The Conglomerate Problem
Private equity is trying to gobble up baby formula. Broadcom is going to ruin VMware. Can antitrust enforcers stop the arson? Will judges let them?
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Today I’m writing about the wave of large mergers happening in the economy - such as Broadcom-VMware, Microsoft-Activision - and the legal questions surrounding whether antitrust enforcers can stop them.
On March 7, 1976, a priest officiating at a service of a Federal judge, Richard McLaren, quietly intoned at the ‘incorruptible public servant’ being laid to rest. Just three lower ranking government officials attended, and his obituary didn’t make the New York Times. But McLaren was the last great antitrust enforcement chief, brought to Washington in 1969 under the assumption he would remain the quiet defense lawyer from Chicago he had always been.
It turned out differently.
“I do not want McLaren to run around prosecuting people, raising hell about conglomerates,” screamed Richard Nixon in 1971, “McLaren’s (expletive deleted) is to be out within one hour. Goddamn trustbusters. Get him out. In one hour, and he’s not going to be judge, either.”
McLaren, as it turned out, had not been a quiet prosecutor. While at the Antitrust Division, he sued some of the most important firms in the country, like Standard Oil of Ohio, Bethlehem Steel, Kennecott Copper, Alcoa, RJR Reynolds, and a whole series of bank mergers. McLaren was best known for attacking the most important trend of the decade, which was the emergence of financial engineering through the conglomerate craze.
In the late 1960s, loose money, nascent deregulation through new financial instruments such as commercial paper, and high valuations in the stock market had fostered an environment of get-rich quick schemes, the so called ‘Go Go’ years of Wall Street. Out of this came the conglomerate, which was a firm buying unrelated or loosely related business lines, such as a computer leasing firm LeaseCo buying a much larger insurance company.
Such acquisitions were done by the acquirer issuing a mix of stock and debt, securities known as ‘dirty underwear’ because of the poor quality of the acquiring firm. As long as the stock market went up, however, this kind of transaction seemed to make sense. The year after buying a firm with much larger profits, the acquirer’s profits increased dramatically, and it could take certain tax write-offs. Wall Street minted millionaires for the first time since the 1920s, high-flying things known as ‘mutual funds’ spread the prosperity to everyman, and business periodicals had a new and exciting business model to write about, with the cult of management excellence making for a great story. Everyone won.
Of course, it was all a scam, since conglomerates were quick to collapse when the markets went south. And mostly, the managers were distant financiers who ended up making cruel financial decisions at the same time as they ruined businesses.
The conglomerate trend was the precursor to leveraged buyouts of the 1980s and private equity barons of today. Conglomerates were a massive public policy problem in the 1970s, and antitrust enforcers and policymakers across government, including McLaren, sought to limit conglomerate mergers. Get rich quick schemes were a tell for these men, since most of them remembered the Great Depression. “The current tax-propelled merger mania,” McLaren said in 1969, had produced “severe human and economic dislocation.”
The main mechanism enforcers used was to go after a tactic called reciprocity, which essentially meant big firms only selling to other big firms, and thereby excluding smaller firms from the market. The Supreme Court, in a 1965 case called Consolidated Foods, had determined that reciprocity was an unfair method of competition. McLaren also used the Clayton Act’s incipiency standard, arguing that mergers that might facilitate an entire industry to consolidate were illegal. In United States v. White Consolidated Industries, for instance, the court blocked the merger and laid out the stakes.
This case is not so much a contest between the United States Department of Justice and the two defendant companies as a skirmish in a broader battle over the direction American economic life will take in the coming years. At the center of this struggle is the concept of the conglomerate corporation not a particularly new development, but one which lately has gained great momentum. One reason for its recent popularity is the attempt of companies to expand through acquisition of other firms, while avoiding the antitrust problems of vertical or horizontal mergers.
The resulting corporations have had none of the earmarks of the traditional trust situation, but they have presented new problems of their own. Although the market shares of the several component firms within their individual markets remain unchanged in conglomerate mergers, their capital resources become concentrated into ever fewer hands. Economic concentration is economic power, and the Government is concerned that this trend, if left unchecked, will pose new hazards to the already much-battered competitive system in the United States.
