The First U.S. Restriction of Outbound Investment in Unlisted Chinese Tech Companies: What Does It Mean for UK Institutions Investing in U.S.-Managed Funds?
U.S. private equity and venture capital funds will soon be prohibited from investing in unlisted Chinese companies active in any of three sectors relevant to the military
We explain what UK investors in such funds need to know about this legislation, and recommend how they can prepare themselves.
By Executive Order dated 9 August, President Biden instructed the U.S. Department of the Treasury to create a programme that would prohibit U.S. persons from investing in the equity of unlisted companies in China, Hong Kong and Macau that develop any of three technologies or products posing a "particularly acute national security threat". 'U.S. persons' include U.S.-managed private equity and venture capital funds.
The three sectors are:
- semiconductors and microelectronics, including the sale or installation of supercomputers
- advanced quantum information technologies
- artificial intelligence systems
in each case, to the extent critical for the military, government intelligence, mass surveillance, or cyber-enabled capabilities of China.
Treasury opened a consultation on the same day outlining its plan for regulations.
This is the first general restriction by the United States of "outbound" investment in the equity of unlisted, non-U.S. companies - or "reverse FDI". The Biden Administration is concerned that advanced computational capabilities will lead to more sophisticated weapons, the breaking of cryptographic codes, and other applications providing military advantage.
Although this development will directly impact U.S.-managed funds targeting Chinese technology in these sectors, it will indirectly apply to UK investors in such funds because the latter's investment scope will narrow. Given that the list of their holdings is often publicly available, UK investors will seek to avoid the reputational risk of backing fund managers that violate the new prohibitions.
A few words of context and a brief description of the proposals are provided below, together with recommendations for action by UK investors in U.S.-managed funds that favour Chinese technology.
Context and target of programme - U.S. private equity and venture capital.
- Since at least 2019, journalists have been highlighting U.S. funds' investment in Chinese companies developing technology with military or surveillance applications. They uncovered investment in Chinese surveillance technology allegedly used to monitor Uighur Muslims, and have named many U.S. charitable and academic endowments and pension schemes among those funds' limited partners, after painstakingly matching limited partners with fund managers listed on financial statements and IRS Forms.
- The U.S. government responded initially by imposing additional license requirements on U.S. exporters of semiconductors and other inputs to specific Chinese companies. But U.S. private equity and venture capital funds' continuing provision of capital and expertise to such Chinese companies eventually resulted in this programme.
- The programme clearly concentrates on taming the U.S. private equity and venture capital industry, which it considers to provide value to its Chinese private portfolio companies in the forms of "enhanced standing and prominence," "managerial assistance" and "talent networks". Commentators speculate that the Administration was deeply concerned by the technology investments of Sequoia's wildly successful Chinese arm, and that Sequoia separated its U.S. business from its Chinese and Indian arms in July in order to avoid being named in the Order.
Description of programme
- The programme claims to restrict Chinese development of only a small area of critically important technology (the "small yard, high fence" strategy). The dimensions of the "yard," however, depend on the specificity of the definition of the proscribed items of technology, which varies in the consultation.
- The nature of the private funds that must comply is clear. All Delaware funds will be subject to the restrictions, together with any side funds formed in non-U.S. jurisdictions. Standalone non-U.S. funds will also be covered, if U.S. residents on their management teams are directing Chinese acquisitions.
- These funds will not be able to obtain advance clearance by the government of their deals, and so will need to self-determine whether a proposed Chinese company is engaged in any of the prohibited activities.
- Penalties on U.S. persons are expected to include civil fines. The divestment by funds of prohibited investments could be ordered.
- The effective date of the new rules on prohibiting acquisitions appears to be the publication date of the regulations in their final form, which is likely to be many months hence (despite indications that the Administration is moving quickly). U.S.-managed funds will not need to divest any existing Chinese holdings, and they may call capital to complete acquisitions before the effective date.
Recommendations for action
- This programme will raise many legal questions for U.S. fund managers as they seek to comply. UK institutional investors interested in Chinese technology should ensure that their U.S. fund managers and their investment advisors take a proactive and competent approach to this programme.
- UK investors should expect to receive communications from their managers explaining their intended approach. For example, some managers may wish to limit themselves to purchasing shares in public Chinese technology companies in future.
- UK investors should expect that their investment advisors recommend future commitments only to Chinese-oriented funds that are committed to complying with this programme.
- UK investors determined to maintain exposure to Chinese technology in these three sectors might consider investing in standalone funds formed outside of the United States, if they have few or no U.S. citizens or residents among their senior staff - assuming that it is realistic to determine this ab initio and to monitor it during the lengthy lock-up period of such funds (at least ten years).
- One imagines that the former Sequoia Chinese arm, now named HongShan, will scrupulously avoid U.S. persons among its senior staff - or arrange for their recusal.
- Chinese-oriented funds formed in member states of the European Union or the UK, however, would not be a good home for this strategy to the extent that their jurisdictions of formation or management impose similar reverse FDI legislation, as has been hinted at by the European Union and United Kingdom.
Summary
- UK institutional investors will be interested in how U.S.-managed private equity and venture capital funds oriented to Chinese technology adjust their investment goals in reaction to this new programme.
- While in no way offering investment advice, we at VWV can state that these changes in U.S. legislation are anticipated to have a future impact by deterring these funds' investment in the three specified sectors.
- Investors will wish to avoid the reputational risk arising from backing a fund manager that violates the future investment prohibitions.
- Also, UK investors should ensure that they make future commitments to U.S.-managed funds oriented to Chinese technology only in full awareness of the restrictions of the new programme.