EU FSR could impact PE fundraising with potential rise in ‘clean funds’

The FSR, which enables the EC to review subsidies granted by non-EU countries that may distort competition within the EU, entered into force on 12 January 2023 and applies as of 12 July 2023. The regulation carries with it stringent reporting obligations, which may pose new challenges to PE firms, lawyers have observed.

PE firms may intentionally exclude foreign Limited Partners (LPs) or LPs from countries considered as riskier to mitigate compliance complexities and regulatory risks associated with the FSR, lawyers told this news service. The LPs are responsible for funnelling capital into GPs' funds.

“There may be a competitive advantage in how funds are structured for the purposes of an FSR review.  Sellers may prefer GP buyers who have relatively “clean” investing funds.  Bidders with more complicated fund structures may be less well-placed, even if they are ultimately likely to be able to survive an FSR review,” Ruchit Patel, partner at Ropes & Gray, said.

As GPs are paying more attention to how they structure their deals in Europe to assess whether they are caught under FSR, this could lead to the EU losing investments, said Elisabetta Righini, partner at Latham & Watkins.

Under the FSR implementing regulation (IR) there are limited exceptions for not providing information on foreign financial contributions granted to funds of a PE group or to their portfolio companies, managed by the same investment company, but different from the investment fund involved in the notified transaction, said Marianna Meriani, partner at Akin Gump. The GP will need to demonstrate that various requirements are met, including that there are no links between these funds or that such relations are very limited, she added. “We do not know what the approach of the EC will be, they might narrowly interpret the already narrow exception and ask for information on various funds,” she said.

Although the FSR’s purpose is not to impede foreign commitments from LPs, it adds red tape for GPs – particularly those that are looking to amass commitments from sovereign wealth funds (SWF), Michael Okkonen, partner at Dechert, said. “GPs need to factor in FSR implications and tap into regulatory advice early,” he added.

“There is a significant risk that the LP investments backed by non-EU governments will qualify as a foreign financial contribution,” said Niels Baeten, counsel at Skadden.  Article 3.2 of the FSR outlines foreign contributions as not only those granted by governments but also those granted by public and private entities if their actions can be attributed to the government, he said. This attribution test is going to be assessed on a case-by-case assessment, he added.

The FSR's stringent reporting obligations and oversight mechanisms are upending traditional fundraising dynamics, prompting a revaluation of risk-reward trade-offs. Documenting situations that may qualify as financial contributions quickly and effectively is a good way to navigate the FSR requirements, Clemens York, partner at Dechert, said.

The EC will have to reflect the EU treaty principle and be neutral to private or public ownership when analysing financial contributions under the FSR, said Righini. Hence, if a private investor is acting in parallel to a SWF, that should be enough to exclude the subsidy nature of the financial contributions, she said. However, this solution will not avoid the need to notify the financial contributions, she added.

Waivers
It is important for investors to have an ongoing dialogue with the EC, York added. In merger control, SWFs have requested waivers and have been taking advantage of that in several jurisdictions, said Okkonen, adding that these SWFs will likely be applying for waivers under the FSR regime. The EC will grant waivers, but it's unpredictable how much it will do this, Meriani said.

“We are advising LPs and GPs to approach the EC for waivers and convince them the financial contributions received by SWF are on market terms and do not constitute state resource,” Righini said.

Initially, the EC will be cautious with waivers as the FSR implementation is virgin territory and it needs to ensure it does not compromise its future position, Righini said. At the same time, they will be under huge pressure as they will receive a lot of data and they will have to find a way to pick out the problematic foreign contributions, she added. So, they may use the waivers to discriminate between what is interesting and what is not, she said. The State aid block exemptions are a parallel example of this, she added.

GPs will be required to monitor investments closely under the new regime as financial contributions have been defined broadly in the FSR and more resources will have to be devoted to this, said Giorgio Motta, partner at Skadden. This will inevitably increase the time it takes to get a deal approved, he added. While the FSR does not list specific industries that the EC may target under the new regime, certain sensitive sectors including energy, defense, essential infrastructure, and renewable energy, may draw in the regulator’s attention as these sectors tend to be subsidised and are increasingly strategic, he said. Also, deals that receive third-party complaints may also attract attention, he added.

