Heightened U.S. national security concerns and trade tensions with China have resulted in new and expanded U.S. regulations that have created barriers for Chinese buyers seeking to acquire assets in the U.S. A number of years ago, U.S. funds seeking to dispose of assets in the U.S. would typically have received bids from one or more Chinese companies. However, these new regulations, trade tensions, and the general macroeconomic environment have led to a significant reduction in such Chinese bidders, leading, in some cases, to the U.S. assets being sold at a reduced price. Asian-based funds, which had previously partnered with Asian companies to acquire U.S. assets, will likely also feel the impact of this new investment environment.
The most recent developments in this area and their application to PE funds include:
EXPANDED CFIUS REGULATIONS
In February 2020, the regulations pertaining to the Committee on Foreign Investment in the U.S. (“CFIUS”) were revised, among other ways, to expand CFIUS’s national-security review jurisdiction to include non-controlling foreign investments in U.S. businesses developing or producing critical technologies, performing critical infrastructure functions, and collecting or maintaining sensitive personal data pertaining to U.S. citizens. Under these new regulations, a foreign entity investing in a U.S. company (including a non‑U.S. company with a U.S. subsidiary or branch office) will need to determine not only (i) whether the target company falls within the definition of a technology, infrastructure, and data (“TID”) U.S. business, but also (ii) whether the transaction will afford the foreign investor certain key rights, such as access to “material nonpublic technical information,” board membership or observer rights, or involvement in substantive decision‑making regarding the target’s TID assets. The CFIUS regulations include specific definitions for many of these terms, including examples, so it is important for parties to consults those definitions.
The new regulations also include mandatory CFIUS filing requirements for certain transactions involving U.S. businesses with critical technologies, as well as for foreign government-owned investors obtaining a “substantial interest” in a TID U.S. business. CFIUS’s expanded coverage presents additional hurdles for Asian corporations and funds wishing to invest in the U.S., particularly for those entities with ties to Chinese and other foreign governments.
REVIEWING CLOSED DEALS AND PUNISHING VIOLATIONS
CFIUS is increasingly identifying and investigating companies involved in transactions covered by this expanded jurisdiction that were not notified to CFIUS prior to closing. For example, in 2019, CFIUS forced Beijing Kunlun Tech Co. Ltd. to divest its 2016 acquisition of the dating-app company Grindr LLC, apparently based on concerns about the Chinese government’s potential exploitation of sensitive data relating to U.S. citizens, and pressured a partially Russian-backed investment fund, Pamplona Capital Management, to divest its minority stake in a U.S. cybersecurity firm. CFIUS also imposed the first-ever civil penalty—$1 million—for repeated violations of a mitigation agreement. These enforcement actions serve as a warning to Asia-based funds that in cases where it is unclear whether the parties should notify CFIUS of a proposed transaction prior to closing, they should consider the increased possibility that CFIUS might inquire after the fact.
EMERGING AND FOUNDATIONAL TECHNOLOGIES
The Department of Commerce is working on regulations to identify and apply new U.S. export controls to “emerging and foundational technologies,” following its November 2018 Advance Notice of Proposed Rulemaking seeking comments on 14 categories of proposed emerging technologies. Technologies identified as emerging or foundational will also be deemed “critical technologies” and subject to CFIUS’s expanded jurisdiction described below. These regulations could therefore have a big impact on Asia-based funds seeking to invest in fast-growing technology companies in the U.S.
ACTIONS AGAINST SPECIFIC ACTORS AND END USES IN CHINA
The Department of Commerce added Huawei, SenseTime, Hikvison, and other companies to its “Entity List,” thereby prohibiting these entities from obtaining any hardware, software, or technology that is subject to the U.S. Export Administration Regulations. The Department of Defense (and other agencies) also prohibited federal agencies from buying “covered telecommunications equipment or services” from designated Chinese entities, including Huawei and ZTE, as a substantial or essential component of any system, or as critical technology as part of any system. In addition, the Administration has issued executive orders authorizing the Department of Commerce and the Department of Energy to issue regulations to review and mitigate certain types of transactions in the telecom and bulk energy sectors, respectively. Finally, the Department of Commerce has issued rules that will expand substantially U.S. export controls on certain fairly commoditized technology in the semiconductor and other sectors. Prior to making an investment, funds should analyze the likely impact of such an action by the U.S. government on the daily operations of the target company and on the fund’s exit options.
U.S.-CHINA TRADE CONSIDERATIONS
It remains to be seen what impact the ongoing trade dispute between the U.S. and China will have on the use of the U.S. Administration’s national security toolbox, or whether new legislation may be proposed. The terms of the “Phase 1” agreement to alleviate trade tensions released in mid-January 2020 are relatively vague and high-level. It will be quite some time before the market can digest those terms, especially in the current circumstances. In any case, because the U.S. government’s national security concerns with respect to certain foreign actors and U.S. businesses pre-date the current trade war, a resolution of these trade tensions will not eliminate the other concerns outlined above.
Prior to the Covid-19 pandemic, some funds were exploring opportunities to structure deals in such a way to capitalize on increased tariffs applicable to Chinese goods and, generally, to benefit from the ongoing trade tensions. However, given the ever-changing situation and the major uncertainties and disruption stemming from the Covid-19 pandemic, these strategies would be difficult to implement and have an uncertain future, particularly given recent U.S. government efforts to prioritize and prevent attempts by foreign investors to capitalize on the pandemic’s effects by acquiring vulnerable U.S. businesses and technologies.
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