Betting Against Regulators

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There are three certainties in life: death, taxes, and hedge funds employing novel strategies in pursuit of outsized returns.

Today, we are going to talk about how one hedge fund has made millions by employing a particularly novel strategy: fading Lina Khan, the Chair of the Federal Trade Commission.

According to Wikipedia, the Federal Trade Commission (FTC) is an independent agency of the United States government whose principal mission is the enforcement of civil antitrust law and the promotion of consumer protection.

Put more simply, the FTC is a safeguard against deceptive advertising and potential monopolies.

In 1914, when deceptive advertising was the norm and manufacturers regularly formed price-fixing cartels, the Federal Trade Commission provided a necessary safeguard for consumer interests.

However, since the turn of the century, the volume of US federal enforcement actions stagnated. While merger filings increased from 1,100 to 2,000 per year between 2010 and 2018, US federal enforcement actions stayed level at ~40 per year.

At first glance, this seems bad for consumers like you and me. More mergers = less competition = more price gouging, right?

Not exactly.

In reality, the increase in merger filings was mostly driven by big tech companies acquiring startups, often creating synergies that lowered prices for consumers.

Between 2001 and 2021, Alphabet, Amazon, Apple, Meta, and Microsoft acquired more than 1,000 firms, and none of those transactions were blocked. The reason? These acquisitions didn’t really harm the consumer.

But in June 2021, a then-32-year-old Lina Khan was appointed as Chair of the Federal Trade Commission, and under her tenure, big tech companies have often found themselves in the cross-hairs.

As a third-year student at Yale Law School in 2017, Khan published her now famous article, “Amazon’s Antitrust Paradox,” in the Yale Law Journal. Her central thesis argued that American antitrust laws, as currently constructed, only focus on keeping consumer prices down, and they cannot adequately regulate the anticompetitive effects of platform-based businesses like Amazon.

The anti-big tech ideals outlined in Khan’s 2017 article have defined her actions as the FTC’s chair over the last two years, and her agency led multiple antitrust suits and investigations against Microsoft and Meta before finally turning their sights toward Amazon with a new antitrust lawsuit yesterday.

Khan has made a name for herself by challenging big tech. Unfortunately, in the eyes of the United States court of law, Khan’s antitrust claims are difficult to prove.

Regardless of the opinions of Khan (or anyone else, for that matter), the Federal Trade Commission is responsible for protecting consumer interests. More specifically, it safeguards against faulty advertising and anticompetitive pricing.

If Big Tech companies are able to offer lower prices than their competition thanks to smart acquisitions and well-run business models, they actually benefit consumers. Without evidence that consumers will be harmed by an acquisition, regulators don’t have much ground to stand on.

Pentwater Capital, a Florida-based hedge fund has made a killing by betting against these lawsuits. Allow me to explain how this works.

Imagine that we have a $5B company and a $100B company. The $100B company expresses interest in purchasing the $5B company. The situation will play out something like this:

1. The large company offers to pay a premium (let’s say, $8B in this case) to purchase the smaller $5B company.

2. The smaller company’s shareholders will likely approve this merger proposal, as it creates an additional $3B in shareholder value.

3. The stock price of the smaller company (assuming that it is publicly traded), climbs to ~$7.9B, almost reaching the deal price, but leaving some margin for error in case the deal falls apart.

Barring any unexpected discoveries, the deal will close soon thereafter, and the smaller company’s shareholders will receive the full $8B outlined in the deal.

Now, once again, let’s imagine that we have a different $5B company and $100B company. The $100B company expresses interest in purchasing the $5B company, but regulators take issue with this deal on antitrust grounds. The situation will play out something like this:

1. The large company offers to pay a premium (let’s say, $8B in this case) to purchase the smaller $5B company.

2. The smaller company’s shareholders will likely approve this merger proposal, as it creates an additional $3B in shareholder value.

3. The market cap of the smaller company (assuming that it is publicly traded), climbs to ~$7.9B, almost reaching the deal price, but leaving some margin for error in case the deal falls apart.

4. The FTC announces that it is investigating the deal on anticompetitive grounds and suing the larger company.

5. The value of the smaller company declines to ~$7.2B to account for the regulator-induced risk that the merger might fail.

In this second scenario, the introduction of a regulator lawsuit opens a window for a valuable trade (as denoted by the gap between $7.2B and $8B), but this trade will only be a success if the regulators lose in court.

Pentwater Capital has (correctly) bet on the FTC losing several of these lawsuits.

In January 2022, Microsoft announced that it planned to acquire Activision Blizzard for $95 per share. In December 2022, the FTC sued Microsoft to stop the deal from closing. Despite the deal being priced at $95 per share, Activision’s stock price stayed between $73 and $85 as investors waited in limbo to see if the deal would be approved.

Pentwater took advantage of the uncertainty and built a holding of 21.3M shares over the following months. By August, both the FTC and CMA (Britain’s competition regulator) had pulled their investigations, and Activision’s stock now sits just below its Microsoft bid at $94.

The hedge fund pulled a similar move earlier this year, acquiring millions of Horizon shares after the FTC attempted to sue to block Amgen’s acquisition of the biopharmaceutical company on (you guessed it) anticompetitive grounds, and they made bank when they ultimately dropped the investigation.

Not a bad strategy, right?

So what’s my big takeaway from this? Just because something feels like an anticompetitive monopoly doesn’t mean that it is, especially when that “monopoly” actually succeeds in lowering prices for consumers. Seriously, have you ever been pissed that Amazon underprices its good?

No.

That being said, if the FTC really wants to die on this hill, at least we can buy more shares for cheap.

- Jack

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