Middle Eastern Sovereign Wealth Funds (SWFs) and State-Owned Entities (SOEs) have become increasingly significant investors over the last decade, investing billions, often in the implementation of long-term, sustainable strategies.
Globally, SWFs now manage over USD 10 trillion in assets across multiple asset types and in a range of markets. They have established themselves as seasoned and valuable (co-)investors across the world. The number and value of direct investments made by SWFs has grown steeply in recent years, with over 450 deals, valued at over USD 120 billion, in 20211. While SWFs and SOEs might have been passive investors (often acquiring minority stakes) ten years ago, their investment strategies2 are diversifying away from minority stakes in listed companies, to include outright acquisitions and other acquisitions of controlling stakes, as they seek to generate durable value by backing less mature companies. SWFs are also investing heavily in large infrastructure projects and taking a long-term view through investments in sustainable and renewable assets. This evolution has occurred as geo-politics have increased scrutiny of the origins of invested funds, reflecting both pressure to protect strategic national assets against being acquired by foreign companies (including those backed by foreign states) and a desire to ensure that there is a level playing field when European entities that are subject to State aid rules compete against entities receiving funds from ex-EU states.
As a result, an increasing number of EU member states have adopted foreign direct investment (FDI) laws, and there have been recent proposals in the U.S. for the Federal Trade Commission to obtain information when 'foreign entities or countries of concern' are economically active in the U.S. These measures aim to protect national assets from being controlled or acquired by companies or countries deemed to threaten strategic or economic independence.
The recent EU Foreign Subsidies Regulation (FSR) is driven more by free market principles - that companies should compete on their merits, not benefiting from the state or state-linked entities. These principles underpin EU State aid law (ensuring that EU member state intervention in the economy does not distort competition). The EU is not alone in pursuing these principles - the U.S. Congress recently concluded that "foreign subsidies can distort the competitive process or otherwise change the incentives of the firm in ways that undermine competition following an acquisition".
Against this background, the EU addressed this gap in legislation by adopting the FSR in November 2022. Any acquisition, merger or joint venture concluded on or after 12 July 2023, that has not closed by 12 October and meets the notification thresholds, and any public procurement processes that remain open on or after 12 October and meet the notification thresholds, will need to be approved by the EC. And, since 12 July, the EC has had the power to launch investigations on its own initiative, if it believes that subsidies may distort competition (including in circumstances where a competitor has alerted the EC to potential subsidies).
What does the new Foreign Subsidies Regulation mean for Middle Eastern SWFs and SOEs?
The FSR applies to all companies who receive financial support or have economic ties with non-EU countries or state entities (regardless of where those companies are established). However, given the differences in approaches to state investments across the world, companies established in certain parts of the world may have more access to state funds than others. SWFs and SOEs, including those established in the Middle East, are rapidly becoming some of the largest and most active investors in the world with access to state funds. The EU FSR is designed to allow the European Commission to investigate non-EU state funding of businesses, to ensure that such financing does not distort competition in the EU.
What are the main elements of the FSR and how do they impact SWFs and SOEs?
The FSR introduces new approval requirements for certain transactions and creates new concepts for use in the analysis of funding received (e.g., Foreign Financial Contribution (FFC) and Foreign Subsidy (FS)).
FSR notifications are required for acquisitions when i) the target or the JV achieves EU revenues of at least EUR 500 million, and (ii) any of the participants (including the entire acquiring group) have received at least EUR 50 million in combined FFCs in the last 3 years.
For EU public procurement tenders, the notification thresholds are lower, namely EUR 250 million for the contract (and, if split into lots, EUR 125 million per lot) and EUR 4 million of combined FFCs over the previous 3 years, per third country.
The concepts of FFCs and FSs may be new to SWFs and SOEs, since they are borrowed from EU State aid law. FFCs include, broadly, financial contributions provided by non-EU States or entities linked to a State.
The financial contribution concept is defined very broadly, and includes provision of capital, loans or guarantees, to tax advantages and tax exemptions that are not broadly applicable, through the provision of state-funded R&D or exclusive rights given to a company. Even contracts for the purchase from, or sale of goods or services to, State-owned entities fall within the definition, whether or not they involve any element of "subsidy".
As a result, SWFs' and SOEs' activities fall within this definition, as do private companies with state-affiliated investors and other entities that receive (most of) their funding from the state. In this context, it is important to appreciate that government guarantees on loans are more often than not implicit, due to the nature of the ownership. Similarly, SWFs can often borrow cheaply on the market, which would be considered to amount to 'implicit state support' in the rating context (so-called 'sovereign-backed ratings' vs 'standalone rating').
