IBM-Red Hat approval offers clues to defending deals behind closed doors

28 June 2019 00:00

International Business Machines' receipt of EU approval for its $34 billion buyout of open-source pioneer Red Hat came in the end with a whimper, not a bang.

After reviewing no fewer than seven types of overlapping software, examining potential knock-on effects in neighboring markets and scrutinizing the nature of Red Hat’s business, the European Commission concluded that the merger raised no competition concerns whatsoever. None.

If anything, the acquisition had a “potential procompetitive rationale,” the regulator said yesterday afternoon in a press release. The anticlimax was complete.

A swirl of heated anticipation had surrounded the case, as hedge fund managers spent months in the runup to the formal probe reviewing overlaps in the companies’ software and picking through clues to how case handlers might view them.

Analysts also combed through previous EU merger decisions involving open-source software, which developers are free to download, rework and use as they see fit.

Investors on edge

Some took comfort from the fast, unconditional clearance Microsoft secured last year to buy software development platform GitHub.

But investors remained on edge, largely because the IBM-Red Hat deal was long stuck in what looked like regulatory limbo — months of closed-door “prenotification” talks between company representatives and the case team at the European Commission in Brussels.

In the end, yesterday’s unconditional clearance looked like a routine approval following a formal review lasting a little more than one month. Yet the outcome offers valuable hints to other tech companies doing deals in the complex business of cloud computing and beyond.

It also offers insights into how the commission views open-source software and “conglomerate effects” in tech deals — the risk that two companies, once combined, would have “the ability and incentive” to curb competition in neighboring markets.

Radio silence

Lesson No. 1: Companies should not even think about formally filing to the commission until they have explained their business to EU case handlers in granular detail during prenotification talks.

The regulatory radio silence during these discussions can cut two ways. Keeping a tight lid on the consultations tends to make investors twitchy: The spread between Red Hat’s stock price and IBM’s offer of $190 a share in cash stood at some 8 percent in January and narrowed only slowly over time.

But handled correctly, prefiling talks can and do provide a safe space for companies and their lawyers to bring case handlers up to speed on competing products in obscure corners of a complicated business.

They can also allow the two sides to iron out any misunderstandings before the clock starts ticking on a formal investigation. That can prevent a case from slipping into an in-depth phase II probe by accident — not because the deal presents problems, but because the case handlers don’t feel comfortable after an initial probe of 25 working days.

Overlapping software

The IBM-Red Hat review shows just how detailed prefiling talks can get. The EU probe explored an array of middleware and system infrastructure, examined conglomerate effects and looked at whether the deal might make it “more difficult or impossible” to copy the source code for Red Hat Enterprise Linux, the popular open-source operating system.

Understanding these markets takes time. In IBM’s case, some seven months elapsed between the deal announcement last October and the moment when the official paperwork reached the commission.

One focus of the probe involved IBM’s WebSphere Application Server and two competing Red Hat products, JBoss Enterprise Application Platform and JBoss Web Server. All supply core services on which applications can run — like a shopping mall providing stores with basic services, such as parking and security — leaving the apps to focus on what they do best.

Case handlers also had questions about “business process management suites” — software platforms designed to help businesses handle processes such as insurance claims and mortgage approvals. They also asked about “event-driven middleware,” which enables programs and components to talk to each other. And so forth.

By the time IBM lodged official paperwork at the commission on May 20, case handlers were ready. Within days, competitors received a 50-page questionnaire that highlighted the breadth and complexity of the deal.

Little public opposition

Competition reviews often give rivals, suppliers and customers a platform for airing concerns about a merger. A prime example can be seen in the intense backlash to Vodafone’s plan to acquire Liberty Global cable operations stretching from Germany to Romania.

The IBM-Red Hat deal, by contrast, drew relatively little opposition, at least in public. Leading cloud-computing providers such as Amazon Web Services flatly declined to comment on the deal.

One company that did raise concerns was Nutanix, whose “hypervisor” software allows one computer server to do the work of several servers.

Nutanix was said to be worried that the merged entity would have the leverage to encourage customers to use Red Hat hypervisors instead of rival products. Might IBM use its power and reach in cloud computing to curb competition in this neighboring open-source software niche?

Without citing Nutanix, the commission dismissed such concerns for two reasons. The merged company, it said, “would not have sufficient market power to shut out or marginalize its competitors by bundling or degrading interoperability.”

Besides, Red Hat’s success “hinges on its neutrality,” it said. “Any strategy impairing this neutrality would likely damage Red Hat's business” by driving customers, developers and partners to “competing open-source solutions,” the release said.

As for the software overlaps, the commission concluded that “the merged entity would continue to face significant competition from other players in all potential markets.”

As if that weren’t vindication enough for the deal, the commission went on to cite the buyer’s potentially “procompetitive” intention to “use the complementary capabilities of Red Hat to further develop and offer open hybrid cloud solutions. This would increase choice for enterprise customers who could more easily shift workloads between on-premise servers and multiple public and private clouds.”

IBM’s lawyers could be forgiven, at that point, for throwing some high fives.

*Additional reporting by Natalie McNelis

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