Vertical Mergers: A Key Role in the Defense Innovation Lifecycle

By: Jack Ellrodt - Georgetown School of Foreign Service

On July 9^th of this year, President Biden issued a sweeping Executive Order entitled “Promoting Competition in the American Economy”. The order, which includes more than 70 distinct initiatives, seeks to address the Administration’s concerns surrounding corporate consolidation and anti-competitive practices across an array of industries.  Of important note for the defense industry, the order focuses particular attention on encouraging the Attorney General and Chair of the Federal Trade Commission to “review the horizontal and vertical merger guidelines and consider whether to revise those guidelines”.

Vertical mergers – those in which two noncompeting firms providing different supply chain functions merge – have long played a key role in the defense innovation lifecycle. Research and development of emerging technologies is a costly and risky business. Vertical mergers allow entrepreneurial firms to focus on innovating by removing some degree of financial risk. Once the value of proprietary technology is demonstrated, vertical mergers and acquisitions afford innovators a financial reward while their proprietary technologies are scaled up and incorporated into the larger defense-industrial ecosystem. Despite this established precedent, the Administration seems to be trending towards a general aversion to vertical mergers and acquisitions.

On July 16^th, Senator Elizabeth Warren (D-Mass.) sent a letter to the Chair of the Federal Trade Commission (FTC), Lina Khan, regarding concerns about “monopolistic behavior of firms in the defense industry”. Senator Warren’s letter comes as antitrust regulators continue to review Lockheed Martin’s planned $4.4 billion acquisition of Aerojet Rocketdyne, a major rocket and missile propulsion manufacturer. In her August 6^th response, Chair Khan indicated that she is skeptical of the proposed Lockheed-Aerojet merger and, perhaps more troubling, the broader practice of vertical mergers and acquisitions across the defense industry. General speculation is that the FTC and DoJ Antitrust Division will ultimately challenge the proposed merger, especially given President Biden’s July 9^th Executive Order.

At the very least, it seems likely that regulators will require Lockheed to submit to certain mandates if the merger is approved. In the past, regulators have required firms to submit to certain behavioral or structural mandates if a potentially anticompetitive merger is approved. Behavioral remedies are designed to prevent newly merged companies from using acquired information or technologies to the detriment of their rivals (e.g., mandating that an acquired technology still be provided to competitors). Alternatively, structural remedies are intended to prevent companies from obtaining an anticompetitive advantage in the first place, namely through the forced divestiture of certain assets. Even so, Chair Khan has also argued that such directives are often not enough, and that regulators should more often consider opposing potentially anticompetitive deals outright.

Recognizing the sentiment established in both President Biden’s July 9^th Executive Order and Chair Khan’s August 6^th letter, it seems that the Administration is gravitating towards discouraging vertical mergers and acquisitions. It is unclear whether the Administration’s aversion, especially as it relates to the defense industry, is derived more from a concern of consolidation amongst the largest players or a general perception that all vertical mergers hinder competitiveness. Unfortunately, the relevant statues and review frameworks fail to effectively differentiate between the merger and/or acquisition of small, medium, and large companies.  Given that the statutory rules do not afford separate classifications for different sorts of companies, regulatory decisions intended to prevent consolidation and anti-competitiveness at the highest levels may very well stifle innovation and investment in emerging technologies and the lowest levels. The resulting effects of such trends could be devastating.

As noted earlier, investment in entrepreneurial endeavors and unproven technologies is risky. Preventing larger firms from acquiring smaller companies once proprietary capabilities are proven valuable removes the financial incentive for any initial investment in research and development. A broad policy of opposition to vertical mergers and acquisitions in the name of mitigating anticompetitive behavior at the highest levels is likely to suppress innovation and technological advancement. As the Administration moves forward in implementing President Biden’s Executive Order, it is imperative they recognize that any revisions to the current regulatory framework must be tailored to account for these nuances.

Topics: Mergers and Acquisitions