Committed Capital

Sidecar: CFIUS, Springing Rights and the Equity Stack

• Dechert LLP • Episode 13

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Despite evaluating fewer transactions for potential national security risks, the Committee on Foreign Investment in the United States (CFIUS) is taking longer than ever to complete its reviews, significantly impacting deal closing timelines for PE transactions involving foreign investors. In this Sidecar episode, Dechert private equity partner Bernardo Piereck and national security partners Jeremy Zucker and Hrishikesh Hari discuss the current length of CFIUS reviews, insights into the Committee’s mitigation measures as detailed in its annual report to Congress, and steps that investors can take to structure their transactions with CFIUS considerations in mind.

Show Notes

“Highlights from the Annual CFIUS Report,” Dechert OnPoint (August 7, 2024)

“Finally, An Update on Outbound Investment,” Dechert OnPoint (June 26, 2024)

“The Evolving Global Foreign Direct Investment and National Security Review Landscape,” Dechert LLP (May 2024) 

Jeremy Zucker:

Welcome to Dechert's Committed Capital. This is an episode of Sidecar, a special bite-sized discussion of the latest market issues.

Bernardo Piereck:

Hello and welcome to Committed Capital Sidecar. My name is Bernardo Piereck, and I'm a partner in Dechert's private equity practice. This year marks Dechert's 40th anniversary of assisting private equity clients to navigate dynamic deal environments. On today's episode, we want to focus on the increasing importance of considering the Committee on Foreign Investments in the United States, or CFIUS, in transactions involving foreign buyers and the equity stack. In particular, we want to discuss for our listeners the insights to be gained from the declassified version of the annual CFIUS report to Congress. I'm joined today by my colleagues, Jeremy Zucker and Hrishi Hari of Dechert's national security practice, with whom I've had the great pleasure of navigating dozens of CFIUS processes for our private equity clients. Hrishi, before we begin, perhaps it would be useful to give a very brief introduction to CFIUS for our listeners.

Hrishi Hari:

Hello everyone, and thank you, Bernardo. CFIUS is an interagency committee principally comprising nine member agencies and chaired by the Secretary of the Treasury. The Committee has broad power to review foreign investment in and acquisitions of U.S. businesses to determine the potential impact on U.S. national security. The Committee's authority includes the power to impose mitigation measures, suspend transactions, and recommend that the President block or unwind a transaction.

Bernardo Piereck:

Thanks, Hishi. Jeremy, as you know, getting a clear path to closing, and closing timeline is very important part of any private equity transaction. The latest data from the annual report suggests that it's taking longer than ever for CFIUS to review and clear a transaction. Was that true?

Jeremy Zucker:

Yeah, it is true, Bernardo, and thanks for having me. What's interesting is that it's true even in a year where the number of transactions reviewed by CFIUS declined by more than 20%. Now, of course, the decline is measured against the prior year 2022 in which CFIUS reviewed a record number of transactions, but it's still a notable reduction in the absence of extenuating circumstances. The timeline for a CFIUS review is typically 90 days, which is divided into two 45-day periods - an initial review period and then an investigation period if CFIUS thinks it's necessary. The earliest that CFIUS can conclude its review is the end of that first 45-day initial review period. And according to the report last year, about 45% of CFIUS reviews were concluded at the end of that initial period. Of course, that means more than half of the reviews, about 55%, get kicked into the second 45-day investigation period. And according to the report, the average duration of a review that was kicked into the second period was 86 days. What we typically see on the ground are CFIUS reviews that go the full 90 days, although it is possible for CFIUS to conclude its review during that second stage at any time during that period.

Bernardo Piereck:

Wow, 86 to 90 days makes CFIUS a very material timing consideration for transactions that don't otherwise have meaningful regulatory requirements, other than HSR.

Hrishi Hari:

Absolutely. And at the same time, there's things we can do to structure transactions to allow parties to close more quickly. Essentially, parties can structure their transactions using a tool called springing rights that allows them to receive the economic benefits of their investment prior to the conclusion of the CFIUS review, while tabling the receipt of their governance rights until the CFIUS review has finished. In addition to the formal CFIUS review and timeline, investors should also be thinking about their overall CFIUS strategy, more generally.

Bernardo Piereck:

CFIUS strategy- can you expand on that a little bit?

Hrishi Hari:

I'm happy to do so. When we structure our transactions, we give a lot of thought to making sure that not only is a transaction commercially feasible in the way we just described with springing rights, but we also think about how the Committee might view the deal. For example, as is often the case, a potential deal may involve a target that is data rich, and there may be concerns that arise during the course of a CFIUS review about what it means when a foreign investor acquires or invests in such a company. One way that investors can get ahead of this is to make clear that they are, as is often the case in PE, financial investors that don't need to see the underlying sensitive information. These investors can structure their ownership rights or other information rights, for example, to restrict access to PII or other information that isn't really required to monitor the financial performance of an investment.

Bernardo Piereck:

Thanks, Hrishi. And what about CFIUS mitigation imposed by the Committee? The declassifiedreport suggests that CFIUS continues to rely on the use of mitigation agreements such as national security agreements and clearing certain transactions. Can you tell me what that is and what it might mean for dealmakers?

Hrishi Hari:

Absolutely. CFIUS imposes mitigation measures on a proposed transaction to resolve national security risks that are identified by the Committee. Although CFIUS doesn't necessarily share what those risks are - it's classified - you can typically deduce the areas of concern based on the mitigation measures that the Committee imposes. For example, if CFIUS imposes security controls on a company's information systems, you can bet that the perceived vulnerabilities concern access to sensitive personal information. In 2023, CFIUS adopted mitigation measures for 18% of deals that were submitted for review. And while this number may not seem high, that means CFIUS has actually negotiated mitigation with respect to 43 different transactions.

