Changes to the Foreign Investment Framework: Implications for Private Equity and Venture Capital Investment in Australia

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1 16 May 2016 Mr Adam McKissack Principal Adviser Foreign Investment and Trade Policy Division The Treasury Langton Crescent PARKES ACT Dear Adam Changes to the Foreign Investment Framework: Implications for Private Equity and Venture Capital Investment in Australia Thank you for the opportunity to put forward a submission in relation to recent changes to the foreign investment framework. This submission follows on from our letter of 12 February 2016 and our meeting of 10 March 2016 in which we outlined certain issues which have emerged following the reforms to Australia s foreign investment framework which came into effect on 1 December The Australian Private Equity & Venture Capital Association (AVCAL) is a national association which represents the private equity and venture capital industries. AVCAL's members comprise most of the active private equity and venture capital firms in Australia, who together manage over A$28 billion on behalf of Australian and offshore superannuation and pension funds, sovereign wealth funds and family offices. Private equity and venture capital firms provide capital for early stage companies, later stage expansion capital, and capital for management buyouts of established companies. These businesses help contribute more than 4% per annum to Australia s national output and support, both directly and indirectly, over 500,000 jobs. 1 Owing to the fact that a significant proportion of the investment capital managed by private equity and venture capital firms is sourced from institutional investors based offshore, Australia s foreign investment policy framework including tax conditions is highly relevant and important to the efficient functioning of our industry. As Australia transitions away from resources to innovation as a key driver of growth, it is essential to ensure there is adequate and timely access to capital. In particular, we note that there is a renewed focus by Government on stimulating innovation in Australia, with private equity and venture capital funds essential to this process. Much of the capital invested by these funds is in smaller, high growth Australian companies, with a particular focus on innovating and expanding established businesses and commercialisation of research & development. The revised foreign investment framework has the potential to deter such investments, given the costs and time involved (detailed below) would be disproportionate to the size of the intended investment. Accordingly, Australian businesses would be denied the capital and expertise of private equity and venture capital funds which is critical to driving growth and innovation across our economy. 1 Deloitte Access Economics, The Economic Contribution of Private Equity in Australia, 2013

2 As highlighted below, several issues in relation to the foreign investment reforms have emerged as potentially significant roadblocks to investment by fund managers of private equity and venture capital funds (each, a fund) in Australia. These relate to: the broad definition of the term foreign government investor ; new application fees for the new statutory notification requirements for foreign government investors 2 ; and their flow-on effects on managed funds and businesses with FGI investors. The purpose of this submission is to outline potential solutions to the above problem, within the existing legislative framework. AVCAL stands ready to work with the Government in whatever way possible to address these issues. 1. Background and context As used in this submission, the term Relevant Fund Information means: information about the fund manager; basic information about the fund s governance rights; and the name, jurisdiction and percentage ownership of each person that holds 5% or more of the FGI Fund Vehicle and each person that is an investor in the FGI Fund Vehicle that is a foreign government investor (regardless of percentage interest held). In summary, as a result of the December 2015 reforms: 1) in many cases, one or more (pre-existing or new) vehicles comprising a fund will be considered to be a foreign government investor (FGI Fund Vehicle) because its investors comprise 20% or more foreign government investors from a single country or 40% or more foreign government investors from multiple countries (see section 17 of the Foreign Acquisitions and Takeovers Regulation 2015 (FATR)); 2) this can be the case even though, if calculated on a whole of fund basis, the fund itself would not meet the thresholds described above and would not be considered to be a foreign government investor; 3) an FGI Fund Vehicle must make an application to the Foreign Investment Review Board (FIRB) and obtain a statement of no objection (FIRB approval) to acquire 10% or more (or less than 10% in certain circumstances) of an Australian target, regardless of the value of the target or the investment (see section 56 of FATR); 4) if the FGI Fund Vehicle acquires 20% or more of a target, the target will be considered to be a foreign government