Private capital and political risk: Lessons for dealmakers from investor-State disputes

Private capital accounts for a significant share of global foreign direct investment (FDI). States generally welcome private capital investment which may support economic growth and development, but that position can change if policy priorities or the geopolitical climate shifts.  

When the interests of States and foreign private capital investors diverge and investors face losses, investors may look to a number of different legal avenues for recourse, including international investment treaties. Investment treaties typically contain:  

• Substantive protections granted to qualifying investors of one State (home-State) who have an investment in another State (host-State), often including guarantees of fair and equitable and non-discriminatory treatment, and protection against unlawful expropriation;  
• The right for a qualifying investor to bring independent arbitration proceedings against the host-State when a dispute arises, rather than in the host-State's own courts. 

Investment treaties can therefore enable private investors to bring a claim for damages before an independent tribunal, when their investment has been undermined by host-State action which violates the substantive protections in an investment treaty. Significantly, there does not need to be a contract between the investor and the host-State for the investor to benefit from these protections.  

Particularly in the current climate of heightened geopolitical risk, increased nationalism, and regulatory flux as the world grapples with the climate crisis, private capital investors must anticipate how investor-State disputes may unfold over the lifecycle of an investment, including during deal structuring, deal closing, investment management, and investment exit.  

Deal structuring 

After identifying a prospective target, a private capital firm typically considers how to structure the transaction.  A conventional private capital structure involves (for a number of good reasons, including operational flexibility, tax, and liability issues): 

• One or more funds, usually organised as unincorporated partnerships in financial centres or tax-efficient jurisdictions. The fund is used as the collective investment entity of the partners. 
• A general partner (GP) which directs the fund(s), invests capital into the fund(s) and assumes unlimited liability for the fund(s). On investment exit, the GP usually receives compensation calculated on the performance of the investment. 
• Limited partners (LPs), typically corporate investors or individuals from multiple jurisdictions, who invest capital into the fund(s) and receive a pro rata share of the profits or losses of the fund(s).  
• One or more holding companies through which the fund(s) hold the investment.

Investment structures may involve other "entities" without legal personality, such as trusts, foundations or unincorporated associations. These structures can raise complex questions when considering rights available to the different entities within it under investment treaties. In particular: 

In a private capital investment context, when considering political risk, the key question is whether all of the upstream partners’ interests in the fund / holding companies are protected directly under a treaty between their home-State and the host-State, and if not, whether any entity downstream in the structure may satisfy the definition of "investor" under an applicable treaty so that they may bring a claim if needed.

Notably, tax-driven structures often mean investments involve offshore jurisdictions that form part of the territories of another State or are dependent on another State, such as Hong Kong, and the Cayman Islands. However, the treaties of that State may not extend to those territories / dependencies. These issues must all be considered at the outset of an investment when tax-structuring so that investors may be able to rely on treaty protections if needed down the line. 

Deal closing 

Host-State FDI screening is often a condition precedent to closing the transaction. National security and other domestic political concerns can lead to approval delays, conditions or refusals.

In an increasingly competitive market, this can create fertile ground for disagreements. For example, disputes may emerge when investors believe an FDI review contravenes treaty protections. In this circumstance, key questions private capital investors will need to consider are: 

• Whether or not the relevant treaty gives rise to protections prior to an investment closing. The protection offered by treaties ranges from broad (eg, applying to investors that “seek to make” an investment, or extending the non-discriminatory protections to establishment or acquisition of an investment) to narrow (eg, applying to investors that “have made investments”).  
• Whether or not the FDI process and outcome is in accordance with the rights and obligations in the relevant treaty, and if there are any applicable carve-outs to those obligations.

Investment holding and management 

Depending on the particular investment strategy, a private capital firm will typically hold and/or manage the investment for a 3 to 10-year period. During this time, for an equity investment, the investor may control the board and pursue operational improvements targeted at reducing costs and increasing revenue, to enhance value. However, in a debt investment context, the investor may simply hold the investment to obtain value accretion. In this holding and management period, host-State actions that alter the investment environment may trigger investor-State disputes.  

Common State actions that may prompt an investor-State dispute include: 

Investment exit 

The investment exit – which may be via an initial public offering or a strategic sale to a third party - is a critical step in the private capital lifecycle. This is when the GP is compensated for its efforts, LPs receive their capital and yield back, and liquidity is generated for future ventures. Host-State approvals or oversight are often key at this stage, particularly where the investment is in a ‘strategic’ or ‘sensitive’ sector. Disputes may arise at this stage too, and this is likely to be the subject of heightened scrutiny in the immediate future given the number of delayed exits. 

For private capital firms, anticipating State scrutiny of, or influence over, exits — and signalling treaty protections when necessary — is critical. 

Takeaways

Evolving State policy objectives and the changing geopolitical climate may cause private capital firm and States’ interests to diverge. Private capital firms should be alive to these issues, particularly at the deal structuring stage, to manage such risk with investment treaty protection.