Nixon did eventually get McLaren, turning him out of the Antitrust Division by promoting him to a Federal judgeship. Really though, it was conservative antitrust thinker Robert Bork who did in McLaren. For it was Bork, in public print, who attacked McLaren with venom and relish, especially over McLaren’s attempt to stop the agglomeration of capital. “McLaren sounds as if the antitrust laws were his mandate to pursue every social policy except the prevention of lascivious carriage,” Bork wrote, in typically overwrought prose. What Bork wrote, Nixon read, and acted upon. It didn’t hurt, of course, that Nixon was getting large campaign contributions from conglomerates like ITT, who McLaren was suing. Still, it wasn’t just McLaren himself who was turned out of office, but the entire activist antitrust policy archetype.
By 1981, Bork’s mockery had significantly ratcheted back competition law. Bork killed antitrust action against conglomerate and so theories of harm like ‘product line extensions’ where firms would buy adjacent businesses, or ‘reciprocity,’ where large firms would box out smaller firms through sheer size, were no longer being litigated in the courts.
Then, Jimmy Carter and Ronald Reagan changed the financial system to allow for cheap financing for speculation. The collapse of antitrust law at the exact time Wall Street was able to finance mergers without restraint led to a spectacular explosion of financialization in the 1980s. Michael Milken, junk bond king and current private equity billionaire, ensured that Wall Street’s mergers and acquisitions shops would be busy reorganizing corporate America, unimpeded by financing needs. Like most of the concepts underpinning modern commerce, private equity was created in the 1970s but operationalized in the 1980s, led in the business world not only by Milken but also by Jack Welch, the GE CEO who transformed corporate America.
Bork had already taken care of the antitrust laws, and other scholars like Henry Manne had built arguments, like the theory of the ‘market for corporate control,’ about why mergers were efficiency enhancing. Michael Jensen at Harvard Business School seeded an entire generation of management consultants and private equity barons. And Richard Posner eliminated the idea that big firms could wield superior access to capital, calling the idea that anyone might have trouble getting a bank loan to compete with a corporate giant so “unlikely” as to be irrelevant in policy discourse.
These men did not only restructure the existing titans of corporate America. Entire industries, like computing, information technology, cable TV, social media, mobile telephony, and other forms of data-intensive industries grew up in an environment with not only lax merger policy when trying to combine with rivals or suppliers, but absolutely NO merger policy when pursuing conglomerate mergers. As a result, today, we live in a world of conglomerates run by financial engineers, who are either registered corporations or private equity funds that own portfolios of firms.
Take, for instance, the baby formula crisis. One of the little noted aspect of the industry is that all the key formula producers are part of larger conglomerates. And now, despite a shortage and pricing power, the second biggest one is being put on the chopping block, being sold off likely to a private equity firm.
Reckitt Benckiser Group, the maker of Enfamil, is pushing ahead with a multibillion-dollar sale of its infant-formula business as severe shortages scramble the key U.S. market.
Reckitt kicked off a sale process for its formula business last month, with first-round bids submitted this week, according to people familiar with the matter. Bidders include buyout firm Clayton Dubilier & Rice, they added. The unit could fetch around $7 billion, some bankers and analysts have estimated.
Clayton Dubilier & Rice is one of the original gangsters of private equity, founded in 1978. It had classic pedigree; Jack Welch was an advisor. The firm is perhaps best known for shipping respiratory equipment out of the U.S. in the early days of the Covid pandemic, as well as the standard stripping of assets from companies it buys, and then letting them go bankrupt. So one can expect Clayton Dubilier & Rice, if it buys Mead Johnson, to attempt to raise prices on formula, or cut corners.
Another example is Broadcom, which is a private equity firm disguised as a semiconductor maker, and its attempted purchase of VMware. The strategy here is to exploit market power, as the Wall Street Journal noted.
The goal: find companies with deep links into large corporations’ information-technology setups that would be difficult for them to abandon. Then cut costs and get the most out of their products by “cross-selling and up-selling” them, as Broadcom’s head of software, Tom Krause, described the strategy in November.
