Merger control review has long been a key factor in traditional private equity deals, particularly in the United States and European markets. PE sponsors are therefore typically well-acquainted with allocating risks associated with, and managing the mechanics of, any required filings, including the impact on deal documentation, time to close and the collection of data about an acquiring fund and its portfolio companies.
Secondary transactions, whether GP-led or LP-led, have until recently largely escaped such regulatory scrutiny, since secondary investors generally only take relatively small indirect interests in the underlying assets, with the overall control of the sponsor remaining unchanged. However, in the last few years, in the wake of concerns regarding national security, economic vulnerability, and supply chain disruption highlighted by the Covid-19 pandemic, foreign direct investment (FDI) screening has significantly expanded the scope of what is reportable in the United States, EU, UK and elsewhere. Now, any new money that has a connection to a third-country entity, even if taking indirect passive minority positions in existing fund assets, is potentially of interest to governments and can trigger FDI review in parallel with, or independent of, any required merger control approvals. As a result, navigating FDI requirements is increasingly important to deal making in the secondaries market.
What is FDI review?
FDI screening gives governments the ability to review and approve investments in certain critical assets and infrastructure to ensure M&A activity will not harm national security or public order. Historically, FDI regimes, such as the Committee on Foreign Investment in the United States (CFIUS), focused on defence and similarly sensitive areas of the economy. Recent changes in investor profile and investment patterns—even when those changes have been the result of government policies promoting FDI—have resulted in a significant expansion in the scope of many national FDI regimes to include strategic sectors such as energy, healthcare, biotech, food security, raw materials, telecoms, and businesses that collect or maintain sensitive personal data. Unlike merger control, FDI rules vary greatly between countries (the current efforts of the European Commission to harmonize regimes among Member States notwithstanding) and there is no consistent bright line percentage threshold below which investors can be certain their investment will escape regulatory scrutiny. While most jurisdictions do have minimum thresholds, governments usually have the ability to call in any transaction they deem of national interest, regardless of its value.
In addition to the transaction structure and individual investment, an FDI filing analysis therefore mainly considers two factors:
(i) Target risk: Any third-country entities investing in sectors considered to be of critical strategic importance need to consider whether the target falls under relevant national FDI rules and, if so, how sensitive its activities are.
(ii) Acquirer risk: There is heightened scrutiny of third-country investors deemed to be “governmental investors,” a definition that typically incudes not only state-owned enterprises and sovereign wealth funds, but also entities such as public sector pension funds, universities, etc.
Challenges for secondaries
FDI filings can be onerous. In many cases, FDI reviews are suspensory and can take longer than merger control ones, while at the same time being more opaque and less predictable in outcome due to the involvement of government intelligence services in the evaluation of transactions. In addition, FDI filings often have burdensome disclosure requirements that investors may find intrusive. These requirements can include details about the identity of the ultimate beneficial owners; personal information (such as passport data) of directors, officers [and investment professionals]; a detailed description of the source of funds; the investment structure (including any side agreements); and the identity of other passive investors in the fund.
Furthermore, investors are usually dealing with government departments beyond the established and independent competition regulator. In the UK, for example, decisions are taken centrally within the Cabinet Office, while in the United States, multiple disparate agencies, including the Departments of Treasury, State, Defense, Commerce, Energy, and Justice are involved in the review of transactions. That often means, particularly in jurisdictions with relatively new or expanded regimes, less transparency and communication and thus greater uncertainty and delay.
As a result, sponsors are becoming more and more cognizant of FDI filing requirements and seek to preemptively address potentially problematic issues. Deal documentation therefore increasingly includes FDI-targeted clauses granting the GP the ability to:
- Restrict an investor’s voting rights or participation on a limited partner advisory committee, or even expel an investor, if the GP determines its inclusion may have an adverse effect on the fund or underlying investments due to FDI restrictions.
- Withhold information to an investor where the GP determines such disclosure may have the potential to affect an FDI review of the fund’s existing or future investments.
- Block a proposed transfer that could subject the fund to an FDI review.
- Block a proposed transfer of an interest where the GP determines such transfer may have the potential to affect the FDI review of the fund’s existing or future investments.
Managing FDI scrutiny
Given current geopolitical tensions, scrutiny of foreign investment can be expected to increase further. Secondary investors—particularly those involved in more complex secondary transactions, such as acquisitions of a portfolio of investments or fund restructurings—should be mindful of possible FDI implications. Even if an individual investor’s holding may not itself trigger a filing requirement, the overall investor composition in the aggregate and/or the activities of the underlying assets may mean the investor will be referenced in a filing—for example, in a filing made by the lead investor. Therefore, investors should be prepared to address any FDI regulatory issues through the implementation of mitigation measures prescribed by regulators.
Additionally, investors in secondary transactions involving sensitive industries should anticipate and plan for significant FDI scrutiny. Some examples of industries which can be expected to receive enhanced FDI review include: (i) climate adaptation and advanced clean energy; (ii) semiconductors, artificial intelligence, and advanced computing; (iii) insurance, financial institutions, social media, internet-connected vehicles, and other companies which collect or maintain significant amounts of sensitive personal data; (iv) critical minerals and materials; and (v) critical infrastructure.
Finally, any filings that an investor is required to make or is part of, such as securities filings and merger control filings, should be substantively consistent to avoid potentially invasive follow-up questioning—and, potentially, fines for providing misleading information. Care in this regard is particularly important given the increased information sharing taking place among national governments and intelligence agencies involved in FDI screening. The United States, for example, amended its CFIUS rules explicitly to permit the sharing of confidential company information with any foreign governmental entity of a United States ally or partner. The same is true of the relevant UK legislation. Similarly, the European Commission and the individual Member States within the EU actively cooperate with each other to exchange information and share concerns related to specific investments, as well as with international partners such as the United States.
Private Equity Report Spring 2024, Vol 24, No 1