Managers await changes for foreign investment

Private equity and venture capital fund investors are braced for changes in how the U.S. government reviews foreign investment when regulators begin to implement legislation that was passed last week.

The Senate on Aug. 1 joined the House in approving legislation updating the authority of the Committee on Foreign Investment in the United States, CFIUS, to review — and potentially block — foreign investments that could raise national security considerations. President Donald Trump has promised to sign the bill, the Foreign Investment Risk Review Modernization Act of 2018, which is part of a must-pass defense authorization package.

The interagency committee is chaired by the Treasury secretary and includes representatives from 16 U.S. departments and agencies, including Defense, State, Commerce and Homeland Security.

Mr. Trump, who has expressed particular concern over China's investments in the U.S., characterized the expansion of CFIUS as a way to better protect "the crown jewels of American technology and intellectual property from transfers and acquisitions that threaten our national security — and future economic prosperity."

The first major CFIUS update in more than a decade, the bipartisan bill expands the U.S. government's ability to look at foreign investments in, or acquisitions of, U.S. firms. It also allows a deeper look into foreign minority-position investments made through U.S. venture capital and private equity funds.

While streamlining the review process, the bill expands the scope of review to include vetting transactions involving real estate and infrastructure located near sensitive U.S. facilities, and any deals structured to evade the committee's jurisdiction, such as transactions using shell companies to hide ownership.

Under the bill, CFIUS members gain new privileges and can review any investment in a critical technology company that gives a foreign entity access to material non-public technical company information. In addition, they can also review membership or observer rights on a company's board or similar governing body, and situations where the foreign entity is involved in substantive decision-making of the company except through voting of shares.

Venture capital and private equity officials are relieved that the measure's definition of material non-public technical information did not include financial performance information that's typically provided to limited partners quarterly. They also welcomed a special clarification for investment funds, which exempts foreign limited partners from review if the fund is managed by a U.S. general partner or the investor cannot otherwise control investment decisions.

Jason Mulvihill, general counsel for the American Investment Council, a Washington advocacy group for the private equity industry, noted that the measure "reflects some positive tailoring from lawmakers. We believe this tailoring is designed to ensure that the expanded CFIUS process will not discourage passive foreign investments in U.S.-controlled private equity funds."

Chris Hayes, director of industry affairs for the Institutional Limited Partners Association in Washington, which represents more than 450 institutions with a collective $2 trillion in private equity assets, agreed the final bill provides a safe harbor for foreign limited partners.

"It will protect non-U.S. LPs in U.S. private equity funds from being subject to review. It won't impose a blanket requirement," he said.

A risk-based approach

A key change from current CFIUS practices is a more risk-based approach to reviews that focus on investments from "countries of special concern."

The final compromise contains a "country specification" section that directs CFIUS to come up with specific criteria for applying the new law, taking into account how a non-U.S. investor is connected to a foreign country or foreign government, and whether the connection might affect national security.

(The House version favored a blacklist of certain countries, including China and Russia, while the Senate sought global coverage unless a country was specifically exempted.)

"On the one hand, knowing an entire country is excluded would have provided certainty for investors. On the other hand, CFIUS would likely have been reluctant to exclude entire countries, and the final (legislation) provision allows CFIUS to still exclude specific entities that may be large LPs or co-investors," said Jeff Farrah, general counsel of the National Venture Capital Association, Washington, in a member alert.

While the compromise was seen as a way to allow CFIUS to exempt certain entities such as foreign pension funds, he said in an interview, "it's too soon to tell how this provision will work in practice."

Need to remain vigilant

The suspense is not over yet. Mr. Farrah noted in a recent blog, "it is imperative that NVCA and the venture industry remain vigilant" once the measure is signed into law because that "kicks off a rule-making process that will decide major issues and define terms in ways that affect the thrust of the bill."

Venture capitalists, limited partners and startups raising capital should be cognizant of the new review factors "because if any of these factors is triggered, then a CFIUS filing is very likely necessary," Mr. Farrah noted in the blog.

The American Investment Council's Mr. Mulvihill said his group also will remain engaged during the regulatory process, "so that issues unresolved in the legislative text are addressed properly."

Mr. Farrah said: "I do think this bill is going to change how other investors approach investing in the U.S. People need to realize that this is an altering law coming forward, and that it will require people to pay attention to how they structure deals."