The implications of the UK’s proposed national security investment screening regime have been widely debated since the National Security and Investment Bill (NSI Bill) was introduced to Parliament on 11 November 2020.
However, as the NSI Bill progresses through the House of Lords, there has been a notable lack of public analysis of the effect of the new NSI regime on private equity, despite the significant implications for fund managers and institutional investors, whether as holders, sellers or acquirers of investments.
Poll results from our recent private capital webinar on this topic confirmed the importance of the new regime in this context:
prior to the webinar, just 17% of webinar attendees had already considered the potential impact of the NSI Bill on their investment strategies or processes in any detail;
at the end of the webinar, 78% of attendees expected that they would be likely to be involved in a deal requiring filings under the NSI regime in the course of the next two years.
We first set out below a short re-cap of the circumstances in which a mandatory notification may be required under the new UK regime, and when a voluntary notification should be considered in light of the Government’s powers to call an investment in for review on national security grounds.
We then consider in more detail:
potential differences in the application of the new regime depending on the type of investment vehicle/structure used;
the material impact of governance and information rights on execution risk profile; and
other practical considerations for institutional investors and fund and asset managers, whether as holders, sellers or buyers of affected interests.
- The UK’s proposed NSI regime represents an important new execution risk factor, with a similar risk profile to merger control rules.
- Broadly speaking, the new regime will apply to any acquisition of “material influence” in a company (which may be deemed to exist in relation to a low shareholding, potentially even below 15%) and the acquisition of control over assets or intellectual property, which potentially gives rise to national security concerns in the UK.
- The additional execution risk applies not only to new investments, but also to increases in existing stakes which result in the investor gaining material influence, or crossing the 25%, 50% or 75% thresholds.
- Mandatory notification obligations (and a prohibition on completion prior to clearance) will apply to certain transactions in specified sectors (including acquisitions of a shareholding/voting rights of 15% or more).
- Whilst notification of relevant transactions in any other sector will be voluntary, in practice it may, in the interests of certainty, often be advisable to notify if there is any risk of a national security issue (broadly defined), owing to the Government’s power to “call in” transactions for review in any sector and – potentially – to restructure or undo them.
- The potential application of the NSI regime should be considered on every deal completed on or after 12 November 2020. Although the NSI Bill has not yet been enacted, once in force the Government’s “call in” power may be exercised retrospectively for up to six months after the commencement of the Act or six months after the date on which the Government becomes aware of the transaction, whichever is the later (subject to a longstop of five years after completion of the relevant transaction).
- There remains a significant degree of uncertainty as to how the new rules will be applied in practice, in particular in relation to common structures used by private equity and it is important to seek advice at an early stage. The Government is encouraging parties to seek informal advice from the new Investment Security Unit (including prior to formal commencement of the new regime).
- Investments in “blind pool”, multi-asset funds seem unlikely to fall within scope of the new regime, assuming typically limited governance and information rights of institutional (limited partner or “LP”) investors over portfolio companies. The “blind pool” funds themselves (and their managers) will usually be caught in the same way as other direct investors, but the LPs should not generally expect to have to make individual filings in respect of fully discretionary investments made by the fund manager on their behalf.
- At the other end of the spectrum, directly-held investments where an institutional investor has engaged an asset manager on a non-discretionary advisory mandate (ie the LP retains control and discretion) will usually result in the institutional investor being caught by the new regime in the same way as any other direct investor.
- For more-bespoke or ad hoc investment vehicles and structures, including single-asset funds, funds of one, and separate managed accounts, the analysis becomes more nuanced and will require a detailed assessment of governance rights of LPs and information flows in relation to the underlying entity or asset.
- Key factors to consider in relation to LP governance rights in more-bespoke investment vehicles will include: influence over portfolio company-level decisions and reserved matters, no-fault general partner (GP) removal rights (particularly if exercisable unilaterally), representation on portfolio company boards or limited partner advisory committees (LPACs), and the extent to which the GP has discretion to vary governance or information rights.
- From a practical perspective, it may be possible for LPs to mitigate the impact of the new UK regime by considering the use of fully discretionarily-managed investment structures rather than making direct investments, or the use of post-acquisition syndication opportunities rather than bidding in consortium at the outset, depending on the particular circumstances.
- Parties may also wish to explore carving-out potentially-problematic components of the target for the purposes of the investment (acknowledging that this may not be an option in competitive auction processes).