investor, and will need to obtain FIRB approval to acquire 10% or more (or less than 10% in certain circumstances) of an Australian target, regardless of the value of the target or the investment (see sections 17 and 56 of FATR); 5) the circumstances described in point (4) above are particularly difficult for the company which the fund invests in (investee), because: o it is frequently part of a fund s strategy to cause the investee to make bolt-on acquisitions (i.e. where an investee grows its business by acquiring companies in the same or similar industry which provide complementary services, technology or geographic footprint diversification); o the small size of these acquisitions means the fees charged may dwarf the other transaction costs o and are disproportionate to the risk posed by the investment; and the investee will generally not have access to the Relevant Fund Information, and in many cases this is subject to confidentiality restrictions, which can result in delays in obtaining FIRB approval; 6) application fees are $25,000 (where the FGI Fund Vehicle or investee, as applicable, would not be required to obtain FIRB approval but for the operation of section 56 of FATR) (see section 7 of the Foreign Acquisitions and Takeovers Fees Imposition Act 2015 (Cth)), and therefore the introduction of the fee regime has had a disproportionate impact on investments by FGI Fund Vehicles as compared to other foreign investors into Australia. 2 While we recognise that the treatment of many funds as foreign government investors and the notification requirements applying to them has been policy for some time, there was significant ambiguity in the application and effect of the policy which has now been removed which, coupled with the new application fees, has had a significant impact on fund managers. 2

3 Fundamentally, we believe that resolving these issues is in Australia s national interest, including the ongoing need to attract productive foreign investment at a time of economic transition: 1) Private equity and venture capital funds many of which would be considered to be foreign government investors due to upstream investments by pension funds and sovereign wealth funds invested around $3.2bn into Australia last financial year alone. Requiring these funds to obtain approval for such a wide range of transactions puts them at a competitive disadvantage, particularly in a bid situation, as compared to other investors who may not need FIRB approval. The fund managers that manage these funds may ultimately elect to take less money from pension funds and sovereign wealth funds (meaning less money for investment in Australia) due to the increase in time & financial costs resulting from the introduction of application fees. 2) As noted above, bolt-on strategies are important for fund managers. The volume of applications made by investees of FGI Fund Vehicles is high. For example, since 1 December 2015, one investee for one fund has made four applications for bolt-on acquisitions ranging in value from $1.2m to $45m, paying over $100,000 in application fees. The fund expects that it or its investees will make a further 20 applications in the 12 months to 30 November 2016, purely as a result of section 56 of FATR. We are also aware of one potential roll up transaction that has been abandoned due to the relatively high cost of doing business in Australia, given the introduction of the new regulatory regime. 2. Executive summary recommendations to Government In summary, to address the issues arising from the December 2015 changes to the foreign investment framework, we propose the following: 1) Issuance of an exemption certificate where a fund would not be considered a foreign government investor if calculated on a whole of fund basis (see section 3 below); 2) Issuance of an exemption certificate on an annual basis under certain prescribed circumstances (see section 4); 3) Issuance of an exemption certificate for bolt on acquisitions under certain prescribed circumstances (see section 5); 4) Widening the current de minimis exemption to better reflect market realities (see section 6); and 5) Alternatively, if these exemptions are not granted, a reduced fee regime should be introduced so as not to deter much needed foreign investment into Australia (see sections 7-8). More broadly, we recommend a regulatory amendment to better target when a fund will require foreign investment approval (see section 9). 3. Exemption certificate not FGI on whole of fund basis We understand that a guidance note is potentially being prepared which would clarify that a fund would not be considered to be a foreign government investor if, on a whole of fund basis, the relevant threshold ownership percentages are not met (notwithstanding that one of the fund vehicles may meet the threshold ownership percentages). If this guidance note option is not pursued, we submit that a new exemption certificate should be issued, pursuant to section 63 of the Foreign Acquisitions and Takeovers Act 1975 (Cth) (FATA), to exempt a fund from the operation of section 56 of FATR where the fund is not a foreign government investor when considered on a whole of fund basis. In particular, an FGI Fund Vehicle should be exempt from the operation of section 56 of FATR where: 1) the fund of which the FGI Fund Vehicle is a part would not be considered to be a foreign government investor on a whole of fund basis; and 2) the fund governance structures are such that it is appropriate for the foreign government ownership test to be administered on a whole of fund basis. 3

