EU foreign subsidy rules and private equity deals

A regular briefing for the alternative asset management industry.

The increasing presence of sovereign wealth funds in M&A deals – as well as the expansive investment strategies of other government-related investors – has been a concern for EU policymakers in recent years. As well as the obvious national security implications, the EU has been determined to combat the effects of potentially distortive subsidies granted by other national governments to companies operating in the EU. The result is the Foreign Subsidies Regulation (or FSR).

So far so good: alternative asset managers might welcome a level playing field for their portfolio companies and, on the face of it, have no reason to object. But, as is so often the case, the unintended effects are concerning.

These unintended effects arise from the design of the FSR. Among other things, the new Regulation, which is already in force, introduces a mandatory notification regime for M&A deals where certain financial thresholds are met. This new requirement sits alongside existing EU merger control and national foreign direct investment screening.

From 12 October 2023, deals where the target has revenues of at least €500 million in the EU will need to be notified, and an associated stand-still obligation will apply, where the acquiror and target groups (combined) have received at least €50 million in "financial contributions" from non-EU states in the preceding three years.

The theory of harm behind the FSR is simply that the grant of a financial contribution by a government-related body to an acquiror can give it an unfair advantage. However, in practice, the regime extends well beyond this.

Whilst the Commission's rhetoric focuses on the distortive effects of foreign subsidies – which are, in essence, benefits granted by a state to specific firms on non-market terms – the notification thresholds are not based on the level of subsidies received by the transaction parties. Rather, the notification requirement is based on a much wider concept of "financial contribution".

"Financial contributions" can be made by a wide range of bodies, not just limited to governments and government authorities. Investments by sovereign wealth funds into an asset manager or private equity fund are intended to be caught as a "financial contribution". There are other types of entity that may be analogous to sovereign wealth funds that may also be caught; for example, a government-aligned pension fund, depending on the relationship between that fund and the state.

One particular feature of the new rules is that revenues flowing from a purchase of goods or services by a state body – or by a private entity whose actions can be attributed to a state – from a portfolio company would count as a "financial contribution". It does not matter whether these contracts have been negotiated on arm's length commercial terms or were subject to a strict public procurement process. Examples might be, government cleaning contracts, defence contractors, suppliers to schools and other innocuous purchases of goods or services.

Also, given that the FSR applies a group-wide concept to calculating the notification thresholds, financial contributions to one portfolio company could trigger an obligation to file all EU deals going forward. This is the case even where the particular deal in question does not involve any degree of foreign assistance, and even where the acquiring fund has not itself received any foreign assistance.

In short, the very wide definition of foreign "financial contributions" means that, in practice, many deals by (EU and non-EU) alternative investment funds involving targets with at least €500 million of EU turnover will require notification, even in cases where there is clearly no real foreign subsidy to be concerned about.

The theory of harm behind the Foreign Subsidies Regulation is simply that the grant of a financial contribution by a government-related body to an acquiror can give it an unfair advantage. However, in practice, the regime extends well beyond this.

European Commission officials have acknowledged that private equity firms will face a higher notification burden under the new rules than other types of dealmakers, and is actively considering how to accommodate the specificities of their structures in the Implementing Regulation that is currently being finalised.

Whilst the text of the FSR itself is set, asset managers and private equity firms are now focusing on this Implementing Regulation in the hope that it will reduce the practical notification burden for the industry. The regulation will set the precise content for the notification forms, and interested parties are calling for a "short form" route for unproblematic deals in the asset management space. Concessions in the level of reporting required in the notification form could make a significant difference from a procedural efficiency standpoint, but also in terms of the amount of information that asset managers will need to collate internally on an ongoing basis. (We worked with Invest Europe to put forward the industry's views on these points during the consultation period that ended earlier this month.)

Once the final version of the Implementing Regulation becomes clear, all firms will need to consider how best to collate records of the required data on non-EU financial contributions received from their investors, and by their portfolio companies and other group investments, in order to assess their likely exposure to filing obligations under the FSR. This will need to be done in relatively short order, given that the notification regime will be effective from October and, unless the Commission fully reflects the industry's feedback, the exercise is unlikely to be straightforward.

In the meantime, it is to be hoped that the European Commission can find a way to make the new rules achieve their laudable objective, without creating additional and unnecessary bureaucracy and delay for private equity acquirors in deals that clearly do not cause public policy concerns.

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