- Sanctions for non-compliance with the NSI regime will be severe. In addition to the risk of the transaction being void if completed prior to clearance, non-compliance may result in fines of up to 5% of worldwide turnover or £10 million (whichever is the greater) and imprisonment of individuals for up to 5 years, as well as disqualification of individuals from serving as a director of a UK company for up to 15 years.
- Whilst the focus of the new regime is clearly on foreign investment, it applies equally to UK investors, who will be subject to the same notification obligations and potential sanctions. We note, however, the inherent probability of the regime having a lesser impact – and operating as less of a deterrent – in practice where investors of UK origin are concerned.
When will mandatory notification be required under the NSI regime?
On the basis of the NSI Bill as currently drafted, mandatory notification will be required where a transaction involves:
- the acquisition of a shareholding/voting rights of 15% or more in a qualifying entity;
- an increase in control of a qualifying entity by increasing the percentage of shares or voting rights held which results in crossing the 25%, 50% or 75% thresholds; or
- the acquisition of voting rights that enable the acquirer/investor to secure or prevent (i.e. veto) the passage of any class of resolution (e.g. an ordinary or special resolution) governing the affairs of a qualifying entity.
In this context, qualifying entities are broadly defined to cover any legal person (but not individuals), which carries on specified activities in the UK in a specified sector.
Notifiable acquisition regulations (yet to be published) will set out in detail which specified activities are covered in which sectors, but the Government has consulted on draft definitions relating to 17 sectors which are very broadly defined: civil nuclear; communications; data infrastructure; defence; energy; transport; artificial intelligence; autonomous robotics; computing hardware; cryptographic authentication; advanced materials; quantum technologies; engineering biology; critical suppliers to Government; critical suppliers to the emergency services; military or dual-use technologies; and satellite and space technologies.
Where a transaction falls within the scope of the mandatory notification obligation, there is a corresponding prohibition on completion until formal clearance is obtained. Completion in breach of that prohibition will (under the NSI Bill as currently drafted) result in the transaction being deemed automatically void.
In terms of the impact on the deal timetable, once a notification is accepted as “complete”, the Government must decide within 30 working days whether to call it in for an in-depth assessment. If it does so, it then has a further 30 working days, extendable by a further 45 working days (and potentially further with consent of the parties), to carry out that assessment and determine whether remedies are required to address any national security concerns. Remedies could include for example protecting national security sensitive information, granting access rights to national security sensitive assets, and in a worst case scenario prohibition of the transaction.
When will the Government be able to call-in a transaction for review?
The Government will have wide-ranging powers to call in transactions for review in any sector which result in the acquirer gaining “control” of a qualifying entity or asset, and which may potentially give rise to a national security risk. Control will be considered to arise where the transaction involves:
- an increase in control of a qualifying entity by increasing the percentage of shares or voting rights held which results in crossing the 25%, 50% or 75% thresholds;
- the acquisition of voting rights that enables the acquirer/investor to secure or prevent (i.e. veto) the passage of any class of resolution (e.g. an ordinary or special resolution) governing the affairs of a qualifying entity;
- the acquisition of “material influence” over the policy of a qualifying entity (which may be deemed to arise in relation to a low shareholding, potentially even below 15%); or
- in relation to the acquisition of qualifying assets (including land, tangible property and IP), the ability to use or direct the use of the asset to a greater extent than before.
For this purpose, qualifying entities are defined more broadly than for the mandatory notification obligation, so as to include not only an entity carrying on activities in the UK, but also an entity supplying goods or services into the UK. Similarly, an acquisition of an asset may be caught if it is situated in the UK or used in connection with activities carried on in the UK or the supply of goods or services to persons in the UK. This extra-territorial reach is unusual compared to foreign investment regimes in many other jurisdictions.
The call-in power may be exercised retrospectively in relation to qualifying transactions completed on or after 12 November 2020 - for up to six months after the commencement of the Act, or six months after the date on which the Government becomes aware of the transaction, whichever is the later (subject to a longstop of 5 years after completion).
Assessing the likelihood of a transaction being called in for review will be a key factor in determining whether to make a voluntary notification to reduce the risk of uncertainty surrounding call-in of the transaction at a later date (and the potential imposition of remedies post-completion). Limited guidance on the intended exercise of the call-in power is set out in a statement of policy intent published by the Government alongside the NSI Bill, but this does not consider the potential application to transactions involving investment funds.
