Not on the guestlist
The interesting stuff in any legal document comes with the fine print and, in the case of the EU’s new Foreign Subsidies Regulation (FSR), the writing spells “public procurement”.
Formally adopted on 23 December 2022 as Regulation 2022/2560 on Foreign Subsidies, it differs from the legislator’s rules on foreign direct investment (FDI). “Rules concerning FDI are a tool aimed at safeguarding national security, barring foreign governments and companies from acquiring businesses and assets of strategic importance,” explains Michael Okkonen, a partner in Dechert’s EU competition law practice. “The FSR is economic in nature, a tool to restore fair competition in the EU, so the two sit side by side.”
The FSR has two levels. On the M&A side, it includes a turnover threshold and only applies if one of the merging companies or joint venture generates an aggregate EU-wide turnover of minimum €500m and both parties have received foreign financial contributions in excess of €50m in the three years prior to the conclusion of the deal. As a tool for merger control, it is unlikely to constitute a concern for the wider PE industry. Veit Konrad, general counsel and co-head of legal at SwanCap, notes: “The regulation hinges on a control investment. It will predominantly affect buyout investors and any fund with a controlling investment strategy.”
Through the backdoor
The FSR knocks twice on a GP’s doors – once for the single economic entity doctrine and twice for its broad definition of “foreign subsidy” in the context of public procurement.
The single economic entity doctrine is a concept applied in EU competition law, which views distinct legal entities as one undertaking. In other words, the PE firm, the fund, its backing LPs and the individual portfolio companies are all a single entity in the eyes of the Commission.
According to the regulation, a foreign subsidy appears “where a third country provides, directly or indirectly, a financial contribution which confers a benefit on an undertaking engaging in economic activity in the internal market”, or where “a foreign public entity whose actions can be attributed to the third country” provides financing. “This definition of ‘foreign subsidy’ creates some concern,” comments Rachel Wolfenden, partner at Fried Frank. “The wording is extremely broad and it is unclear what this exactly classifies. There is a chance of paralysis, which is detrimental to success in the fast-paced environment of dealmaking.”
Guglielmo Katte Klitsche de la Grange, who handles legal and compliance matters at SwanCap, concurs: “Considering how generic the definitions of subsidy and market distortion are, paired with large discretionary powers awarded to the Commission in regards to enforcement of the regulation, they require further guidance.”
The catch that both de la Grange and Wolfenden refer to comes from the regulation’s writing suggesting that any money provided by an entity with some degree of connection to a public institution constitutes a foreign subsidy.
Consequently, any dealings that the economic cosmos of a GP has with partially state-backed entities is likely to fall under the regulation. At the portfolio level, this can look like public tenders the individual companies participate in. Especially in industries like IT, infrastructure, mobilisation and healthcare, GPs should be vigilant where their portfolio gets its money from.
Unfortunately, the FSR might also open a backdoor into the firm. The LPs behind a fund could very well constitute a partially public entity. Likely examples include college endowment funds, state pension funds or institutional investors with ties to royal families involved with states such as Saudi Arabia.
In order not to cause too much disruption to the dealmaking festivities, it is therefore best to accommodate this unwanted guest. Financial contributions should be monitored. PE’s legal advisers suggest implementing this as a part of both fundraising and dealmaking, in order to be prepared in the long term and minimise possible disruptions to a firm’s deal process. The reason for this is twofold. First, the FSR applies retroactively for a period of three years. Second, the notification process can be lengthy and freeze a deal until clearance.
While the portfolio level should cause comparatively little headache, it is unclear how much information LPs would be willing to provide. Further, the regulation does not allow for calculations of financial contributions to be based on the last financial year. GPs will therefore need a system in place within their portfolio companies, which require reporting on a constant basis or an information-gathering exercise on an event-by-event basis.
Similar to its merger review, the Commission offers a pre-notification process by means of which the notification of any foreign subsidies can be reviewed prior to its official submission. However, the regulator is notoriously slow in its dealings and this might not be the best route, as Fried Frank's head of EU/UK competition and international trade practice, Tobias Caspary, suggests: “The process tends to be lengthy and should only be used with very clearly defined questions. The last thing you want is a deal falling through because of a long review process you cannot control.”
Ironically, this could lead to the FSR actually reinforcing anti-competitive behaviour as deals will be subject to the Commission’s approval, and firms with an increasingly streamlined process are likely to bring them home much quicker.
While the merger control side of the FSR is likely to affect a specific part of PE, the rules on public procurement stretch, due to their ambiguous and open-ended wording, much further. Combined with the single economic entity doctrine, they forgo the carefully crafted separation of liabilities and sink their teeth in wherever a partially public entity has injected cash into a GP’s cosmos. However, with the right information and by ingraining the notification process into the structure of a deal, GPs can accommodate this unwanted guest with minimal disruptions to the dealmaking party. “Private equity is attuned to conducting deals in a highly regulated environment,” concludes James Renahan, a partner at Fried Frank. “In contrast to corporate acquirers, this could actually create opportunity as PE firms will likely be able to act faster.”