €5bn; AND
- At least two parties achieve a turnover of more than €250m in the EU.
- Combined aggregate worldwide turnover of the parties is more than €2.5bn; AND
- In each of three member states the parties’ combined turnover exceeds €100m; AND
- In each of the same three member states the turnover of each of at least two parties exceeds €25m; AND
- The EU turnover of each of at least two parties exceeds €100m.
Neither EU threshold will apply where at least two-thirds of each party's EU turnover is derived in the same member state.
Care needs to be taken in particular when considering whether joint ventures meet these jurisdictional thresholds. There is no requirement for the transaction to have a so-called ‘local nexus’ to the EU. Because the thresholds take into account any two companies involved in the transaction, the EU Merger Regulation applies to the acquisition of any business (however small) and wherever in the world that business is located by two JV partners which each meet the EU’s turnover thresholds individually.
For example, the threshold could be met if two large pension funds with significant European interests decided to co-purchase a shopping centre in the UK – even after 1 January 2021 - that had a rental income of, for example, only £7m per annum. The reasoning behind this is to capture so-called ‘spill-over’ effects where the JV parties might more easily coordinate their activities in the EU as a result of the proximity that is created between them due to the JV.
Calculation of turnover for merger control analysis (most jurisdictions)
All turnover is measured according to the audited accounts from each party’s last completed financial year, adjusted to take account of the turnover of any acquisitions or disposals since the accounts were signed off.
Turnover should be based on income from an undertaking’s ordinary activities and should exclude rebates, taxes and intragroup turnover such as dividend payments.
Turnover should be allocated in the jurisdiction where it is earned (e.g. the location of the property on which rent is paid) not necessarily where income is booked.
"Group turnover" has an expansive meaning. Whatever the identity of the company involved in the transaction, it is necessary to take into account the turnover of all other companies controlled by that party’s ultimate parent company. For businesses controlled jointly with one other party, only 1/2 of turnover needs to be included, and 1/3 of turnover if there are two other JV parties.
For funds, it is necessary to take into account not just the turnover of companies held in the same fund as the acquirer, but also of all other funds which have the same manager.
Special Considerations for JVs
The EU Merger Regulation, coupled with case law, makes clear that the establishment of a joint venture, either (i) a ‘greenfield’ JV; or (ii) the sale of a percentage interest in assets previously wholly-owned by one party to incoming JV partner(s) where the first part retains an interest, will only create an obligation to notify the European Commission where the joint venture will be ‘full function’ ie it will lead to the creation of an entity “performing on a lasting basis all the functions of an autonomous entity”.
This analysis is not always straightforward but guidance from the European Commission tells us that where the purpose of the joint venture is limited to the acquisition and/or holding of certain real estate for the parents and based on financial resources provided by the parents, it will not usually be considered to be ‘full-function’, since it lacks an autonomous long-term business activity on the market and will typically also lack the necessary resources to operate independently.
Perhaps counter-intuitively, once a non-full-function JV is established, it may be necessary to make a merger control notification to the European Commission whenever a ‘business’ (ie assets that derive a market turnover) is acquired, since the legal personality of the acquirer is not attributed to the JV; it is attributed to each of the parent companies as if they are jointly acquiring that asset from a third party. That could be a notifiable merger in the EU.
This can be awkward where non-full-function JVs are established with the purpose of the JV parties identifying and purchasing assets which meet certain investment criteria, since in a competitive bid situation a seller may not be inclined to choose a bidder who is unable to complete until after a merger control process.
Parties who have formed JVs for the purposes of making multiple investment acquisitions may therefore prefer that the JV is created on an autonomous ‘full-function’ basis. An EU merger filing may be required when it is formed, but after that because any acquisition would be treated as having been made by one party only, the EU turnover thresholds which are triggered by ‘at least two’ parties to the transaction are significantly less likely to be met.
Another approach to avoid the need for EU filings is to stick to a fund manager structure, whereby one JV partner (usually the manager) takes sole control over the budget, business play and appointment of key staff for the JV. The other JV partners may enjoy key investor protections for their capital. Certain other strategic veto rights can often be negotiated, but these need to be carefully calibrated and properly understood by all parties. This can be a frustrating structure for investors who are not comfortable ceding such a degree of management control to a third party.
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