Linking up: Vertical integration makes a comeback Transactions up and down the supply chain become more appealing to acquirers As horizontal deals become more challenging due to consolidation, dealmakers increasingly consider opportunities to go vertical. Vertical mergers have been stealing some conglomerate with a network of retail Will the trend of vertical transactions of the thunder from horizontal deals of locations, it could result in health continue in the coming months and late. As horizontal targets become harder insurance and other medical services at years despite these headwinds? In which to come by, some acquirers are focusing lower prices to consumers. types of situations are vertical deals most on companies up or down the supply appealing, and when do they not make chain from them—presenting both new Before these combinations can be sense? In order to answer these and opportunities for expansion and a new consummated, however, they must be other pressing questions on the subject, set of challenges. approved by antitrust authorities. Vertical we spoke with four leading experts. mergers have recently drawn greater Some of the most significant vertical scrutiny by the government, causing integrations penned recently also have would-be acquirers to second-guess the power to transform whole industries. their intentions as court actions play out. Contents Take the US$69bn tie-up between M&A advisors may also be hamstrung in pharmacy operator CVS Health and their ability to counsel clients regarding The upside of verticality 2 insurance giant Aetna, announced the types of cases the U.S. Justice in December 2017. By creating a Department elects to challenge. Seeking approval 6 1 I Linking up: Vertical integration makes a comeback The upside of verticality The experts Mergermarket Several high-profile vertical integration deals have been done recently in sectors such as healthcare and media. What have been the main drivers of this trend, and do you expect Logan Breed it to continue? Partner, Hogan Lovells Mark McCareins, As for main drivers, there are many industries and Kellogg School sectors that are clogged from a consolidation of Management standpoint. Whether it's grocery chains, consumer packaged goods companies, airlines, banks, or Cathy Leonhardt others, they have all seen a significant amount of Managing Director, PJ Solomon consolidation over the last twenty years or so. As a result, the ability to achieve regulatory clearance in horizontal deal has become increasingly difficult in concentrated markets. Put another way, when there is a four-firm market, and the deal would decrease Mark McCareins the four players to three, the government will be Professor of Business Law, hard-pressed to give a quick clearance. Kellogg School of Management In response, firms have started looking outside the box, and vertical integrations have been one Jeff Swearingen opportunity they are now considering in greater Managing Director, Edgemont Capital numbers. In the last 18 to 24 months, there has been a significant upswing in interest for many American businesses in exploring vertical alliances. One example is Boeing's recent acquisition of a major parts supplier—a deal likely prompted as much by the company needing to grow but having no one to acquire as the need to compete on the global stage. After all, there are a lot of efficiencies to be gained 2 I Linking up: Vertical integration makes a comeback by becoming more vertically integrated, as well as the chance to control one’s "In healthcare, several of the destiny by integrating major suppliers into production chains. To the best of vertical transactions involving my knowledge, the government has payers happened after they tried not challenged that Boeing acquisition, which is just one example of many deals a horizontal transaction." of a vertical nature that are either in the hopper or will be announced. Jeff Swearingen, Edgemont Capital Jeff Swearingen, In healthcare, we have seen a tremendous Edgemont Capital amount of horizontal consolidation many of them look to change the typical across the payer-provider continuum, healthcare delivery and reimbursement and several of the vertical transactions model. Of the attention-grabbing involving payers happened after they transactions announced over the last tried a horizontal transaction. If you 12 to 18 months, the buyers have been will recall, there are five big payers: a very small group of extremely large, UnitedHealthcare, Cigna, Aetna, Anthem well-capitalized providers and players in and Humana. Similar to what Mark said, the retail space. In the case of a CVS or four of the five tried to merge, which Wal-Mart, those companies were looking would have resulted in just three players, to leverage their retail footprint and but the Justice Department stepped in, presence, while Optum/UnitedHealthcare blocking the deals on antitrust grounds. and Humana were already very large That's what drove Aetna, Humana and and well-capitalized companies in the others to look