PE braces itself for the EU Foreign Subsidy Regulation

With the regulation due to come into force next year, PE groups must ready themselves for the compliance challenges that are ahead, according to Jay Modrall, senior counsel at Norton Rose Fulbright.

Following the European Parliament’s approval of the EU Foreign Subsidy Regulation on 10 November, the countdown has now begun with regards to a new merger notification regime for the region.

From autumn 2023, the FSR will require private equity firms to have another approval to acquire targets that have EU revenues of up to €500 million, or more if they and the target together have received more than €50 million in non-EU ‘financial contributions’ over the past three years.

The European Commission will have the power to require notification of transactions that do not meet the mandatory notification thresholds. A similar requirement will also apply where portfolio companies participate in significant public tenders in the EU.

Firms that may need to notify the European Commission cannot simply wait and see what happens over the coming months, as financial contributions are defined very broadly and correspond to no existing financial or accounting metric. To have the needed information available in time, private equity groups will need to start collecting financial contribution information six to nine months before the earliest point at which notification may be required, if not more.

As part of these notifications, the FSR distinguishes between three related concepts: financial contributions, foreign subsidies and distortions on the internal market. Financial contributions include a wide range of interactions with governments and public or private entities that are attributable to governments, including capital injections and other investments; tax exemptions and other fiscal incentives; and contracts for the purchase or sale of goods or services, whether or not these involve any kind of subsidy.

Indeed, when it receives an FSR notification, the European Commission must determine whether any financial contribution qualifies as a foreign subsidy, and if so, whether the subsidy is liable to distort competition in the EU.

While the FSR will create significant compliance difficulties for multinationals across many industries, the challenge is particularly great for private equity firms. There are several reasons for this: first, lean GP staffing and the siloed management of portfolio companies means PE groups lack the centralised compliance and reporting systems that traditional corporates can draw upon.

Second, PE groups engage with governments and government-affiliated entities at many levels. At the fund level, investments by sovereign wealth funds, government pension funds and the like will probably qualify as financial contributions. Private equity firms will also need to identify and quantify the financial contributions of their controlled portfolio companies, whose businesses may entail a wide range of interactions with non-EU governments.

Third, the turnover of portfolio companies will make it more difficult to keep financial contribution information current. This will be especially true when portfolio companies that have not needed to track this information are onboarded and included as part of the group as from the acquisition date.

What do PE firms need to do next?

In the medium- to long-term, the new regulatory approval requirement will entail many changes to transaction documents and processes. Transaction documents will need to account for the new requirement; deadlines will need to take account of FSR timelines; and obligations to obtain approvals (such as ‘hell or high water’ provisions, where a party’s contractual obligations must be adhered to regardless of any difficulties) will need to be revised.

Due diligence procedures, which already include a review of state aid received by targets in the EU, will also need to expand to consider the implications of potential non-EU subsidies.

In the near term, the first priority for private equity groups that may need to notify will be to begin reviewing existing reporting and compliance systems at the fund and portfolio company levels, and identify required changes. Although the commission’s new notification forms will not be finalised until the summer, private equity groups will need to launch their FSR compliance efforts well before then to be ready when the notification requirement kicks in.

The new FSR notification and approval requirement is unlikely to raise substantive concerns in many private equity transactions. Nonetheless, being prepared to notify by the time the new obligations apply will create a significant challenge for many large groups. There is no time to waste.

Jay Modrall is an antitrust and competition lawyer based in Brussels. He joined Norton Rose Fulbright in September 2013 as partner, having been a resident partner in a major US law firm since 1986. A US-qualified lawyer by background, he is a member of the bar in New York, Washington, DC and Belgium.