Where a transaction is voluntarily notified, or called-in for review on the Government’s own initiative, the same review timetable applies as for mandatory notification and subsequent call-in for in-depth assessment (see above). In the event that remedies are required to address national security concerns, the same powers also apply – including a power to require the transaction to be unwound, if it has already been completed.
How the form of investment vehicle/structure will affect the application of the new regime
When considering the application of the NSI regime to transactions involving indirect investment structures (as will usually be the case where funds and managers are involved), the key question will be the extent to which interests held via an investment structure should be treated as being held by the end investors (i.e. institutional investors or LPs) (and potentially aggregated with any parallel interests held directly by those investors, including through co-investment structures). In other words, do you need to look through the fund structure or managed vehicle to the underlying LPs when considering whether any notification obligation arises and who is responsible for submitting that notification?
The answer to this question will largely depend on a detailed assessment of the governance rights of the LPs and information flows in relation to portfolio companies in each individual case. However, there are a number of general principles which can be drawn out when considering the spectrum of potential investment vehicles, with a clearer position emerging at either end of the spectrum and a more nuanced “grey area” in the middle:
“Blind pool” multi-asset funds
Where an investment is held via a “blind pool” multi-asset fund, this will typically involve a fairly large number of LPs, with investment risk spread across a number of different assets. In these structures, none of the LPs will have control over decisions taken in relation to portfolio companies, or access to sensitive information (information rights of LPs being typically limited to financial performance).
In such circumstances, it does not seem appropriate to “look through” the fund structure and treat individual LPs as controlling the fund or, indirectly, controlling voting rights in the underlying portfolio companies; by definition they are passive investors. Equally, individually it is unlikely that they would be able to control a vote to remove the fund's GP, which is structurally and commercially responsible for management of the fund and its assets. Although “indirect holdings” are covered more generally by the NSI regime, the relevant provisions do not appear to apply to this sort of passive fund investment.
By way of a practical example (albeit a deliberately extreme fact pattern), consider an investor with a blind pool fund exposure of 1.1% to a privately-owned UK electricity distribution network operator, who intends to acquire a further direct interest of 14% in the same entity. This should not generally be treated as breaching the 15% shareholding threshold, which would trigger a mandatory notification requirement (on the basis of the current definitions of specified sectors).
There would however need to be a careful assessment of any governance or information rights, and consideration of whether the investor would be in a position to exert “material influence” over the entity (which would amount to a qualifying transaction for the purposes of the Government’s call-in power if the acquisition potentially gave rise to a risk to national security, even if no mandatory notification obligation was triggered). An assessment of material influence would need to take into account any other relevant factors, including for example any right to appoint one or more directors to the board of the target entity. Whilst a right to appoint a single director would not normally result in the acquisition of material influence, consideration would need to be given to the total number of directors on the board, and the extent to which the board member in question was responsible for national-security related aspects of the target entity’s business.
Single-asset funds will typically involve a smaller number of investors investing in a vehicle and appointing an external manager but retaining no greater governance rights than would be typical in a “blind pool” scenario. Again, in principle LPs are not able to control portfolio-level decisions in such vehicles. However, a careful analysis of rights under the limited partnership agreement will be required in each case.
Where an investor holds an indirect interest via a single asset fund and then seeks to acquire a further stake through a separate managed account/”Fund of One”, it will be important to look closely at the mandate given to the manager of the single asset fund, and who is actually controlling the interest held by that fund in practice. If the investor were effectively able to control the interest held via the single asset fund, this holding seems likely to be aggregated with any additional stake it subsequently acquires for the purposes of determining whether the relevant notification/call-in thresholds of the NSI regime have been met.
Separate Managed Accounts / “Funds of One”
Where an investment is made by way of a separate managed account (whether structured as a discretionary mandate or a “Fund of One”), the investor will usually have some form of right to terminate the arrangement on notice, and to step into the shoes of, or otherwise replace the manager/GP.
To the extent that the investment vehicle has a controlling stake in a portfolio, it is therefore likely that the investor would be deemed to also have that control. A further factor likely to be relevant in this context is the ability to appoint one or more directors to the board of a portfolio company, although this will not necessarily be determinative and will need to be assessed on the particular facts of the case (see above).
