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How Do Institutional Investors approach FDI Regimes?

Institutional investors are used to navigating regulatory regimes, but the evolving FDI regime landscape globally is set to pose challenges.

Institutional and, more broadly, private investors are key players in the cross-border investment landscape. As they have a mandate – either institutional or private – to handle money on behalf of others, they have a duty towards their clients and are therefore used to dealing with regulatory frameworks in different fields and jurisdictions.

Foreign direct investment (FDI) regimes are no exception to this and the likes of pension funds, asset managers, insurance companies and sovereign wealth funds certainly know their way around filings processes and have built good relationships with most investment promotion agencies (IPAs) around the world.

Why the origin of the capital is important

Overall, institutional investors tend to see FDI regimes as one of the standard clearances to go through during their investment process, especially when it comes to mergers and acquisitions deals.

These investors have become increasingly skilled at investing abroad in an attempt to broaden and diversify their portfolios and have therefore often become known to IPAs, meaning they often only have to go through the FDI clearance process once.

In the wake of the Covid-19 pandemic, which brought with it broader protectionist trends, many governments have taken significant steps towards tightening the scrutiny over foreign investors and are paying more attention to their country of origin and political ties.

“Navigating FDI regulatory regimes has become harder for sovereign wealth funds that have what are seen as problematic links to certain foreign governments or entities,” says Veronica Roberts, head of the FDI group at law firm Herbert Smith Freehills.

It is no secret, for instance, that some Western governments have significantly increased their scrutiny over Chinese investment in their jurisdictions.

Concerns over the origin of investors and sponsors is a recurring hurdle that institutional investors need to overcome at different stages of their investment process.

For funds and asset managers in particular, the investment process is split into three stages, each of which presents different potential regulatory challenges.

Fund managers, for example, initially raise capital (the fundraising phase), then invest that capital (the investment phase), and finally divest it, aiming at returning money to their clients with high profits and returns (the divestment phase).

“Fundraising can present its challenges,” says Jonathan Gafni, head of US foreign investment at law firm Linklaters. “In the US, for instance, the Committee on Foreign Investment in the United States [CFIUS] is not very welcoming of capital from China and Russia. At this stage, the US regulatory body tends to focus its attention on what stake investors from those countries have in the fund in question; or what their rights are when it comes to vetoing or approving certain investments.”

Beware the disclaimers

Theoretically, investors in funds – also known as limited partners (LPs) – give a mandate to the fund’s sponsor – also known as general partners (GP) – and are not supposed to have a say in investment decisions.

However, warns Gafni, disclaimers exist, and some LPs sometimes end up having strategic weighting in the investment process.

“GPs need to think carefully around this, especially for countries of concern,” he says. “We often see a push and pull dynamic where the investors want to avoid CFIUS scrutiny but at the same time sponsors do not want to scare money away by excessively limiting investors’ rights. The final decision tends to be based on the investment mandate.”

Similar issues can arise during the divestment phase, or rather when an investor is looking to sell its assets and make good returns for its clients.

“When selling, an investor wants to get out and get paid quickly but needs to consider carefully who the buyer is and, most importantly in certain instances, where they come from,” says Gafni. “Again, CFIUS is not keen on Chinese investors paying huge premiums to get US assets.

“Some investors are more singularly focused on maximising proceeds of a sale than others and are therefore more willing to take regulatory risks. Again, it depends on the investment mandate and the risk profile of said mandate.”

In the investment phase, FDI regulatory challenges for institutional investors tend to emerge in certain sectors. Technology, for instance, is a sector that often falls under the scrutiny of FDI regulatory bodies, mostly due to its implications in the national security field. Infrastructure, energy, logistics and supply chains also often fall under FDI regime rules.

“At this stage, investors need to assess whether they need a filing and, if so, what the outcome is likely to be,” explains Gafni.

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