Regulatory scrutiny of secondaries investments on the rise

Merger control review has long been a key factor in traditional private equity deals. Private equity sponsors are therefore typically well-acquainted with managing any required filings, including the impact on deal documentation, time to close and the collection of data about an acquiring fund and its portfolio companies.

LP-led and GP-led secondary transactions have until recently largely escaped such regulatory scrutiny: secondary investors generally only take relatively small indirect interests in the underlying assets, with the overall control structure unchanged.

However, in the last few years, spurred on by concerns about economic vulnerability and supply chain disruption highlighted by the covid-19 pandemic, foreign direct investment  screening has significantly expanded the scope of what is reportable in the EU, UK and elsewhere.

Now, any new money coming into a fund, even if taking indirect passive minority positions in existing fund assets, is potentially of interest to governments and can trigger FDI review in parallel or separate from merger control. As a result, FDI requirements are increasingly important to the secondaries market.

What is FDI review?

FDI screening exists to ensure M&A activity will not harm national security or public order by giving governments the ability to review and approve investments in certain critical assets and infrastructure. Historically, those countries that had FDI regimes focused them on defence, media plurality and similarly sensitive areas of the economy. A change in investor profile and investment patterns, often with government backing or direction, has resulted in a significant increase in the scope of many national regimes to include strategic sectors such as energy, healthcare, biotech, food security, raw materials, telecoms and sensitive personal data.

Unlike merger control, FDI rules vary greatly between countries and there is no consistent bright line percentage threshold below which investors can be certain their investment will escape regulatory scrutiny. While most jurisdictions do have minimum thresholds, governments usually have the ability to call in any transaction they deem of national interest, regardless of its size.

In addition to the transaction structure and individual investment, an FDI filing analysis therefore mainly considers two factors:

• Target-risk: Any third-country investors in sectors considered to be of critical strategic importance need to consider whether they come within relevant national FDI rules.
• Acquirer risk: There is heightened scrutiny of investors deemed to be ‘governmental investors’. This typically captures not only state-owned enterprises and sovereign wealth funds, but also public sector pension funds, universities, etc.

Challenges for secondaries

Making an FDI filing can be onerous. FDI reviews are suspensory and tend to take longer than merger control ones, while at the same time they are more opaque and less predictable in outcome. In addition, FDI filings often have burdensome disclosure requirements that investors may find intrusive. These can include details about the identity of the ultimate beneficial owners, personal information of investment professionals such as passport details, a detailed description of the source of funds, the investment structure including any side agreements, and disclosure of the identity of other passive investors in the fund.

Furthermore, investors are usually not dealing with an established and independent competition regulator, but rather the relevant government departments. In the UK, for example, decisions are taken centrally by the Cabinet Office. That often means, in particular in jurisdictions with relatively new or expanded regimes, less transparency and communication and consequential uncertainty and delay.

As a result, sponsors are becoming alive to the issue of FDI filings requirements and seek to shield the fund and other investors from the potential implications of filing. Deal documentation therefore increasingly includes FDI-targeted clauses such as the following, granting the GP the ability to:

• Expel an investor if the GP determines its inclusion may have an adverse effect on the fund or underlying investments due to FDI restrictions;
• Withhold information to an investor where the GP determines such disclosure may have the potential to affect an FDI review of the fund’s existing or future investments;
• Limit the information the GP will provide to any government for the purposes of an FDI review;
• Block a proposed transfer that could subject the fund to an FDI review;
• Block a proposed transfer of an interest where the GP determines such transfer may have the potential to affect the FDI review of the fund’s existing or future investments.

Navigating the issue effectively

Given the current geopolitical tensions, scrutiny of foreign investment is set to increase further. Secondary investors should therefore seek early advice on possible FDI risk.

In particular investors in more complex secondaries transactions, such as acquisitions of a portfolio of investments or fund restructurings, should be alive to possible FDI implications. Even if an investor’s holding may not itself trigger a filing requirement, the overall investor composition in the aggregate and/or the activities of the underlying assets may mean the investor will be referenced in a filing, for example in one made by the lead investor.

Finally, any filings that an investor has to make or is part of, should be substantively consistent to avoid potentially invasive follow up questions and even potentially fines for providing misleading information.