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Crashing the party

The US government's concerns over national security are likely to increasingly hamper the sale of stakes in management companies to sovereign wealth funds.

US private equity firms looking to follow in the footsteps of Apollo Management, The Blackstone Group and The Carlyle Group in selling stakes in their management companies to foreign investors may be affected by the US government's increasing interest in transactions that can impair national security, according to law firm Kaye Scholer.

The increased scrutiny by the government comes in the form of The Committee on Foreign Investment in the US (CFIUS) reform legislation signed by President George Bush on July 26. CFIUS has widened the definition of acquisitions under its domain to include the control of any ?critical infrastructure,? which is defined as assets so vital to the US that ?the incapacity or destruction of such systems would have a debilitating impact on national security.? Official regulations for the act will be issued on January 1, 2008, although the act applies to ongoing acquisitions, says Christopher Griner, a managing partner at Kaye Scholer.

The national security review process, called Exon-Florio, was brought into law in 1988 largely in response to the alarm created over acquisitions in the US by Japanese companies. Under the new law, CFIUS is allowed to mitigate any threat a transaction poses to US national security. It can also impose civil penalties if these agreements are breached or other conditions of Exon-Florio are not met.

While it has always vetted foreign ownership of assets, CFIUS has become more draconian recently. The Dubai Ports acquisition of UK shipping company P&O is regarded as a turning point. The acquisition, which involved six US ports, caused a political and media uproar due to worries that essential infrastructure would fall into the hands of a foreign ? Middle East ? government, as Dubai Ports is owned by Sheikh Mohammed bin Rashid Al Maktoum, the ruler of Dubai. The deal eventually closed after P&O agreed to divest the US ports upon acquisition.

?With the low dollar and the attractiveness of the US homeland security market at the moment, a host of foreign private equity firms are teaming up with US partners to buy infrastructure and defense assets,? says Kaye Scholer partner Farhad Jalinous. These transactions may often require regulatory approval, but bidders that need to go through the CFIUS process should factor in the potential regulatory delay into their decision-making, the lawyers warn.

In private equity, buyout firms that have or are seeking investments from controversial state funds are at highest risk under CFIUS' new laws. While individual foreign investors are also subject to review, great scrutiny falls on these investors, Jalinous says. Private equity portfolios may include US critical infrastructure or assets vital to national security and so such involvement by a foreign owner may impinge on firms' abilities to make acquisitions and manage companies.

It may be, however, possible to neutralize such scrutiny. CFIUS informally cleared Blackstone and Carlyle's sales of non-control stakes (both were under 10 percent) in their management companies to Middle Eastern and Chinese state funds. While applications to CFIUS are technically voluntary, Jalinous recommends investors to submit applications to CFIUS ?so they don't get hit later by something they were not considering.?

Control acquisitions are far more likely to fall under CFIUS' remit, although the regulator has made clear it is concerned about minority stakes. The lawyers recommend that stakes of above five percent by foreign opportunistic investors or hedge funds should be filed. This is simply to avoid problems should a firm decide to buy a larger stake at a later date.

In a recent talk given by a senior figure at a large US investment firm with the backing of a sovereign wealth fund, the executive made it clear he felt that the negative attention the foreign investors receive is disproportionate to any damage it could possibly do. ?The fuss about sovereign wealth funds is nothing new. The Japanese were acquiring companies in the US in the late 1980's. Yet what did they do when they acquired the Rockefeller Center?? he reportedly said.

Despite the threat of new legislation and greater scrutiny of deals, the effects of CFIUS may be mild, and the financial protectionism dominating the political climate in the US may be exaggerated. The changed reality of direct foreign investment in recent years has come partially in response to the rise and rise of sovereign funds, who are big investors in US buyout funds. It remains to be seen whether CFIUS will eventually bare its teeth against the growing trend of firms to seek these sovereign investments in their management companies.