Medtech M&A: FTC's Changing Mandate And Its Impact On The Industry

By Manya Aggarwal, Decision Resources Group

Medical device companies’ profit margins are under ever-increasing pressure following monumental changes to the U.S. healthcare system brought about by the implementation of the Patient Protection and Affordable Care Act (ACA), as well as the emergence of group purchasing organizations (GPOs).

The ACA stipulates that medical device companies must pay 2.3 percent excise tax on all revenues, which puts a strong burden on their bottom line. Manufacturers also face increased regulatory requirements for a greater number of devices, rather than the cheaper 510(k) approval process, which can dramatically increase their R&D costs. Also, the emergence and huge popularity of GPOs across the U.S. has further increased pressure on medical device companies. These GPOs can secure competitive pricing by negotiating with vendors en masse, rather than individual hospitals and vendors negotiating with each other.

All of these factors have prompted medical device companies to pursue, at breakneck speed, acquisitions that consolidate their position in the market, realize revenue synergies, and establish economies of scale. Thus, the medical device landscape in the U.S. has been marked by a never-before-seen flurry of mergers and acquisitions activity recently. But this heightened M&A activity has brought with it increased scrutiny from regulatory agencies, particularly the Federal Trade Commission (FTC).

One of the FTC’s central mandates, since it was established in 1914, is to promote competition in the American marketplace to ensure that consumers have access to the lowest prices, the widest variety of choices, and the highest quality of goods and services available. However, the FTC’s methods to achieve these ultimate objectives have significantly changed over the last two decades. Up until the mid-1980s, when the FTC identified concerns that defied their mandate — especially in the case of hospital mergers — it tended to raise objections in the early stages of negotiations. This approach often blocked deals before they were consummated.

However, raising objections against mergers in the early stages of negotiation put the onus of proving anticompetitive outcomes solely on the FTC, rather than on the merging companies. The FTC, in these cases, would have to take on ex-ante, the challenging task of providing a comprehensive analysis detailing all repercussions of the transaction — including product quality, variety, and innovation — in all affected markets, for both the target firms and other competitors. During this period, the FTC also adopted a litigious approach toward anticompetitive mergers. Following this approach, the FTC lost eight hospital merger challenges in court due to its inability to prove its anticompetitive allegations. From 1986 to 1988, only a small minority of merger enforcement actions taken by the FTC were settled with divestiture, or with other behavioral relief not involving litigation. The vast majority of cases that did end up in court typically resulted in the dissolution of the proposed merger.

However, the FTC’s modus operandi significantly changed in the late 1990s when it decided on an alternate approach to anticompetitive intervention. It decided to only challenge completed mergers, rather than those still in the early stages of negotiation. Analyzing mergers ex-post places the burden of proving anticompetitive outcomes on the target companies, rather than on the FTC. Additionally, defining the market and analyzing competitive attributes for merging firms and rivals is an easier undertaking for the agency, compared to its earlier ex-ante approach. At the same time, the FTC also reversed its litigious approach to a more flexible, settlement-driven approach for both hospital and medical device mergers. The commission is much more likely to accept licensing agreements and divestitures, rather than litigation in court, now than in previous years. This policy change simultaneously helped promote M&A activity in the economy and helped protect the interests of consumers.     

What’s The Big Deal? Four Cases Of FTC Intervention

The four deals shown in Figure 1 typify the FTC’s policy shift toward anticompetitive mergers and acquisitions. All four mergers represent large medical device deals valued at over $1 billion. In all four cases, the FTC intervened after the deal had been publicly announced to all stakeholders. The FTC also only targeted segments that had few additional players, and those segments in which the combined company held a very large share, as being anticompetitive to the market:

• In the case of the Medtronic-Covidien merger, the drug-coated balloon catheter division was a fast-growing segment monopolized by C.R. Bard. However, both Medtronic and Covidien had drug-coated balloon catheters in clinical trials in the U.S. and would have entered the market as numbers two and three, respectively, once the trials were completed. Therefore, a combination of the two companies would have limited competition in this space.
• Similarly, Zimmer and Biomet together controlled the majority of the market in the unicompartmental high-flex knee, elbow implant, and cobalt bone segments, with Johnson & Johnson’s DePuy Synthes being the only other major competitor.
• The lower-extremity orthopedic space also is a very concentrated market. Had Wright Medical been allowed to retain Tornier’s lower extremities product line, the combined company would have controlled over 50 percent of this market.
• Synergy’s Applied Sterilization Technologies division, combined with Steris’s Isomedix segment, comprise the only players in the gamma irradiation sterilization space, besides Sterigenics. Divestment of these segments is the preferred strategy of the FTC, since it ensures the markets remain at least as competitive as they would have been had the mergers not taken place.