The FSR may create significant red tape, however, if an LP makes an ordinary commitment at arm’s length to the GPs fund with no control over investments, a distortion will be hard to prove, Baeten said.

GPs should plan and ask the right questions to LPs, Motta said. “If a SWF invests directly in a target, the EC will investigate and check if it is operating independently, or has had any advantage because it is state-backed,” he added. The final implementing regulation proposes a few ways to reduce the disclosure burden – disclosure is limited to the acquiring fund if certain conditions are met, Baeten said. “We need to see how this works in practice. It is clear that all foreign financial contributions count toward the threshold, so even if disclosure obligations have been somewhat limited, GPs will need to do the mapping and monitoring,” he added.

A challenge for some GPs that are fundraising is that they may not want the EC to know who certain LPs will be and the amount of commitments they will have provided, Davina Garrod, partner at Akin Gump, said. Fiduciary duties may make disclosure under FSR difficult in some cases, she added. GPs will need to ask LPs before sharing their information and there may be some resistance to this, she added. “A perhaps unintended consequence of FSR is that the EC will know who is funding these funds.

Confidentiality
Confidentiality will be the central concern for investors, according to Meriani. Under the IR, the EC may disagree on points of confidentiality and a wise strategy would be to narrow the scope of information that needs to be reported, she said. The final IR has introduced some exemptions from the disclosure obligations and the parties can try narrowing the type and amount of information they disclose on such a basis, she added. For example, supplies on pure market terms fall under such exemption and a similar argument may be made for LP funding, she said. The extent to which the EC may accept such reasoning is difficult to predict at this stage, she cautioned.

“We are dealing with a new regime, and there is no precedent or guidelines yet,” Motta said. Companies should use the pre-notification and get waivers to make this manageable, he added.

Although there is a waiver process, GPs and LPs still need to set up a system now to collect the necessary information, Garrod said.  They cannot rely on an untested waiver process, she added. It’s a new regulation and it'll be frustrating, but once you have a system up and running it will become easier,” she said. “[GPs] can advocate not to provide certain information which is not germane to the analysis and difficult to obtain,” Garrod said.

GPs may need to have contractual provisions in place with LPs so they can request information from them for filings, York said. As information needs to be gathered by a certain time, it would be wise to think about this during the fundraising process and put in place a mechanism to gather information and track the relevant information on an ongoing basis, he said. “If GPs do this at the fundraising stage, it would not be likely to cause delays in a transaction. It will be difficult to get LP cooperation within a shorter time. It is typically easier to gather information when fundraising. Doing due diligence in the context of a specific deal would generally be more cumbersome,” he added.

Attribution and fundraising
The question of attribution might be tricky with some LPs, Garrod said. In the case of a non-EU SWF, attribution is clearer, she said. “But there are certain types of ostensibly private entities where you will need to ask questions, such as whether they are directed or entrusted by a third country to undertake a certain action. Some private entities may be linked to a State, for example, a minister on the company board,” she added. The question of attribution is broadly defined in the FSR, going beyond State ownership and control, Garrod said. “Attribution could be a prickly area for GPs and LPs – just as imputability has been contested in State aid cases over years,” she said.

Among the many reasons the EC may be interested in knowing who is funding a certain investor can also be related to the broad powers that it could exercise under the FSR, Meriani said. The EC could launch market investigations, or review tender procedures, she added. The thresholds for reporting tenders under the FSR are extremely low and a tendering authority may not know who is funding the bidder, which is in most cases the indirectly controlled portfolio company, she added. Having a broad overview of who ultimately invests in Europe may be valuable for the EC to have a view on whether certain entities are linked to a foreign country, she said. Also, it could raise some claims and litigation to determine whether the actions of a private company can be attributed to a foreign country, she added. In recent years, some cases have been litigated up to the EU Court of Justice on “attribution to the State” grounds, she said.

At the fundraising stage, if a GP is considering a public or private entity whose actions can be attributed to a non-EU State, they should ask them how compliant and familiar they are with the information they may need to provide under the FSR, Garrod said. The GP needs to inform LPs if any proposed controlling investments might trigger FSR and ask the relevant LPs to provide the necessary information, she added. If a fundraising GP is inundated with prospective LPs, they may not want to prioritise investors who present FSR risks, she cautioned.

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