Modern robber barons ride wave of M&A deals

 30 October 2016

 In the unlikely event of ever being asked to name an economist on the TV quiz show Pointless, one could do worse than nominate either of the wonderfully obscure Orris Herfindahl or Albert Hirschman.

Given the events of the past week or so, maybe it is time for investors, politicians, regulators (at least outside the US) and consumer groups to dust off their A-Zs of economic theory and get up to speed with the duo's largely overlooked contribution to the subject.

In recent days, AT&T, the US telecoms group, has bid $85bn for Time Warner, the media conglomerate, and British American Tobaccooffered $47bn for the shares it does not already own of its US peer, Reynolds American.

In the more important agribusiness sector, three potential deals are awaiting regulatory approval: ChemChina's $44bn offer for Swiss peer Syngenta, Bayer's $66bn deal for Monsanto and a proposed $130bn tie-up between Dow Chemical and DuPont.

If these three deals are all given the green light, nearly two-thirds of the global seed and chemical supply chain will be in the hands of just three companies. This matters, and the largely forgotten work of our unsung economic heroes gives us a framework to measure just how much.

The Herfindahl-Hirschman index, calculated by summing the squares of the market shares of the participants in a given market, is used by the US Department of Justice to measure industry concentration.

It is also used, uniquely it would seem, by the European equities team at BNP Paribas Investment Partners to attempt to make money. And, spoiler alert, it seems to work.

The French bank's asset management team, led by chief investment officer Andrew King, uses the HH index to find industries that are becoming either more concentrated, often as a result of mergers and acquisitions, or more fragmented. They are often minded to invest in the former and steer clear of the latter.

That a concentrated sector allows scope for a cabal of powerful oligopolists to gouge prices and bank excess profit was a truism fully grasped by the robber barons of the late 19th century. That more than a century of antitrust legislation has failed to eradicate the problem is perhaps more disturbing.

Mr King wields an impressive array of charts to demonstrate. In Colombia's highly concentrated beer industry, for example, the HHI is almost 10,000 and earnings before interest and tax are 42 per cent of revenues. In the hyper-competitive German beer market, where the HHI is in the low hundreds, the Ebit margin is just 10 per cent. Across a wide array of countries, there is a clear relationship between lack of competition and profitability.

On a global basis, the HHI of the beer industry had risen from around 170 in the mid-1990s to more than 900 in 2014, as a result of constant consolidation. This was even before industry leader AB InBev's takeover of SABMiller, the number-two player by sales, which is likely to send it spiralling to around 1400. Over the same period, the average operating margin of the four largest brewers has risen relentlessly from 8 per cent to 20 per cent, the Paris-based asset manager's figures show.

Similarly, the UK mortgage market was competitive before the global financial crisis, with a HHI of around 900 and a mortgage spread (over the cost of funding) of around 0.35 percentage points in 2007. As the likes of the Icelandic and Irish banks retreated after the crisis, and Santander hoovered up a host of lenders, the HHI jumped to 1500 by 2010, and mortgage spreads ballooned to 2.8 percentage points.

The same can be seen in Spain, where the number of lenders has fallen from 52 to 13, but not in Germany or Italy, where the market remains fragmented and profitability is poor.

This focus on what Mr King refers to as "well-structured industries" has helped his Parvest Equity Best Selection Europe fund to outperform the MSCI Europe index by 28 percentage points since 2008, admittedly before fees.

The upshot is that regulators and their political overlords need to start fighting harder to prevent industries becoming overly concentrated. Although the resultant elevated profit margins could be driven by greater efficiency in part, the bulk is likely to spring from price gouging.

Moreover, if industries generally are becoming more concentrated, this could be a contributory factor in the widely observed, and lamented, trend for a rising share of income to flow to corporates and a declining share to labour.

Mr King is unconvinced about the latter, arguing that excess profit pools act like a "red flag to a bull" in drawing entrants into a market, such as the UK food retail sector, where a cosy oligopoly was upended by cut-price insurgents Aldi and Lidl.

Competition is less likely to be reinvigorated where barriers to entry are high, however, suggesting politicians and regulators should strive to keep these to a minimum.

Mr King cites the tobacco sector, where advertising bans mean entrants could never get off the ground, and profit margins may be as high as 80 per cent in the UK. Politicians might not care much about smokers nowadays, but consumers in general deserve better protection from the profiteers.

Steve Johnson is deputy editor of the FT's EM Squared

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