4 The effect of this exemption certificate would be that section 56 of FATR would not apply to the fund, but Division 2 (significant actions) and 47 (notifiable actions general) of FATA would continue to apply. 4. Exemption certificate annual exemptions Similarly, we submit that a new exemption certificate should be created to exempt an FGI Fund Vehicle from the requirement to obtain FIRB approval for an annual program of business acquisitions (see section 63, FATA). Specifically, an FGI Fund Vehicle should be exempt from section 56 of FATR where: 1) the FGI Fund Vehicle provides the Relevant Fund Information; 2) the FGI Fund Vehicle specifies a maximum individual investment (which is below the then current monetary threshold) and maximum aggregate annual investment; 3) the investments will not include investments in sensitive businesses; and 4) the FGI Fund Vehicle notifies FIRB on a quarterly basis of investments made under the exemption certificate. The effect of this exemption certificate would be that section 56 of FATR would not apply to the fund, but Division 2 (significant actions) and 47 (notifiable actions general) of FATA would still apply. 5. Exemption certificate bolt on acquisitions An equivalent exemption certificate should be issued to exempt investees from the requirement to obtain FIRB approval for bolt-on acquisitions for a period of 5 years. In particular, an investee should be exempt from section 56 of FATR where: 1) the FGI Fund Vehicle received FIRB approval to acquire its interest in the investee and provided the Relevant Fund Information in its application; 2) the FGI Fund Vehicle certifies that the Relevant Fund Information has not changed since that prior application was lodged; 3) the investments will not include investments in sensitive businesses; and 4) the investee notifies FIRB on a quarterly basis of investments made under the exemption certificate. We note that such an acquisition may actually involve two notifiable actions under the current regime that is, the additional injection of cash into the investee by the fund, and the acquisition by the investee of the bolt-on target. The exemption certificate should cover both of these. The effect of this exemption certificate would be that section 56 of FATR would not apply to the fund or the investee in relation to the bolt-on, but Division 2 (significant actions) and 47 (notifiable actions general) of FATA would still apply. 6. Expanding the de minimus exemption section 56(4) of FATR Section 56(4) of FATR provides for an exemption for FGI where: 1) the FGI acquires the direct interest in the Australian entity by acquiring an interest in securities in a foreign entity; and 2) the total asset value for the foreign entity is less than 1% of the value of the total assets of that entity; and 3) the total asset value is less than $10m; and 4) none of the assets taken into account in working out the total asset value are assets of a sensitive business. We submit that this exemption is exceedingly narrow, and would therefore be very rarely used. Instead, we recommend that the thresholds be increased, for example to 10% of the total asset value and $100m. Such a change would better reflect market realities, and not deter foreign investment, without compromising the underlying policy rationale behind the legislative provision. 4

5 Indeed, we note that many FGI Fund Vehicles will make off-shore investments where the target entity has an Australian business. That business may be relatively immaterial, however the asset value would easily exceed the prescribed thresholds, thereby triggering the FIRB regime. 7. Fee exemption under section 115 of FATA Section 115 of the FATA gives the Treasurer the power to grant relief from payment of fees if the Treasurer is satisfied that it is not contrary to the national interest to waive the fee. We submit that the high volume of applications made by FGI Fund Vehicles that would not be required but for the operation of section 56 of FATR, combined with the passive nature of the investment by the actual foreign government investors in the FGI Fund Vehicle and the benefit to Australia of the investment, means waiving fees in the circumstances described below would not be contrary to the national interest. In particular, in our view, the Treasurer should grant fee relief to an FGI Fund Vehicle in circumstances where: 1) there is no significant action or notifiable action but for the operation of section 56 of FATR; 2) the FGI Fund Vehicle has made at least one prior application for FIRB approval during that financial year which discloses the Relevant Fund Information; and 3) the Relevant Fund Information has not changed since that prior application was lodged. We further submit that the high volume of applications lodged