The U.S. government is planning to ramp up its scrutiny of foreign investment in national-security-sensitive businesses and technology, which could affect the way some private equity funds deal with potential foreign investors.
The 2018 National Defense Authorization Act, passed in August, expanded the jurisdiction of the Committee on Foreign Investment in the United States to include a broader range of investments.
CFIUS, a multiagency body that includes representatives from the U.S. Departments of Defense, Treasury, Homeland Security, Commerce and others, has long had authority to review and block transactions that could lead a foreign buyer to acquire control of a business or location that could affect the national-security concerns of the United States.
Broad view of mandate
That mandate was often interpreted broadly by CFIUS – such as when it prevented a Chinese company from building wind farms near a U.S. Navy facility.
But the new defense bill gives CFIUS even more authority, sweeping in investments that do not include “control” but enable foreign investors to access critical technology, critical infrastructure or personal data.
“This is going to sweep a larger number of transactions into the ambit into CFIUS review, and so it will be a challenge for investors,” said Priya Aiyar, a partner at Willkie Farr & Gallagher and a former acting general counsel of the Treasury Department.
“It is a significant expansion, but we think Congress tried to provide a fair degree of clarity to allow foreign investors and companies that are dealing with foreign investors to navigate the changes.”
The new defense bill also makes other changes to CFIUS reviews, including requiring mandatory declaration to the committee for certain potentially covered transactions, providing budget authority to hire more staff, expedited timeliness for CFIUS decision making, and allowing the committee to charge a filing fee.
But for private equity funds and their investors, the questions will focus on whether CFIUS will take expanded interest in their technology investments.
The law does provide a carveout for PE funds with passive foreign investors. But depending on the fund’s structure, and the level of influence and insight an LP is given, PE firms could have cause for concern.
The key question is whether an investor can gain access to underlying technology developed by portfolio companies, according to Rod Hunter, a partner at Baker McKenzie who previously conducted CFIUS reviews while serving as senior director for international economics at the National Security Council.
“If the goal is of an investment is financial, this legislation should be a positive,” Hunter said. “It will make it more difficult to make investments that are aimed at the transfer of technology.”
The carveout, while providing important protection for the private equity industry, is fairly restrictive, and won’t cover, for example, a technology-focused fund that gives a foreign investor an advisory-board seat that provides access to “material nonpublic technical information” for CFIUS purposes.
The exemption doesn’t cover other structures, like a fund of one, separately managed account or certain co-investment vehicles. GPs should take care to ensure that they aren’t accidentally giving too much control or access to investors like sovereign wealth funds, Aiyar said.
“There’s a fairly narrow definition of what purely passive is,” Aiyar said. “Without this carveout, if a private equity fund had a foreign limited partner, that could potentially sweep all of that fund’s transaction into CFIUS’s jurisdiction.”
The addition of mandatory declarations may also affect a broader range of PE investors, as GPs are pushed to seek CFIUS review just to ensure that they won’t fall afoul of the new rules.
While the full impact of the reforms won’t be felt until the Treasury releases its full regulations, expected within the next 18 months, the government launched its first implementing regulations on Oct. 10.
The interim rule creates a pilot program for “critical technologies,” and covers investments in a U.S. business that produces, designs, tests, manufactures, fabricates, or develops a critical technology that is used in or specifically design to be used in one of 27 listed industries.
These include aircraft manufacturing, computer storage device manufacturing, semiconductor and related device manufacturing, and telephone apparatus manufacturing.
Attorneys operating in the space say the regulations will continue to add clarity over time, but they predict a period of upheaval while the new legislation takes effect.
“There is transition risk, but I think for the investment community this is ultimately going to turn out to be a good thing because there will be more clarity,” Hunter said.
Action Item: Read more about CFIUS here https://bit.ly/2OqzTnP.
The Treasury Department’s initial implementing regulation on CFIUS reforms: https://bit.ly/2yjrJ6E
Baker McKenzie’s client alert on the reform legislation: https://bit.ly/2QVnbun
An overview of the CFIUS process, from Latham & Watkins: https://bit.ly/2CjwJeD