Bernardo Piereck:

Well, 18% to me sounds fairly high, and so it'd be helpful to understand what are some examples of the mitigation measures that you're seeing being imposed on the targets.

Jeremy Zucker:

Well, mitigation measures can really run the gamut, Bernardo, and we've seen a wide variety, especially in recent years. I'll run through a couple examples real quick. Examples can include prohibiting or limiting foreign access to certain IP assets or technical information of the U.S. target company; ensuring that certain facilities, equipment and operations are located only in the United States now and on a go-forward basis; establishing corporate governance mechanisms to limit foreign influence in certain aspects of a company's operations - think about cybersecurity, for example. They can also require the appointment of U.S. government approved security officers to ensure compliance; require U.S. government approval for the use of certain third-party vendors or suppliers; require U.S. government approval in connection with any increase in the foreign investors' ownership or governance rights beyond what was disclosed to the Committee in the instant transaction. Of course, in the most extreme case, CFIUS can require divestiture by the foreign investor of all or part of its stake in the company, and also can require the company to hive off part of its own operations.

Bernardo Piereck:

Thanks, Jeremy. That's a good segue into the enforcement and the cost of non-compliance here. CFIUS enforcement actions have historically been few and far between, is that right?

Hrishi Hari:

Historically, yes. Until the last year, there were only a couple of CFIUS enforcement actions that were publicly disclosed in 2018 and 2019, respectively. But that's changing. The Committee is taking steps to enhance its enforcement authority and making that pretty clear to the market, it's increased applicable civil monetary penalties. It's also releasing enforcement and penalty guidelines that articulate the penalty process and potential aggravating and mitigating factors.

Jeremy Zucker:

And it's not just about guidelines and theoretical penalties. After more than a year of previewing it would come, CFIUS has now released information on some of its recent enforcement actions. We now know that in 2023, CFIUS assessed four civil monetary penalties for breaches of provisions of mitigation agreements, and also reached four determinations of non-compliance with mandatory filing requirements.

Bernardo Piereck:

Well, it sounds like there's quite an increase in focus on enforcement by CFIUS. Is there information available about what these enforcement actions were about, and the order of magnitude in terms of the monetary penalties imposed?

Jeremy Zucker:

Yep, CFIUS just put that information on its website. It's really the first time we've been able to see that sort of thing publicly. The headline number here is an enforcement action brought against T-Mobile, where they assessed a US$60 million penalty, really an eye popping number in the case of CFIUS enforcement. We've never seen anything of that magnitude before. It appears the penalty was assessed after a determination that, for a period of about a year, the company violated provisions of its mitigation agreement and also was aware of at least some of what was going on, failed to disclose it to CFIUS voluntarily and may actually have engaged in activities that delayed CFIUS's ability to get to the bottom of what was going on there. You know, CFIUS increasing compliance and enforcement actions really highlights the importance of building an actionable compliance framework to oversee the compliance commitments that are entered into in mitigation agreements, commitments made both by the U.S. target company and the foreign investor. Clearly, the work isn't over when the NSA gets signed, and CFIUS has now made very clear through these enforcement actions that the cost of noncompliance will be more than just a cost to your reputation. Bernardo, while I'm holding the mic, I hope you don't mind if I turn the tables on you. Given what you've heard here, what would you say are the key takeaways as the M&Amarkets begin to rebound?

Bernardo Piereck:

Thanks, Jeremy. Look, I think dealmakers really need to consider transaction timing, CFIUS strategy and the consortium makeup early with CFIUS reviews taking an average of 86 days and the potential for pull and refile, sending that out to 180 days. CFIUS review really can be the long pole to getting a deal closed in a competitive auction process. Sellers should conduct due diligence into the makeup of the buyer group to understand whether there are any CFIUS considerations that they need to factor in. When reviewing any particular bit, I can definitely see CFIUS risk becoming a material consideration in early deal negotiations. On the buy side, we've seen an increase in club transactions over the last few years as financial sponsors seek to hedge the risk of a particular transaction and to fund larger deals. With many participants in any particular consortium being foreign investors, it's important, therefore, for lead sponsors to perform a CFIUS analysis early in an acquisition process. If there's a possibility that a meaningful foreign investor could join as a co-investor or a member of a consortium, this will allow the lead sponsor to understand early whether a CFIUS filing would be required or advisable and to formulate a strategy to optimize the CFIUS review process and reduce the risk of an adverse mitigation effort being imposed by CFIUS.

Jeremy Zucker:

Well, Bernardo, you know, I'm going to agree with that. I can't resist encouraging all of our listeners to check out some of the publications that are available, both at dechert.com and hopefully in links on the show notes below where you clicked in to listen to this podcast. And I'll just point out that in addition to our most recent publication with highlights from the CFIUS annual report, you'll also find just from the past couple of weeks, publications on developments in the CFIUS rules pertaining in particular to real estate transactions, as well as a white paper we published in which we covered what we termed the evolving global foreign direct investment and national security review landscape, reviewing CFIUS equivalent regulations in a dozen different jurisdictions. And of course, we're following developments in the world of the so-called outbound investment regime. It's been referred to as a reverse CFIUS process, but as you'll find, if you read what we're writing about it, it will not be a reverse CFIUS process, but a very different animal, instead, presumably of great interest to our PE clients who invest in other countries as well. Thanks again, Bernardo, for having us.

Bernardo Piereck:

Absolutely. Jeremy, Hrishi, thank you for joining me today, and thank you for your insights. To our listeners, if you found today's discussion interesting, please don't hesitate to reach out to your usual Dechert contacts with any specific questions. Thank you for listening, and until next time.

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