On February 13, final regulations to reform the Committee on Foreign Investment in the United States (“CFIUS”) – the US inter-agency committee that reviews certain foreign investment transactions to evaluate their impacts on US national security – became effective.
Taking a page from the CFIUS playbook, a number of other countries have recently taken steps to enhance the scrutiny of foreign direct investment for similar purposes. The factors spurring these changes have been in play for years, and largely relate to broader shifts in the geopolitical landscape.
But, the emergence of covid-19 has laid bare acute national sectoral and other vulnerabilities. This has accelerated efforts – particularly outside the US – to establish or improve regulatory mechanisms to evaluate foreign investment for national security purposes.
Here are five key things for private equity investors about these global developments.
1. Expect heightened scrutiny in the US, Europe and other OECD countries of transactions with a direct or indirect buy-side nexus to China – especially in connection with deals in the telecoms, healthcare or infrastructure sectors.
It is no secret that the US and other countries often heavily scrutinize transactions with a buy-side nexus to China. In the PE context, national security review-related questions may arise not only in connection with Chinese acquirers, co-investors and liquidity providers, as well as, in some cases, the presence of Chinese limited partners in funds.
In addition, the US and its partners and security allies have been increasingly focused on “third-country risk” – ie buyers’ independent commercial exposure to China – as a source of national security risk. We anticipate this elevated scrutiny will persist beyond 2020 in many OECD countries, and will be particularly acute in connection with telecoms, healthcare and infrastructure transactions – sectors in which supply chain security has been a key area of focus for national security regulators.
Buyers and sellers alike should evaluate whether one or more national security regulators reviewing a given transaction may take interest in the deal based on “third-country risk,” and assess how to address such concerns in any filings (ie, by structuring transactions in a way that the parties believe would mitigate such risk at the outset of a case).
2. In the US, CFIUS is asking more questions, more often about ‘non-notified’ transactions, including deals that closed years ago.
CFIUS’s monitoring of non-notified transactions has become broader and more sophisticated, with new, dedicated staff and resources for outreach to transaction parties on deals where no CFIUS filing was submitted. CFIUS’s interest in a transaction can arise from a variety of sources, including the M&A press, securities filings (including those made to non-US regulators), tips from failed bidders and classified US government intelligence.
If CFIUS takes an interest in a closed transaction, it generally requests parties file a joint voluntary notice of the closed transaction and may impose mitigation measures to address any national security concerns it identifies – including forcing divestiture of the target company. There is no statute of limitations regarding the review of non-notified transactions, and CFIUS has initiated reviews of transactions almost 10 years after closing.
Transaction parties should carefully evaluate the reputational, financial and other risks that may arise from a decision not to notify CFIUS of a transaction that is otherwise subject to its jurisdiction (ie, the risk CFIUS could inquire about the transaction, pre- or post-closing, and take adverse action).
3. Global national security regulators will continue to share information about the potential national security implications of cross-border transactions.
The covid-19 pandemic has prompted many countries (ie, Canada, Australia, Germany, Japan, India) to enhance their own national security review regimes. US-based funds have not been immune from scrutiny as a result of these enhancements and, in a number of cases, have been obligated to agree to supply commitments, governance restrictions and other measures before receiving approval for a transaction.
At the same time, CFIUS has increased its outreach to, and cooperation with, non-US national security regulators as part of its efforts to encourage other countries to adopt CFIUS-like best practices in screening investments. Importantly, national security reviews operate very differently from competition reviews; the policy drivers and criteria for regulators’ assessments are fundamentally different, and there is not always a “fix” for issues identified during national security reviews.
The landscape for global national security reviews is evolving rapidly. Transaction parties must account for these recent changes in deal planning and execution. Parties should ensure that the substance of disclosures to various national security regulators is consistent and accurate, and should assume such disclosures will be checked against any public filings (ie, annual reports, press releases) or through intergovernmental outreach and engagement.
4. PE sponsors should expect more engagement from their limited partners and co-investors on fund and deal-level approaches to address CFIUS and related risks in non-US jurisdictions.
The final CFIUS regulations provided useful color on the types of rights that may be afforded to foreign LPs without triggering CFIUS’s jurisdiction (ie, conflicts waivers). That said, the CFIUS implications of investors’ rights will require careful assessment because many US-based funds already grant LPs more fulsome rights than are contemplated under the final CFIUS regulations and may not have included CFIUS-specific provisions in relevant fund documents.
In addition, LPs and co-investors will now have to build in heightened CFIUS due diligence to their investment triage to ensure they understand sponsors’ CFIUS risk appetites and the likelihood that their information may be disclosed to CFIUS as part of a review in the future.
Private equity sponsors should account for CFIUS considerations early in the fund formation process and should anticipate LPs and foreign co-investors will ask CFIUS-specific due diligence questions – both in connection with an initial fund investment as well as transaction-specific co-investments.
5. CFIUS may issue further guidance regarding when a US-controlled investment fund could be considered ‘foreign’ and therefore have its transactions subject to CFIUS’s jurisdiction.
The final CFIUS regulations included an interim rule defining an investment fund’s “principal place of business” as the primary location where the fund’s activities and investments are primarily directed, controlled or coordinated by or on behalf of the general partner, managing member or equivalent.
The interim rule helps to clarify that US PE sponsors will not necessarily be considered “foreign persons” whose investments are subject to CFIUS’s jurisdiction simply because they invest through non-US entities (ie, Cayman limited partnerships), so long as investment decisions are primarily made in the US and there are no foreign co-investors or other indications of foreign “control.”
However, a fund may not qualify for this exemption from CFIUS’s jurisdiction if it has previously represented to a US or non-US regulator that its principal place of business is outside of the US, unless it can demonstrate its circumstances have changed since the prior representation. Moreover, as the initial definition was promulgated as an interim rule, CFIUS may modify this definition in its final rule-making in response to public comments.
PE sponsors seeking confidence that their transactions are not subject to CFIUS’s jurisdiction should carefully evaluate, with assistance from outside specialist counsel, whether their funds meet the “principal place of business” test enumerated in the CFIUS regulations and the extent to which potential changes in the test may confirm or undermine this position.
Writers and contributors
Mario Mancuso and Ivan Schlager are partners at Kirkland & Ellis and members of the firm’s International Trade and National Security practice. Shawn Cooley is a partner at the firm and Lucille Hague, Matt O’Hare and William Phalen are associates.