With respect to the FSR, the review process of a notification that meets the thresholds has two main steps: First, either the SWF/SOE or the portfolio company must notify the acquisition or the participation in the public procurement process to the EC. Second, the EC will assess whether the FFCs in issue confer an advantage that is not available on the market, such that an FFC qualifies as a FS. If it concludes that there is an FS, the EC will open an investigation if it takes the view that the FS may distort competition in the EU (e.g., by enabling the subsidized company to outcompete non-subsidized companies).
Importantly, for SWFs and SOEs, not all FFCs pose a problem - they might not be FSs, and FSs might not be distortive. FFCs given on market terms do not pose a problem, as the EC considers that they do not confer an advantage. Depending on the structure of an SWF's or SOE's relationship with the state, the SWF/SOE could have obtained the same benefit under normal market conditions. As a result, SWFs/SOEs operating efficiently, implementing strategies, governance, operations and processes similar to those of privately owned, profit-oriented companies, can explain their situations to the EC and demonstrate that the private economic investor principle, the so-called "market economy investor principle" (MEIP) applies.
The Santiago Principles consist of 24 generally accepted principles and practices voluntarily endorsed by International Forum of Sovereign Wealth Funds (IFSWF) members. They promote transparency, good governance, accountability, and prudent investment practices, while encouraging more open dialogue and deeper understanding of SWF activities[3]. SWFs that adhere to the Santiago Principles can rely on observance of the principles to demonstrate their adherence to the private economic investor principles.
In addition, if, during an investigation, the EC concludes that FFCs confer an advantage and may distort competition, an SWF/SOE can provide information to the EC about the positive effects of the FFCs received that counterbalance this potential distortion (e.g., where FFCs have contributed to the development of new technologies and medicines, to implementing the EU green agenda and digital transition or education, demonstrate the link and the benefits that will result).
Ensuring that the market terms on which FFCs were received, and the benefits that should be balanced in assessing potential distortion, are of utmost importance for SWFs and SOEs, since there is little doubt that they receive FFCs. If the EC concludes that an acquisition by, or award of a public tender to, an SWF or SOE may distort competition and that any positive effects do not outweigh the distortion of competition, the EC will impose redressive measures which can include the full repayment of the distortive advantage, reduction of business presence, divestment of assets, publication of R&D results, and - in the worst case - unwinding of the acquisition.
As noted above, in addition to reviewing acquisitions and participation in public tenders, the EC may investigate on its own initiative if it has concerns that FFCs may distort competition.
How should SWFs and SOEs prepare?
SWFs and SOEs will need to carefully consider the implications of the FSR on their transaction planning and documentation and, potentially governance structures and processes. Given the novelty of the FSR, it will be critical for SWFs and SOEs to understand its implications and identify the most pragmatic approach to developing the data and arguments that will be necessary.
For example, SWFs and SOEs should identify benefits received on market terms, and the evidence that they operate, implement strategies and processes, and have governance structures that are in line with privately owned, profit-oriented companies, and then develop their case that the MEIP applies. There are various types of evidence that SWFs/SOEs can use to establish that they have acted as private investors would, including ex ante valuation studies and business plans, documentation of due diligence carried out and internal decision-making processes, and demonstrating independence from the relevant State.
Similarly, identifying potential FSs where there is a good case to be made for the application of the balancing test, particularly where the benefit has been used to develop new technologies that can be deployed in the EU or has contributed to implementation of the EU green agenda, will be important. Identifying the evidence and developing a comprehensive narrative explaining the benefits for the EU of any such FSs will be important.
Finally, it will also be important for SWFs and SOEs to prepare for the more logistical aspects of the FSR. For example, they will be able to document the benefits received, and to explain their governance structures in circumstances where benefits accruing to operations outside the European Economic Area (EEA) have no impact inside the EEA, as a result of those structures.
The EC is encouraging pre-notification discussions, where the approach and details of notifications (and potential waivers) can be discussed. SWFs and SOEs may initiate such pre-notification discussions with the aim of reducing the amount of information that may need to be provided in notifications (whether through waivers or otherwise) and provide an opportunity to better understand sensitive issues and enable a constructive discussion with the EC that may smooth review.
This article was co-authored bySophie Bertin, Legal Consultant and Miranda Cole, Partner at Norton Rose Fulbright Brussels
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