for a different strategy. healthcare space. There just aren't many firms of that size and scale out there From the payer’s perspective, the with the capabilities to pursue large underlying premise of these vertical vertical transactions, although when transactions is the belief that they must they do happen, they are by definition either get bigger or become directly transformative and headline-grabbing. involved in the provision of care in order to effect change in the healthcare Cathy Leonhardt, My focus is the retailing industry, which has industry. Healthcare is clearly on PJ Solomon seen vertical integration only in very specific everyone's mind, as the percentage of instances. I’ll point out some examples GDP consumed by it continues to grow. from recent years. The first area that has Moreover, people who look at the data seen activity is in luxury branded goods, in say we're just not getting the return on which companies use acquisitions to shore investment in healthcare expenditures in up portions of their supply chain. This is terms of life expectancy. driven by a scarcity of raw materials and a high importance placed on quality. In the A lot of the vertical deals in healthcare handbag market, brands such as Hermes have been headline-grabbing, not only and LVMH have purchased foreign firms because of their size, but due to how dealing in alligator and crocodile leather, 3 I Linking up: Vertical integration makes a comeback control, as well as the opportunity for greater consistency and messaging. A third example has to do with the large brands investing in manufacturing that is closer to home. Brands have historically outsourced the majority of their manufacturing to Asia and other parts of the world to access lower labor costs. The assumption was that brands, particularly within apparel, would no longer own manufacturing. However, we’ve seen this trend begin to reverse in recent years as a result of the growth of fast fashion, in which speed-to-market and the frequency of delivery to stores and the consumer have become critical. We’ve also been seeing situations in which large retailers prefer to own particular capabilities and can amortize purchases across a large sales base. Home Depot, which is one of the biggest retailers in the Western hemisphere, acquired US Home Systems, which had been a provider of its kitchen and bath products. Similarly, it made for instance. While not multi-billion-dollar an investment in The Company Store, giving transactions (and typically less than $100 it direct sourcing capabilities in home textiles million), these are very specific to the that it previously did not have. companies’ supply chains. Finally, as Amazon has accustomed The second example involves major consumers to same- and next-day delivery Western brands that expanded through its increasingly verticalized logistics internationally to China, Japan, or other platform, many retailers are beginning to mega markets outside their home market. use M&A transactions as a tool to catch up. In a lot of instances, they did so through Target recently acquired grocery-delivery joint venture or distribution agreements startup Shipt, which will allow customers to with local partners. Over the past 10 years, order groceries and other goods online and many of these brands have bought back have them delivered directly to their homes their partnership arrangements to control from nearby Target stores. This followed activities, particularly in major markets their earlier acquisition of a company called and key product categories. This unifies Grand Junction, which also manages local the brand and gives brand owners more and same-day deliveries. 4 I Linking up: Vertical integration makes a comeback to directly, negotiate with and effectively "If the chance [for a vertical offer their own insurance product. deal] presents itself with respect Mark McCareins, I would say that for smaller firms in less- to a portfolio company, I think Kellogg School concentrated markets, it might be more of Management challenging to start looking at vertical they'd seize upon it." deals. If I'm not a market leader with a lot of intellectual capital and resources, Mark McCareins, Kellogg School I might be a little leery about doing a vertical deal. At the same time, I might also be leery about doing a horizontal Mergermarket In addition to the vertical mega- deal, as I may not have the in-house deals, are you seeing interest in capability and resources to effectively vertical integration transactions manage the transaction and make it work. lower in the market? Mergermarket Could vertical transactions be an Jeff Swearingen, There is interest in the healthcare space, effective strategy for, say, private Edgemont Capital but to a much more limited extent. What equity-owned platform companies? we typically see from a middle-market perspective is continued horizontal Mark McCareins, I think private equity is simply looking consolidation at the level of hospital Kellogg School for good opportunities right now.