The history of Broadcom is instructive. CEO Hock Tan took over a firm called Avago Technologies in 1999, pursuing a string of acquisitions, such as LSI Corp, Brocade, Symantec, and CA Technologies, as well as Broadcom itself (whose name the firm adopted). CA Technologies itself was the original IT roll-up artist, buying dozens of software firms, cutting costs, lowering software quality, and raising prices. Tan just does it on a bigger scale. I bolded the relevant parts for emphasis.
"He runs Broadcom like an investment portfolio ... they are all independent fiefdoms," said a former employee at the company who worked closely with Tan. "If he has a dominant position in any market, he'll go in and raise those prices."
Financial extraction and monopolization is the business model.
Many in the hardware industry that we cover know Broadcom-Avago’s game plan. They purchase companies like PLX that makes PCIe switches. These are usually the best components in markets with few if any competitors. In these low competition markets, Broadcom raises prices and also puts heavy bundling burdens on hardware companies where supply or reasonable pricing are withheld.
It’s easy to find customers of Symantec lamenting the Broadcom takeover, with “slower innovation, and higher prices,” or even just abandoning customers entirely. Take this Reddit thread for system administrators.
Broadcom isn’t unique, but part of the mutated trend of conglomerates that hasn’t been stopped or hindered since 1981, with entire swaths of industries built by executives and policymakers who have no memory of any other legal environment. Indeed, Lee Harris went to the Milken Institute’s global conference last month to schmooze with the financiers that organize these kinds of firms, and they are saying the quiet part out loud.
Take Renee Noto, the president of Brightstar Capital Partners, a buyout fund focused on midsize business-to-business firms. Noto said current conditions are prime for her strategy: Make an initial acquisition in a “fragmented” sector, buy up and add on smaller companies, and raise prices. For instance, she said, Brightstar owns the second-largest used-vehicle auction platform in the country, and has identified opportunities in “150-plus smaller, independent mom-and-pops.”
It’s important to pick essential sectors, she emphasized. “We own a large fleet maintenance business. It’s a national business. Their customers are all folks you all would know. They deliver many things to your homes. We offer critical business. Families and founders, they don’t like to ruffle feathers with their customers, so raising prices is very difficult. It’s something we can coach managements on.”
Family businesses can be counted on to underprice their product, Noto told the Prospect, since “they have these long-standing relationships.” That gives investment firms an opportunity to mark up prices upon entry.
In other words, the job of private equity and conglomerates is to accelerate the mass transformation of America from a ‘nation of trademen’ to a ‘nation of clerks,’ as Brandeis once put it. Everything just gets a little crappier, a little more expensive, with one more nickel and diming fee.
What Richard McLaren, and a host of policymakers were pointing out in the 1970s, is that conglomerates put together by financial actors simply to extract cash were a threat to an efficient economic order, and ultimately a democratic society. The Sherman and Clayton Acts are legally capacious, they bar restraints of trade, they bar monopolization, and they bar mergers that reduce competition. At times, antitrust enforcers could bring these legal challenges to bear.
That hasn’t happened for forty years, and it would require the courage to bring a case to court in which one calls Broadcom’s track record of raising prices and disinvesting after buying a firm a ‘restraint of trade,’ or to use the Clayton’s incipiency standard to resist concentration per se. Right now, the FTC and DOJ are actually rethinking merger guidelines, which is the first step to doing so. Still, there are a wave of conglomerate mergers on deck.
Mergers like Microsoft-Activision, or the rumored Apple-Electronic Arts, or whoever buys Netflix, will require new legal theories if they are to be challenged. The Department of Justice is challenging the merger of UnitedHealth Group's Optum and Change Healthcare, with corporate friendly Judge Carl J. Nichols presiding. So there’s movement.
Ultimately, we have to find a way to challenge conglomerate mergers and private equity acquisitions that are purely meant to raise prices or disinvest in product, because consolidation, whether by a corporation or a private equity firm, reduces the control that we have over our society, and raises the simmering resentment that people across the world rightfully feel towards their political leaders.
What I’m Reading
Cost-Price Relationships in a Concentrated Economy By Falk Bräuning, José L. Fillat, and Gustavo Joaquim, Boston Federal Reserve
Thanks for reading!
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P.S. I did a video for Breaking Points on the baby formula shortage, which you can see below.