Legal briefing | 22 Mar 2024 |

Travers Smith's Alternative Insights: Private markets and foreign subsidies

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A regular briefing for the alternative asset management industry.

Since last October, M&A deals in scope of the EU's new Foreign Subsidies Regulation, or FSR, must be cleared before closing, causing delay and uncertainty for buyer and seller. The EU's regime has a laudable policy aim: to eliminate competition-distorting state subsidies given to companies operating in the EU. Following the US's path-breaking Inflation Reduction Act, with significant subsidies for certain activities, greater focus from European regulators was inevitable.

But, as we wrote last year, its widely drawn rules mean that many private equity deals are needlessly in scope.

Many in the private markets had significant concerns that the regime could be a frustrating obstacle to unproblematic deals. Now, nearly six months on, it is clear the European Commission underestimated the number of cases it would have to deal with, and its procedures are adding time and cost to transactions that raise no substantive issues.

The European Commission's recent policy brief, reviewing the FSR's first 100 days, confirms that the regime is catching more deals than the Commission expected – and that private equity deals make up a significant proportion of the notifications. The Commission had estimated that 33 transactions would be in scope in this initial period – in fact, the total was 53. Of those, one third involved an "investment fund".

That outcome is no surprise. In a straight-forward acquisition, the jurisdictional thresholds require the target to have annual EU turnover of €500 million – designed to catch only the EU's largest deals. But the second, cumulative threshold is much less restrictive: across both the acquirer and target, the parties need only to have received so-called "foreign financial contributions" (FFCs) in excess of €50 million over the last three years. Crucially, this FFC threshold does not require any non-EU government subsidy, but can be reached by investments and supply contracts made with any non-EU entities with state links – even those on market terms. For a private equity fund, portfolio company transactions are included.

Another reason for the wide coverage is that the FSR's definition of contributions that are "state-linked" is broad and vague. Given the significant the legal sanctions associated with failing to notify a transaction, this encourages firms to take a conservative approach where a party, or the counterparties it deals with, have only a tangential or unspecified relationship with a non-EU state.

Taken together, these considerations mean that, if a cross-border private equity deal fulfils the target turnover threshold of €500 million, the deal will often be notified on the basis that it also meets the second threshold.

The question is what happens next – and how fast.

In its briefing, the Commission confirmed that most deals in scope remain in informal "pre-notification discussions". The Commission has started its formal statutory review period in only 14 cases, most of which received clearance after the initial 25 working day review (including one deal that we advised on). The slow rate of progress to a formal review is indicative of the volume of information that must be provided upfront – despite some helpful concessions for asset managers which were made last year. But it is notable that no in-depth investigations have yet been launched. Once it has the information that it has requested, the regulator appears to be adopting a pragmatic and proportionate approach to its substantive review – at least in straight-forward deals using market-standard structures.

"The Commission has helpfully provided further details on the information that it requires from notifying parties, and concessions made last year are proving quite helpful."

The Commission has helpfully provided further details of the information that it requires from notifying parties, and concessions made last year are proving quite helpful. For example, even though they count towards the €50 million threshold, purchases of goods and services need not be reported if conducted on market terms, and – unless the contribution is one that is more likely to amount to a problematic subsidy – little information is required as regards foreign financial contributions received directly by the target. And, importantly, there is a specific exemption for "investment funds", which allows asset managers to limit disclosures to the specific fund (and its portfolio companies) acquiring the target, and not other funds managed by the same firm. The reporting burden is still significant – but considerably less onerous than it might have been.

Firms do need to provide detailed information on foreign financial contributions regarded as more likely to amount to a distortive foreign subsidy, which includes contributions that directly facilitated the relevant transaction. The Commission's policy brief confirms that passive LP investments in the fund, and general debt financing, even if not raised specifically for the transaction, both fall within this category. That means the Commission may require an asset manager to provide details of its LP's investments (at least at a high-level), which could be sensitive for certain investors. Furthermore, passive co-investments alongside the acquiring fund are likely to attract particular scrutiny and, in some cases, it may be helpful to structure the deal in a way that minimises any possible delay that might be caused by such a co-investment.

The Commission expects firms to prove that they fulfil the three, cumulative criteria required to take advantage of the investment fund exemption and report only on the acquiring fund. Unlike some other reporting exemptions, this is not a matter of self-assessment. For example, firms will need to explain how they have established that there are no or "limited" transactions between the firm's acquiring fund and its other non-acquiring funds. This can be a significant administrative challenge. The limited economic links must be proved both at fund-to-fund level, and also between each fund's portfolio companies. That's a data point which is usually not captured in existing portfolio company accounts – it requires a bespoke review across (potentially) dozens, or even hundreds, of portfolio interests.

It is still early days for the EU FSR's transaction screening regime, and the Commission should be applauded for providing early guidance on some of the initial issues it has encountered. It is also welcome that the Commission has formed a new Directorate for the FSR, with three dedicated case teams to deal with this first wave of notifications. That should help to avoid backlogs. It is to be hoped that – as the regime beds in, and the case teams become more familiar with private equity structures – the Commission takes a proportionate approach to straight-forward private capital deals – not only in its substantive review, but also in the information it requires at the outset.