Commentary: How private equity shops can adapt to the new CFIUS rules

If there is one takeaway from the Committee on Foreign Investment in the United States' new rules — which broaden the committee's jurisdiction to review foreign investments that might threaten national security interests — it is that, without some level of inquiry, you can no longer be sure which investments will come under scrutiny.

Take the recent sale at a bankruptcy auction of a specialty chemical distribution company — a sale that, on its face, wouldn't seem to raise any red flags. For one, it did not manufacture anything; it simply distributed hard-to-find chemical ingredients for use in manufacturing products. And at first glance, there did not seem to be any foreign buyers involved.

But as due diligence proceeded with the company's trade policy counsel, they discovered that some of the company's crop protection products had a dual use — as components of rocket fuel. Plus, one of the potential buyers was owned in part by a foreign person — not Russian or Chinese, but Canadian. The company needed that buyer because the stalking-horse bidder in the bankruptcy auction sale had no other competition, and maintaining competition is essential to maximizing value.

For private equity firms, this should serve as a wake-up call to get educated on CFIUS right now. 2018 saw 265 private equity deals in the U.S. backed by foreign investors (up from 253 in 2017), and confusion still reigns around what exactly the new rules entail. In fact, CFIUS has already unraveled several completed transactions. The reason this case should raise the alarm is that it involved chemical ingredients and Canada — it did not involve China or even more ubiquitous, sensitive personal data.

The bottom line is that to keep investors and their deals in compliance, private equity firms need to take serious steps to prepare for potential CFIUS issues — before the ink is dry — even if they think a given transaction cannot possibly pose compliance risk.

Here are three key principles to which private equity firms should commit:

Know your potential buyer's ownership structure — so you can plan ahead. Sounds simple, right? But as many in the CFIUS and private equity businesses know, navigating the various levels of a buyer's organization can be challenging. Under the new rules, however, it is critical that you know exactly where foreign investment comes into play so you can ascertain the amount of control or access those investors will have — Will they really be a limited partner and/or influence finances? Will they be privy to sensitive data? — as well as information about the actual investor — is he or she a dual citizen? Where does he or she permanently reside?

For example, a deal in progress right now involves a dual U.S.-Israeli citizen who will be part of the platform company's board of directors. This checked the box for further CFIUS analysis.

Involve CFIUS counsel early on in the process. As we noted earlier, there is a series of unknowns under the current pilot program — around interpretation, enforcement and the rules themselves. Talking with a group of companies that had to file mandatory CFIUS declarations, we found that the committee approved only a third of them, while telling more than half that a decision could not be rendered within the review period, and instructing them to either file the long-form declaration or proceed at their own risk.

This makes it crucial for trade policy experts to work hand in hand with a transactional team right from the start to identify anything that might be a CFIUS issue down the line. They will help examine companies' products and technology as well as the foreign players involved in those companies. Trade policy counsel can also sensitize transactional teams to potential CFIUS triggers. If a foreign enemy got hold of that dual-use chemical product/rocket-fuel ingredient, for instance, could it threaten our food supply or enable the foreign power to make weapons for use against the U.S. or its allies?

Get creative with your deal structuring. You are not allowed to evade CFIUS, but that does not mean you cannot structure intelligently. This might include mitigating foreign investors' involvement ahead of time as well as provisional "what-ifs" that help pre-empt and guard against CFIUS issues should anything occur down the line. In one aviation-related transaction, for example, the deal went through with a delayed transfer of certain components (to be dealt with after CFIUS approval was given or rejected).

Despite the current confusion, these principles and practices simply have to become routine, just as with pre-merger filings and the Hart-Scott-Rodino Antitrust Improvements Act of 1976. If private equity firms take the time to educate themselves on these issues, they will reduce transactional completion risk, as well as potentially expand the universe of buyers able to bid on their assets (or, conversely, avoid bidding for a company that they cannot buy due to CFIUS limitations).

Expanding that universe of buyers is exactly what ended up happening in the chemical distribution company's sale. Once they sorted out the Canadian bidder's CFIUS issues, the buyer could participate; as a result, the bid increased from the initial $360 million to $422 million during the course of the auction.

This may only be one example. But it does demonstrate just how much preparation, education and due diligence around CFIUS can really pay off.

Published in Pensions & Investments on August 14, 2019. © 2019 Crain Communications, Inc. All Rights Reserved.