Non-discretionary advisory mandates
Where an investor retains control and discretion as to how to vote and exercise rights as a shareholder pursuant to a non-discretionary advisory mandate, it seems clearer that this sort of investment would generally be caught within the scope of the NSI regime. If the investment results in the investor acquiring 15% or more of a qualifying entity in a specified sector, or crossing the 25%, 50% or 75% thresholds, a mandatory notification will be triggered (including where those thresholds are breached as a result of aggregating any direct holdings with the investment held under a non-discretionary advisory mandate). Where mandatory notification is not triggered, the risk of call-in (and therefore the related question of whether to make a voluntary notification) should be considered in any sector.
Impact of governance and information rights on execution risk profile
It is clear from the above that the extent of the governance and information rights of LPs will have a significant impact on the execution risk profile of an investment in terms of the potential applicability of the NSI regime. It may therefore be advisable to consider proactively whether any steps can be taken in the circumstances of a particular investment to minimise that risk, in particular by adapting governance and information rights to take into account the NSI regime when structuring investments via single asset funds or separately managed accounts.
Key factors to consider in relation to LP governance rights in more-bespoke investment vehicles will include: influence over portfolio company-level decisions and reserved matters, no-fault GP removal rights (particularly if exercisable unilaterally), representation on portfolio company boards or LPACs, and the extent to which the GP has discretion to vary governance or information rights.
In relation to information rights, it will be important to consider the extent to which LPs’ access to detailed information about portfolio companies could increase the likelihood of an investment falling within the scope of the NSI regime. Customary information rights including the provision of aggregated financial information are unlikely to be problematic, but particular care should be taken in relation to access to sensitive information which could be of relevance to national security issues.
Whilst investments made via a blind pool, multi-asset fund would not usually be expected to lead to notification requirements being triggered for LPs (as explained above), if a fund is focussed on a particular sector which is clearly within the scope of the regime then it is also possible that we may see GPs seeking discretion to vary LPAC consent rights or to reduce the rights/influence of LPs where there is perceived to be a risk that the transaction may otherwise fall within scope of the NSI regime (although we would anticipate, as has been our experience in relation to the CFIUS regime, that this will remain the exception rather than the rule).
Other practical considerations
In addition to adapting governance and information rights to take into account the potential application of the NSI regime, there are a number of other practical considerations which should be borne in mind by investors, managers, sellers and buyers in this context:
- Availability of “informal guidance”: the Government is encouraging parties to seek informal guidance from the Investment Screening Unit as to the potential application of the NSI regime to particular transactions (including prior to the entry into force of the new regime, given the retrospective application of the call-in power). The Government has promised prompt feedback.
- Consider the “transaction perimeter”: is it possible to carve out the potentially problematic aspects of the target for the purposes of the investment? (acknowledging that this may not be an option in competitive auction processes).
- Direct vs managed interest: it may be possible for an investor to avoid triggering notification obligations under the NSI regime by structuring an investment as a managed interest rather than a direct interest (which may also present an attractive opportunity for managers to bring in capital).
- Consortium vs syndication: in some circumstances, it may be possible for one party to go through the NSI regime approval process first, and then subsequently syndicate the acquired interests to parties who would be considered to pose a greater execution risk if included upfront as consortium parties (provided those syndication rights do not of themselves trigger the regime).
- Aggregation of interests across connected persons: the NSI Bill expressly provides that interests held by connected persons will be aggregated for the purpose of determining whether notification/call-in thresholds have been met. This could potentially be applied to a scenario where a single manager is responsible for a number of different funds which all invest in the same portfolio company.
- Exercise of options/ROFR: an option to purchase a further stake will not in principle be notifiable at the point in time the option itself is acquired. However, if it relates to a target which falls within the scope of the mandatory notification regime, formal clearance will be required before the option can actually be exercised if it would result in one of the relevant shareholding/voting right thresholds being met.
- Early identification of “preferred bidders”: in an auction scenario, the Government has indicated that it will provide informal guidance to sellers in relation to their list of prospective bidders, but likely will only engage with bidders once they are at the “preferred bidder” stage.
For further detailed analysis of the NSI Bill more generally please see our earlier detailed briefing. If you have any questions about the application of the proposed NSI regime, either generally or in relation to a particular transaction, please do get in touch with one of the contacts listed below, or your usual Herbert Smith Freehills contact.