With the EC flagging concerns about foreign subsidies that distort the EU market, 2022 is likely to bring dealmakers a new regulatory hurdle to consider when conducting European transactions. Investment funds with links to non-EU governments or those that receive other forms of beneficial treatment (e.g. tax exemptions) can soon expect heightened scrutiny and an un-level playing field in auctions as a result. Depending on whether your fund is state backed or state linked (or not) this could be a boon or a curse for private equity.

What is it

The proposed regulation aims to address concerns over the distortive effects of foreign subsidies and to ensure a level playing field for EU companies. Two of the three proposed tools would introduce further complexity for M&A transactions in the EU (the third relating to foreign subsidies in the context of public procurement tenders) namely: 

1. A pre-closing notification system, capturing concentrations where the EU turnover of the target (or of at least one of the merging parties) is €500 million or more and the foreign financial contribution is at least €50 million (in aggregate over the preceding three years).
2. A general power to investigate all other market situations (including concentrations not subject to pre closing notification) and where the EC may request ad-hoc notifications.

The first limb would introduce a mandatory notification requirement potentially leading to timetable delays and reduced deal certainty given redressive measures can be imposed (i.e. repayment of the foreign subsidy, divestment of certain assets, or the EC even requiring the parties to dissolve the deal concerned)  . Both factors will need to be addressed in SPA negotiations and are likely to impact the attractiveness of affected bidders.  

The second limb has implications both pre- and post-closing. Before closing, legal certainty and deal timing will be impacted by the EC’s power to call in an otherwise non-notifiable concentration before closing (with transaction parties then having to wait until the necessary approval has been obtained). In addition, the EC will be able to initiate investigations to review (completed) transactions for a period of up to 10 years (and impose redressive measures if needed).

How might it apply

The definition of “foreign subsidy” is broad and capable of catching a variety of financial payments or advantages including favourable tax treatment conferred by foreign governments. Equally, the definition is not limited to financial contributions made to the fund itself (or by a single non-EU government) but could also include payments received by existing investments which, taken cumulatively (and from multiple different governments), exceed the relevant thresholds.

This broad definition may also catch tax exemptions benefiting sovereign wealth funds and public pension funds in particular – even if their investments are akin to those of private investors. Equally there is little guidance as to whether a sovereign wealth fund participating in an investment as a passive investor (e.g. as limited partner in a private fund) may be relevant. 

The impact assessment report released by the EC also reveals how private funds are likely to face extra scrutiny under this new scheme. The EC is concerned that funds presenting themselves as private entities may still have ties to, for example, the Chinese or Russian state. Private funds with such links will therefore be subject to scrutiny to determine the extent of involvement. Irrespective of the specific non-EU country in question, it appears reasonable to expect that EU-based funds will have an increasing advantage over non-EU funds in terms of administrative burden and potential deal certainty (impacting their relative attractiveness as a bidder for EU assets).

Looking ahead

The proposal is expected to come into force at the end of2022 (or early 2023) and will apply six months after its entry into force. The European Parliament and Member States are discussing the proposal and the process may result in amendments (potentially addressing some of the concerns raised by investors). 

From reports published in December 2021 by the European Parliament we know that in addition to the definition of foreign subsidies, length of the review period and a pre-notification system, at least the following discussion points are on the table:

• The scope of the monetary thresholds, including a requirement for joint ventures to only be notifiable where the joint venture is established in the EU (and potentially targeting certain key strategic sectors in the context of agency led investigations); 
• A blanket immunity for subsidies granted by third countries recognised by the EC as having in place adequate mechanisms to ensure ”a level of protection against undue state intervention into market forces and unfair competition which is at least equivalent to the level within the Union” (although no examples of such seemingly acceptable countries have been cited);
• A complaint mechanism, allowing Member States or concerned companies to alert the EC of potentially distortive foreign subsidies (thereby faciliating greater monitoring / enforcement); and
• A notification mechanism which would alert Member States when the EC initiates a preliminary review or an in-depth investigation into a foreign subsidy (which could potentially complicate or delay the EC’s own review). 

It has also been reported that ”credit institutions or other financial institutions” whose normal activities include transactions and dealing in securities for their own account / on behalf of others will fall outside of the notification obligations. However, the exception is proposed to be limited to circumstances where such investors do not exercise voting rights in the target. Such a limited exception is likely to be of little comfort for PE houses typically taking an active role in the management of their investments. 

Irrespective of the final form, this legislation will add another regulatory hurdle for affected non-EU financial sponsors to overcome given it will apply in addition to European merger control and foreign investment rules. As a result, foreign investors in EU-based investments face an increasingly complex regulatory landscape.