In three out of these four cases, the divestments are expected to go through as planned. Steris is the only company that has decided to seek litigation in order to avoid divestment.

As a general strategy, divestment makes sense for the merging companies. Synergies, profitable growth, and revenue combinations identified during the due diligence process usually extend beyond the anticompetitive segments. Thus, it still makes sense for affected companies to merge, even post-divestment. Also, the added advantage of tax inversion makes it even more lucrative to merge. In a tax inversion deal, a U.S.-based company merges with a smaller firm, located in a tax-friendlier European country, and then relocates its headquarters to the foreign country, effectively reducing its corporate tax rate indefinitely. All of the mergers described above, with the exception of Zimmer-Biomet, also are tax inversion deals.

Conclusions

The FTC’s strategy of late-stage intervention, as well as a non-litigious approach of settlement, works to encourage M&A activity in the healthcare sector. Fewer companies are willing to walk away from announced, definitive deals compared to during early stage negotiations. Abandoning definitive mergers usually takes a toll on the stock prices of both companies, and wastes a considerable period of time and resources on negotiations, due diligence, and hiring third-party advisors. More importantly, acquirers are less willing to give up on synergies and tax inversion advantages identified during the due diligence process. Therefore, when the FTC intervenes at this late stage of the merger, both of the merging companies are more likely to divest problematic segments rather than to abandon the deal.

It also is now highly improbable that the FTC loses an anticompetitive challenge against merging companies in court. Since the agency usually limits its interventions to market segments where only a handful of large competitors exist, if two of those competitors merge forces, it is a relatively easy task to establish anticompetitiveness. Even in the litigious case of Steris and Synergy, it is probable that the companies will settle with the FTC through divestment, since the lawsuit will be a difficult one to win.

Finally, it is fair to say that the FTC’s chosen strategy of dealing with anticompetitive segments through divestments is largely successful at its stated aim of keeping markets competitive. With the entry of third parties into the market to replace the original competitors, consumers retain access to similar quality products and prices that would have been available had the merger had not taken place. Smaller competitors also get the opportunity to compete in these markets through the acquisition of cheaper, relatively minor pieces of very large companies.

Takeaways For Device Manufacturers

The FTC’s chosen strategy, at the same time, also enables the economy to reap the benefits of consummated medical device mergers, including increased efficiency, lower costs of production, greater diversification, and a greatly expanded size and scale, which can make the combined company a more effective international player. Thus, it is likely that the FTC will continue this intervention policy well into the future. Given this likelihood, a few key takeaways emerge for major stakeholders in the medical device industry:

For large medical device companies looking to acquire smaller players in the space, it now is safe to assume that the FTC is unlikely to stop the merger from going through. However, it also is more likely that one or more anticompetitive segments will need to be divested for the merger to go through. Device companies should take this into account in their due diligence process. They should identify potentially problematic segments at the start of the process and determine if it is worthwhile to pursue the merger, even if they are forced to divest these segments.

Smaller competitors, desiring a foothold in niche markets controlled by a few large players, also should keep abreast of M&A developments and be ready to purchase a divested segment at the right time. This is a relatively easy way to establish presence in a market without having to build the product or the branding from scratch.

All in all, this is a great time for medical device companies considering new acquisitions. The turf has never looked as favorable as it does now.    

About The Author

Manya Aggarwal is a senior analyst at Decision Resources Group. She has authored several reports on laparoscopic, gynecological, and reprocessed device markets in the endoscopy division of the company. Aggarwal holds a master’s degree in financial economics and a bachelor’s degree in commerce and economics from the University of Toronto.