Foreign Direct Investment: An emerging roadmap for financial investors
Our vocabulary over the past 18 months has expanded to include many new concepts (PCR tests, “R Numbers” and the like) and for repeat dealmakers “foreign investment” or “FDI” is now right up there in their every-day terminology. Newly established (or further empowered) regulators around the world are increasingly testing the scope of their powers.
We reflect below on the two core interests/concerns commonly raised in FDI reviews and how we’ve seen them impact investments by financial sponsor acquirers.
What do FDI regulators want to know?
First and foremost, FDI regulators want to know details of the ultimate controlling interests behind an investment. This inevitably entails having to provide detailed information regarding the fund structure, the various entities involved, and relationships between the fund and the investment manager. However, it is becoming more common to also need to disclose details of beneficial owners (i.e. investors) and their identity / origin. This can sometimes be limited to broad descriptions of the relevant geographic and background split of investors holding more than a certain threshold, but more detailed/complete disclosures may be necessary.
Explaining the role of limited partners has thus become a frequent requirement of FDI filings in many jurisdictions, particularly Germany, as authorities focus on whether limited partners may have influence through parallel arrangements. Regulators may ask for copies of fund agreements, including side agreements with specific investors, to assess the investors’ rights with respect to governance of a fund and its portfolio companies. In many cases, despite the standard disclaimers that limited partners will not control a fund, regulators may focus on specific provisions of these agreements that give investors - either directly or through participation in fund advisory committees - the right to participate in the fund’s investment and other decisions. We are also increasingly witnessing requirements to provide copies of relevant loan / facility agreements as part of FDI filings. The submission of this information can cause tension between fund sponsors and investors hoping to avoid regulatory scrutiny.
Another major area of interest for regulators is the investor’s plans for the acquired assets, meaning that disclosure of business / investment plans along with other deal rationale documents is now regularly required. This is particularly so in Italy, where the government has a special focus on the industrial / business / financial plan, which often also needs to outline specific plans for the Italian business. While plans to invest in, or grow, the business will be viewed favourably, profit maximisation by way of closing down certain (unprofitable) parts or generally reducing the footprint of the target business may at times be at odds with the interests of the regulator in a given country. That said, this aspect can also play to financial sponsors’ advantage, as stand-alone investments are generally made for growth/expansion rather than strategic reasons (whereas an industrial buyer is more likely to want to realise synergies/consolidate operations).
What’s the concern?
Contrary to merger control which has, at least in principle, a framework of well-established theories of harm, FDI is heavily subject to the policy/political goals of the relevant regulator. This leads to a perception of a broader (or less readily identifiable) range of potential issues. That said, to borrow regulatory parlance, two common “theories of harm” are beginning to emerge from the crowd.
The first of these - and for which the identity of the investor or interests behind the investor will be important - relates to the access, possession or usage of sensitive information. Most typically (or obviously), information may be sensitive from a national security, economic or other governmental perspective. In some countries, like the US, sensitive information also extends to holding personal data regarding citizens of that country. The main concern here will be understanding who may gain access to that data and how might it be used. This concern is not just limited to ensuring data does not fall into “unfriendly” hands, but also avoiding widespread distribution within (or even to) the investment company itself.
The second major concern relates to the preservation of the target’s operations and activities in a given country. This concern can manifest itself in a number of ways depending on the sensitivity of the asset. However, most commonly it takes the shape of (i) a concern that government contracts will not be honoured or that government will lose an important source of supply and (ii) a reduction in the operational footprint / employment within a given country. The significance of such concerns will largely be driven, on the one hand, by the nature of government or public administration contracts held by the target business and, on the other, by the investor’s plans for the business post-acquisition.
Common means of problem-solving are FDI-specific
FDI problem-solving can be roughly divided into two categories; (i) carve-outs which can be used to avoid an FDI review altogether and (ii) remedies imposed by the authority in a review context.
Carve-outs may consist of the exclusion of certain subsidiaries, assets, and/or operations from the scope of a transaction to avoid national regulatory reviews. When executed right, these can result in considerable advantages in terms of deal certainty, timing, and conditions. Carve-outs are common in the US to exclude anything that could qualify the target as a “US business” for CFIUS purposes, but these are often relied upon on the other side of the Atlantic too. Further, we expect that carve-outs may be utilised for future deals with a UK nexus to avoid foreign investors gaining access to “sensitive sites or assets”, which would trigger a filing obligation under the new UK regime.
Carve-outs can also be used during the review process to mitigate concerns of an authority whereby a particular subsidiary, asset, and/or operation is separated from the target business so that an authority can place conditions on or even seek to block foreign ownership of that business. That said, remedies imposed by FDI authorities in a review context are in most cases behavioural.
When it comes to concerns regarding access to, or use of, sensitive information, common behavioural remedies include having the target business undertake to submit to third-party compliance audits; creating approved corporate security protocols to safeguard sensitive information within the target business; or applying restrictions on shareholders’ rights to receive information or otherwise participate in the management/governance of the target business.
Of potentially greater impact on a financial sponsor’s investment case are remedies addressing business preservation. Remedies imposed by European regulators (particularly in France and Italy) have included commitments not to transfer certain activities outside of the country and commitments to undertake best efforts to develop certain activities or implement country-specific investments set out in the business plan. Germany is becoming known for its public law contracts: these are typically used when the target has a supply relationship with government institutions, the sensitive product is unique in the sense that it cannot be replaced by another supplier, or there are a limited number of competitors offering the same product. Such contracts can be somewhat burdensome for financial sponsors as the government seeks to identify a legal entity that has (i) control and (ii) sufficient capital to meet any financial obligations or penalties.
While “continuity” remedies are often relatively painless, upon entering into a transaction, care still needs to be taken to ensure that the breadth of the remedy does not jeopardise exit plans/timing and that any practicalities of supplying necessary on-going funding can be met (particularly for closed funds). For instance, should an authority impose an obligation to continue the businesses’ research and development activities or to ensure its industrial capacities are sufficient to meet the needs of the government, these may be coupled with a commitment to inject extra equity into the target business over time.
