The cross-border investment scene is dominated by institutional and, more broadly, private investors. They have a duty to their clients since they have a mandate – either institutional or private – to handle money on their behalf. As a result, they are used to dealing with regulatory frameworks in many industries and jurisdictions.
Foreign direct investment (FDI) regimes are no exception, and pension funds, asset managers, insurance firms, and sovereign wealth funds are well-versed in the submissions process and have established positive relationships with the majority of investment promotion agencies (IPAs) around the world.
Why is it necessary to know where the capital came from?
Institutional investors, on the whole, consider FDI regulations to be one of the usual clearances to go through during their investment process, particularly when it comes to mergers and acquisitions.
These investors have become increasingly adept at investing abroad in an attempt to widen and diversify their portfolios, and as a result, they are frequently recognized by IPAs, allowing them to bypass the FDI clearance procedure.
Following the Covid-19 outbreak, which sparked broader protectionist movements, many governments have taken substantial attempts to tighten foreign investor monitoring and pay greater attention to their country of origin and political relationships.
“For sovereign wealth funds with what are viewed as problematic linkages to particular foreign governments or corporations, navigating FDI regulatory regimes has grown more difficult,” says Veronica Roberts, head of the FDI group at law firm Herbert Smith Freehills.
For example, it is no secret that certain Western governments have enhanced their scrutiny of Chinese investment in their territories.
Concerns about the origins of investors and sponsors are a frequent stumbling block for institutional investors at various phases of the investment process.
The investing process is divided into three stages for funds and asset managers in particular, each of which brings significant regulatory concerns.
For example, fund managers raise cash (the fundraising phase), invest it (the investment phase), and then sell it, all with the goal of returning money to their customers with significant earnings and returns (the divestment phase).
“Fundraising can be difficult,” says Jonathan Gafni, head of Linklaters’ US international investment practice. “The Committee on Foreign Investment in the United States [CFIUS] in the United States, for example, is not very receptive of cash from China and Russia. At this point, the US regulatory body tends to focus on how much of a stake those countries’ investors have in the fund in question, as well as their ability to reject or approve certain transactions.”
Be cautious of the disclaimers.
Investors in funds, also known as limited partners (LPs), are meant to convey a mandate to the fund’s sponsor, also known as general partners (GP), and have no influence in investing decisions.
However, as Gafni points out, there are disclaimers, and some LPs may wind up with strategic weighting in the investment process.
“GPs should think about this seriously, especially for countries of concern,” he says. “We frequently see a push-pull scenario where investors seek to avoid CFIUS inspection while sponsors don’t want to frighten away money by restricting investors’ rights excessively.” The investment mandate is usually the deciding factor.”
During the divestiture phase, or when an investor is attempting to sell its assets and earn a profit for its customers, similar concerns can develop.
“When selling, an investor wants to get out and get paid quickly,” adds Gafni, “but they must carefully assess who the buyer is and, more significantly in some cases, where they come from.” “Once again, CFIUS is wary of Chinese investors paying exorbitant prices for US assets.
“Some investors are more intent on maximizing the sale proceeds than others, and so are more ready to accept regulatory risks.” Again, it is dependent on the investing mission and its risk profile.”
FDI regulatory hurdles for institutional investors tend to emerge in certain sectors during the investment phase. For example, technology is a sector that frequently comes under the scrutiny of FDI regulatory agencies, owing to its ramifications in the sphere of national security. Infrastructure, energy, logistics, and supply chains are all frequently subject to FDI restrictions.
“At this point, investors must determine whether they require a file and, if so, what the anticipated conclusion will be,” Gafni continues.
The long-term vs. the short-term strategy
Institutional and private investors are both long-term investors by definition. A fund investing in real assets, such as infrastructure, real estate, and natural resources, has an average life of roughly 20 years, although pension funds, insurance companies, and sovereign wealth funds may have a longer investment horizon.
“Changes in FDI regimes are a long-term component in institutional investors’ decision-making since they can have a significant impact on project returns,” says Thierry Déau, CEO of infrastructure investor Meridiam.
“As a result, investors pay special attention to the stability of FDI regimes.” Apparently appealing regimes that are known to change frequently are considered a risk factor since they might readily erode contract enforceability.”
Institutional and individual investors have been chasing bigger returns over the past decade, and their increasingly knowledgeable investor base has become less risk averse.
This dynamic has an impact on institutional and private investors’ attitudes toward regulation, as well as their willingness to invest in countries with higher regulatory risk.
Werner von Guionneau, CEO of infrastructure investor InfraRed Capital Partners, states, “There are two fundamentally distinct approaches to this.” “One is for long-term asset ownership, while the other is for developing assets. In the first case, regulatory risk tolerance is greatly decreased because you are looking to hold an asset for at least 20 years and cannot afford to make retroactive modifications.”
InfraRed, he says, concentrates on a few nations that provide a solid regulatory and legal framework, such as Canada, the United States, Australia, and a few European countries, primarily Germany and the Nordics, for long-term transactions.
“When you look at development assets, the methodology changes,” von Guionneau adds. “This is where you have a shorter-term investment and can thus afford to take on more risk; for example, in the case of energy transition assets, where development periods can be shorter than core infrastructure.”
He uses Mexico as an example of a region where there is a danger factor. The country recently shifted its stance on various types of infrastructure investment, moving from actively pushing FDI to somewhat modifying its stance on energy market liberalization.
While a list of ‘safe’ countries for long-term holding can be identified, von Guionneau warns that the current political situation does not always protect investors from unforeseen developments.
“Until recently, the United Kingdom was regarded as the most stable place in which to invest,” he continues. “Then, three years ago, a Labour opposition openly debated the nationalization of critical infrastructure. This harmed its reputation as a safe refuge for a while.”
Since then, the ruling Conservative Party has made a determined marketing campaign to convince investors that the UK is open for business and eager to attract private and institutional capital from around the world.
FDI restrictions are becoming more stringent.
As previously stated, the global FDI regime landscape is generally shifting in the direction of tightening rather than easing of restrictions. There are a few exceptions, and they all come with restrictions.
“While we see a general trend toward the introduction/expansion of FDI screening frameworks like the new UK National Security and Investment Act,” says Vittorio Lacagnina, managing director of Partners Group’s private infrastructure practice, “other established FDI regimes, including the US, continue to mature and offer exemptions that may prove helpful to private markets’ institutional investors.”
“However, some of these exemptions may come with difficulties, such as CFIUS testing for influence – without the exercise of control – for limited partners and co-investors from nations considered sensitive,” he says.
Another country that has been attempting to gradually open certain of its sectors to foreign investors is China. It does, however, provide a variety of obstacles of a different sort.
“In major export markets like China, we weigh the country’s requirement for FDI in connection to its current account against the government’s patriotic approach to industry growth in certain market categories,” Lacagnina says. “While we expect China to continue to open up to foreign direct capital flows, we are aware that certain areas, including as healthcare and media, are subject to foreign ownership limitations in the interest of national security.”
Institutional investors are not immune to the concerns that an increasingly strict and protectionist approach to FDI brings, and the impact it may have on their investment pool, no matter how experienced they are at navigating different regulatory jurisdictions and how good a relationship they have built with IPAs over the years.
