EU Foreign Subsidies rules hold specific challenges for private equity

Legal Analysis 21 June

EU Foreign Subsidies rules hold specific challenges for private equity

  • FSR to create additional reporting obligations across all funds managed by a single GP
  • Longer deal times expected over the next 6 to 9 months as EC finalises requirements
  • Sovereign wealth funds and pension funds commitments may trigger EC attention 

The new EU Foreign Subsidies Regulation (FSR) is expected to hold an additional burden for private equity (PE) funds, which will need to grapple with information requirements across portfolio companies, lawyers told this news service.

The FSR entered into force on 12 January 2023 and will start applying on 12 July. Companies will be required to notify transactions that meet the FSR's thresholds to the EC from 12 October. The regulation’s aim is to tackle distortions caused by foreign subsidies.

Although the FSR does not provide specific rules targeting PE, it may raise certain specific challenges for PE investors that would not equally apply to strategic investors, said Sven De Knop, partner at Sidley Austin. 

As PE investors tend to operate through numerous funds holding extensive and diverse portfolios, this may create challenges in mapping financial contributions and other data necessary to assess the notification triggers under FSR, and, if applicable, prepare notifications, he added. It is not just the investors, the target companies will have reporting obligations too, he said. “Sellers and buyers need to keep this in mind too,” De Knop cautioned.

In addition, PE funds may include a wide range of investors, including government investors such as sovereign wealth funds or pension funds, De Knop said, noting that this may increase questions by the EC about the role and influence of government investors and risks of distortions.

Deal timing

Lawyers predicted an impact on deal timetables, as companies get to grips with the new system.

There may be a greater impact on deal timing over the next six months while acquirers are gathering information necessary for FSR filings for the first time, said Alasdair Balfour, partner at Kirkland & Ellis. With the EC finalising the information gathering requirements shortly before the go live date, it may take funds a while to gather all the information, causing delays in making FSR notifications if the EC does not grant waivers, he said.

“At least initially, parties may not be prepared to provide information at the requisite standard, which may delay the process,” echoed De Knop. The FSR review will run in parallel to Foreign Direct Investment (FDI) and merger control reviews, he said. Depending on the circumstances of a specific deal and regulatory complexities, the FSR review may be the longest process, holding up closing, he added. 

Greater burden

The burden on some PE firms may be greater than strategic investors as the FSR obligations require PE firms to gather information from multiple portfolio companies, Balfour said. The structure of PE firms requires a significant effort to identify everything that qualifies as financial contribution across multiple entities, geographies, and industries, said Stella Sarma, Special Counsel at Cooley.

“We need to see if the final version of the Implementing Regulation will provide a simplified version which might ease the [reporting] burden,” Sarma said. Waivers are likely to be granted on a case-by-case basis rather than to an entire category, Michael Okkonen, partner at Dechert, said. While the notifying parties can request waivers from reporting certain information, there is no guarantee that the Commission will agree to a waiver and, even if granted, it would likely be limited to specific cases, Rosamund Browne, counsel at Travers Smith, said.

For private equity funds, the FSR does not provide a category of exemptions, however implementing regulations will reveal more, Jani Ringborg, a member of the EC’s Legal service, recently told a conference in London. In a recent Q&A published by the EC, it was noted that the notification form for concentrations will contain instructions as to the procedure for the request of any waivers. The upcoming draft Implementing Regulation will clarify practical and procedural aspects of the FSR. This will be published and applied from the 12 July 2023. 

FSR creates an additional layer of deal uncertainty by subjecting the implementation of a deal to an additional review and approval, de Knop said. This may impact the risk assessment and increase the costs of financing, he added. “Financing is expensive at the moment. If you have unnecessary delays because the information is not ready for FSR filings, that has an impact,” Balfour said.

Portfolio companies and LPs

The FSR uses a group-wide view to calculate the thresholds. Therefore, financial contributions to all of a PE firm's funds and controlled portfolio companies will be considered, not just those to the fund and portfolio companies completing the deal. Investors would appreciate concessions that limit the reporting obligations to financial contributions to the acquiring fund, rather than all funds, Browne said.

The scope of financial contribution is extremely wide, including the purchase of goods and services by state-related bodies from a portfolio company, even if they are made on arms-length terms, Browne said. Examples might include anything from sensitive defense contracts to government cleaning contracts and other innocuous purchases of goods or services, she added. Once it has received a notification under the FSR (based on turnover and financial contribution data), the Commission will then assess whether any financial contribution results in a distortive foreign subsidy as described in Article 3 of the FSR, she said.

The presence of a heavily subsidised target may not be needed to put PE firms over the line as they may need to notify deals regardless due to the group-wide view taken by the EC, she said. “The low bar for financial contributions, and the group-wide concept to calculating the notification thresholds, may mean that financial contributions to one portfolio company could trigger an obligation to file all EU deals going forward,” she added. 

Deals could be held up in situations where a fund under the GPs management has exposure to foreign states, for instance, through its limited partners (LP), Clemens York, partner at Dechert, said. Moreover, GPs will have to keep track of LP commitments on an ongoing basis to be able to react quickly in fast-moving transactions, he said. The wide reportability criteria also mean GPs will have to consider the foreign financial contributions received by portfolio companies such as tax breaks or even contracts for goods and services with foreign states, or private or public companies whose actions can be attributed to a foreign state, Okkonen said.

The prudent thing to do is to allow time by factoring in the possibility to prolong deal deadlines in case clearances have not yet been granted, Sarma said.