Foreign investment regulation
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FI Monitor Issue 4, 2022
When a financial sponsor seeks to acquire a new portfolio company, it may not be fully considering the impact its limited partners could have on the FDI regulatory processes to which the transaction may be subject. But those LPs are increasingly subject to scrutiny as part of foreign investment review.
Not all limited partners are created equal in the eyes of FDI screening mechanisms. While an LP’s rights may be sufficiently limited to satisfy legal, corporate, and tax requirements, their particular rights may nonetheless trigger FDI screening notification obligations. Furthermore, depending on the limited partner and the portfolio company, limited partner interests, even with only typical LP rights, can sometimes be the source of regulator concern over a fund’s acquisition of the portfolio company. Consequently, FDI authorities may seek disclosure and assurances about such investors (or the funds in which they invest).
The bottom line is that it is important for financial sponsors to understand that, from a regulator’s perspective, limited partner does not necessarily mean limited risk. Here, we explore this evolving area of risk.
FDI screening regimes require varying degrees of disclosure regarding the ownership and control chain of the acquiring person. FDI screening may involve general disclosures in relation to the mix of nationalities of the limited partners and participation by government entities in the investing fund. In the United States, for example, there is a requirement to disclose any government interest regardless of the nature and size of that investment; and in some European jurisdictions, there is a requirement to disclose any government interest above a certain threshold (e.g. representing a stake of at least 10 percent in the fund).
There may also be a requirement to drill down to specific limited partners, depending on whether any is seen as having an outsized role; a fund of one, or a fund comprised solely of limited partners from a single jurisdiction, for example, is likely to result in a full disclosure obligation.
Additional disclosures around limited partnership agreements – either summaries or production of the full agreements – are not uncommon in the United States and are becoming increasingly so in European jurisdictions, too. In certain instances, such disclosure can extend to cover side letters, minutes of advisory committee meetings, and certain internal documents of the general partner or manager. In general, when regulators request these types of documents, they are looking to confirm that the limited partners in the fund are indeed passive investors with only the rights and accesses typically afforded to a limited partner.
It is important also to consider whether any limited partner independently may have a filing obligation or impact the reportability analysis of the underlying transaction (this applies not only to FDI regimes but equally to merger control regimes, some of which also require non-controlling minority interests to be notified).
Limited partners often will hold an indirect, largely passive, minority investment that will fall below the filing thresholds of many FDI (or merger control) regimes, but it is important to consider those regimes that have fairly low thresholds. For example, the German and Italian FDI regimes apply to acquisitions of a 10 percent or greater interest, although the German regime does not apply where the limited partner does not hold a voting interest. In the US, CFIUS has jurisdiction over covered investments in certain US businesses which can cover non-passive minority investments of any size depending on the rights the investor has. This analysis looks at whether an investor may have, either via participation on an advisory committee or pursuant to a side letter, any right (whether exercised) to a board seat or observer, access to certain information, or, where applicable, involvement in certain decision-making beyond voting shares. When performing its jurisdictional analysis CFIUS can aggregate the interests of limited partners owned or controlled by the same foreign government.
While side letters may grant a limited partner certain rights, they also are often used to blunt the impact of limited partners on the regulatory analysis. Forgoing rights or access via a side letter can provide comfort that a limited partner is not itself independently engaging in a covered investment subject to jurisdiction.
Limited partners can impact the substantive analysis of a transaction even when they are passive. Where a particular limited partner or group of limited partners from a particular jurisdiction has an outsized role, it can have an impact on the risk analysis and outcome of a particular case. Indeed, in light of current and past geopolitical developments, we have seen an uptick in the scrutiny of limited partners from certain jurisdictions.
Regulators increasingly require the disclosure of detailed information, and it may no longer be sufficient to demonstrate that limited partners are truly passive investors that have no legal decision-making rights over investments or portfolio companies. Further safeguards may be required to alleviate any potential concerns by regulators, including extending as far as carving out limited partners or co-investors from certain investments; ultimately regulators may impose an outright prohibition if the involvement or concerns relating to limited partners cannot be mitigated.
Where a single limited partner or a group of limited partners from the same jurisdiction hold a majority or dominant minority interest in a fund, it can be difficult to convince regulators that the investment is truly passive. In the United States, for example, CFIUS blocked a proposed acquisition by a US-based private equity firm that had one limited partner, a wholly owned subsidiary of a large Chinese investment fund. In Europe, we have seen regulators requiring increasing safeguards and conditions relating to the involvement of limited partners from certain jurisdictions, including imposing information conditions. Such conditions, for instance, relate to the general partner or manager keeping the regulator updated on the composition of the investing funds and the identity of limited partners.
When raising a new fund or adding new limited partners to an existing fund, firms should be cognizant of reputational considerations that might be implicated by their choice of limited partners and the technology or sectoral focus of their funds. In general, regulators understand that private equity and venture capital firms raise funds that contain both private and government-owned limited partners from a variety of jurisdictions, including jurisdictions that regulators might view as higher risk in the context of a direct investment. However, regulators may draw a negative inference about a firm that has a significant concentration of limited partner interests from a higher risk jurisdiction and that attempts to invest in sensitive technologies (e.g. artificial intelligence) or sectors (e.g. critical infrastructure). Avoiding this reputational risk requires fund managers to understand how regulators think about national security risk and to select limited partners and target companies for acquisition accordingly.
The original investment may not be the end of the FDI screening. There are a variety of scenarios in which a change in limited partner composition of a fund could come under scrutiny, even with respect to a completed acquisition by a fund. Consequently, it is important to consider your investor mix at every step.
For example, reorganizations, adding additional investors, and bolt-on transactions at the portfolio company level may all result in potential future FDI filings that will disclose the revised investor structure. Specifically, in the United States, but also certain European jurisdictions, even entirely internal reorganizations can trigger a mandatory filing obligation. In certain jurisdictions, even the entry of new limited partners into the funds making the investment can trigger a renewed FDI screening. And if such additional reviews are triggered, or the fund makes a new portfolio acquisition, any changes in the limited partner composition of the fund in the interim could affect the review, particularly if those changes involve the addition of limited partners from higher risk jurisdictions.