Foreign Subsidies Regulation Creates
New Challenges for Private Equity in the EU

The concepts of the free movement of goods, capital and people are core ideologies at the heart of the European Union and are supplemented by robust rules on the prohibition of state aid. The aim, and outcome, has been to create a level playing field for companies, enabling them to operate freely and fairly across the bloc. However, the increase in foreign direct investment (FDI) into Europe – including deals by sovereign funds or other entities associated with foreign governments – has raised concerns among European policymakers, not only about national security considerations (addressed mainly by national FDI measures), but also about the potentially distortive subsidies that might arise from the flow of foreign investment into EU-based businesses.

The result has been the creation of the Foreign Subsidies Regulation (FSR), which entered into force in January this year and began a transition period on July 12, 2023 towards full implementation later on October 12, 2023. The rules extend the European Commission’s (EC) powers to investigate and challenge investments – supported entirely or partly by overseas government sources – that may tilt the playing field in the target company’s favor. In the process of seeking to address imbalances, the FSR may increase the disclosure burden and scrutiny of large EU deals by private equity firms that have backing from sovereign investment funds and other large international investors. As such, private equity groups need to get to grips with the FSR and understand the often-complex relationships that exist between some of their investors – or lenders – and the states they come from.

Foreign Direct Investment Net Inflows (% of GDP), European Union

A Wide Remit to Investigate Potentially Distortive Deals

FSR is designed to be broad and capture any kind of large EU deal that might give a company an unfair advantage in the EU. The rules trigger a mandatory notification and review of a merger or acquisition where:

A company acquires control over another;
the target company’s EU turnover is equal to or exceeds €500mn; and
the parties received non-EU financial contributions of more than €50mn in the three years prior to the transaction.

While the scale of turnover would limit scrutiny to the largest private equity-backed investments, the size and wording of “financial contribution” (which basically entails any economic interaction with a government-controlled entity) would bring most M&A transactions passing that threshold into the possible realm of FSR.

A financial contribution could be a loan from a state-owned bank (or one with significant state ties), an equity injection from a large sovereign fund or public pension fund into a company, or tax measures that derogate from the standard tax rate, such as research and development tax credits, or even sales or purchases from a government owned entity. Furthermore, the terms of a financial contribution would capture a commitment by a state-backed entity (such as a public pension plan) into a private equity fund or portfolio, or an investment by a sovereign entity into a private equity manager. Even an investment exceeding €50mn by a state entity into another portfolio company held by the same fund less than three years prior to the deal in question could trigger a mandatory notification.

The private equity industry is asking what the rules mean for their investments in the EU, how to address them, and the repercussions they might be subject to. When released earlier this year, the regulation provoked concern from private equity association Invest Europe, which warned of the potentially “chilling effect” on investment¹.

A Wide Remit to Investigate Potentially Distortive Deals

A company acquires control over another;
the target company’s EU turnover is equal to or exceeds €500mn; and
the parties received non-EU financial contributions of more than €50mn in the three years prior to the transaction.

PE Faces Increased Data Gathering Burden and Fine Risk

While the aims and outline of FSR are now set, much will depend on how the regulation is implemented and applied. Having understood the thresholds for when to notify the EU authorities under FSR, the real challenge will be how much and precisely what information to provide. The industry will be hoping that most transactions will pose no concerns about distortion and so be subject to less burdensome reporting requirements.

Indeed, the implementing regulation adopted by the Commission setting out the filing requirements avoids the impossibly burdensome obligation of declaring all financial contributions received by the parties that was initially contemplated. Instead, parties will have to provide details only on (i) individual financial contributions over €1mn of a most likely to be distortive nature (such as export financing and aid to ailing firms outside of a viable restructuring plan), as well as as on (ii) any other financial contributions to the extent that they exceed €1mn individually and €45mn per non-EU state in the aggregate in the last three years. In addition, some financial contributions (such as sales and procurement of non-financial goods and services at market terms) are entirely exempted from the notification requirement.

The implementing regulation also contains a welcome simplification for PE Funds, which generally will not have to declare non-distortive financial contributions received by other funds managed by the same GP, if their respective investor pools are different. However, firms will have to track and assemble data on most financial contributions from their investors into funds, as well as any contributions or tax breaks received by their portfolio companies.

Furthermore, the notification is compulsory and subject to a standstill obligation as in antitrust merger control, meaning that the transaction cannot be consummated without the Commission’s clearance. Private equity firms will therefore need to have significant amounts of information readily to hand if they want to close their deals speedily.

There will be strict penalties for companies and firms that fail to make appropriate notifications. As in antitrust, the FSR allows for fines of up to 10% of the company’s global turnover in the preceding year, as well as powers for the EC to block the transaction.

There are also significant corrective measures for those deals deemed to create distortive effects, including reduced capacity or market presence for the company, the requirement to refrain from future investments, repayment of foreign subsidies with interest, or changes to the company governance structure.

Next Steps

The final impact of the FSR on private equity transactions in Europe is still to be fully understood. However, the regulation has the potential to increase the bureaucratic burden on large numbers of private equity funds that have received financial backing from state-owned or sponsored entities from outside the EU.

Firms need to understand the FSR and its mandatory notification requirements. In addition, sponsors may need to investigate and get reassurances about the governance structures of their sovereign wealth investors and other large international institutions, and manage data on their financial contributions to funds and portfolio companies. Doing so will enable them to prepare for and navigate the requirements of FSR, helping reduce the burden and potential uncertainty for their large investments in the EU and also the risk of potential complaints, fines and investigations.