by an investee of an FGI Fund Vehicle that would not be lodged but for the application of section 56 of FATA, combined with the low value of the acquisitions made by the investee and the benefit to Australia of the investment, means waiving fees in the circumstances described below would not be contrary to the national interest. In particular, the Treasurer should grant fee relief to an investee in circumstances where: 1) there is no significant action or notifiable action but for the operation of section 56 of FATR; 2) the FGI Fund Vehicle received FIRB approval to acquire its interest in the investee and provided the Relevant Fund Information in its application; 3) the FGI Fund Vehicle certifies that the Relevant Fund Information has not changed since that prior application was lodged. The effect of these recommended changes would be that, subject to the above conditions, an FGI Fund Vehicle would only pay a fee once per annum, and an investee would not pay application fees at all, where the only significant action or notifiable action is due to the operation of section 56 of FATR. This would not affect the operation of Division 2 (significant actions) or section 47 (notifiable actions general) of FATA, including the obligation to pay the full fee for applications under those sections of FATA. 8. Lower fees for bolt-on acquisitions Alternatively, if a fee exemption is not provided, we submit that given the similarity in and small size of transactions that an investee would be notifying substantially lower fees should be imposed on investees in certain circumstances. Relevantly, section 11 of the Foreign Acquisitions and Takeovers Fees Imposition Act 2015 (Cth) provides that lower fees may be prescribed by regulation. In particular, the Treasurer should reduce the application fees where: 1) there is no significant action or notifiable action but for the operation of section 56 of FATR; 2) the FGI Fund Vehicle received FIRB approval to acquire its interest in the investee and provided the Relevant Fund Information in its application; 3) the FGI Fund Vehicle certifies that the Relevant Fund Information has not changed since that prior application was lodged. 5

6 The effect of these changes would be that, subject to the above conditions, an investee would pay lower fees where the only significant action or notifiable action is under section 56 of FATR. This would not affect the operation of Division 2 (significant actions) or section 47 (notifiable actions general) of FATA, including the obligation to pay the full fee for applications under those sections of FATA. 9. Definition of foreign government investor Notwithstanding our proposed solutions outlined above, we continue to have concerns with the proposed application of the new foreign investment regime to funds. We believe that the restatement of the legislation was a missed opportunity to distinguish between different types of government investors by imposing reduced review thresholds particularly for fund managers with investors including foreign government limited partners. The significant difference between an investment by a foreign government or its instrumentalities, and most investments by funds, should be recognised in Australia s regulatory regime. The fact that other countries do not have such controls or have higher review thresholds means that Australia s approach imposes unnecessary costs and delays for funds undertaking foreign direct investment, thereby encouraging them to invest elsewhere. This is a serious practical issue, especially given the current regime requires regulatory approval in most cases of non-government owned fund managers and other fund managers wishing to make Australian investments. Accordingly, our proposal is to exempt non-controlling (limited partner) investment by commercial funds such as private equity and venture capital funds so that the thresholds are consistent with the general review thresholds (these investments are typically made via Australian venture capital limited partnership (VCLP) vehicles). In particular, the definition of foreign government investor as it applies to a partner of a limited partnership is overly broad and should be amended. Limited partners in a typical limited partnership model are passive investors that have no capacity to influence the management or control of the limited partnership. Management and control is exercised through the fund manager. Therefore, limited partnerships that have government entities (such as pension funds) as passive investors should not be the subject of foreign government investor regulation. Accordingly, we recommend that limited partners that are foreign government investors (for example, via a VCLP) should be excluded by regulation from the definition of a foreign government investor. 10. Next steps We would like to thank you for considering this submission, and look forward to continuing our engagement with you on the new foreign investment regime, and its impact for our members, and the broader economy. We will be in touch with you in the coming days to discuss these issues further. I can also be contacted on Yours sincerely Yasser El-Ansary Chief Executive 6