The impact of the outbound investment rules on LP trades

The secondaries market continues to mature and evolve, offering limited partners (“LPs”) an essential tool for portfolio rebalancing, liquidity management and strategic realignment. However, the introduction of the U.S. outbound investment program (the “Program”), which came into effect on 2 January 2025, may add a new layer of complexity to secondary transactions involving U.S. investors.

Announced by the Biden administration and framed as a national security initiative, the Program aims to restrict or monitor certain outbound transactions engaged in by U.S. persons that involve persons affiliated with China, Hong Kong, or Macau with a nexus to the advanced semiconductors, quantum computing and AI sectors. President Trump has signalled that these sectors may be expanded to also include biotechnology, hypersonics, aerospace, advanced manufacturing, directed energy, and other sectors. While the Program is still undergoing refinement, market participants – particularly secondaries buyers, sellers and fund managers – must begin to assess the implications.

The Program

The U.S. Department of the Treasury (“Treasury”) issued a final rule implementing Executive Order 14105 on 28 October 2024 and this went into effect on 2 January 2025. The Program prohibits certain transactions made by U.S. persons and requires notification for other transactions.

What types of transactions are covered by the Program?

The Program imposes prohibitions or notification requirements on U.S. persons in connection with covered transactions that would involve or create a covered foreign person.

U.S. person nexus

The Program applies to transactions entered into by a “U.S. person”, which includes:

1. any U.S. citizen or lawful permanent resident;
2. any entity organised under the laws of the U.S. or any jurisdiction therein, including any foreign branch of such entity; and
3. any person in the U.S.

The Program also prohibits U.S. persons from “knowingly directing” a transaction to be entered into by a non-U.S. person that would be prohibited if entered into by a U.S. person.

Finally, the Program requires that U.S. persons take “all reasonable steps” to prohibit and prevent their controlled foreign entities from engaging in a covered transaction that would be prohibited under the Program (if engaged in by a U.S. person) and to notify Treasury if their controlled foreign entities engage in a covered transaction that would be notifiable under the Program (if engaged in by a U.S. person).

Covered transactions

The Program applies to certain transactions, including a U.S. person’s direct or indirect:

1. acquisition of an equity interest or contingent equity interest in a person that the U.S. person knows at the time of the acquisition is a covered foreign person; and
2. acquisition of a limited partner or equivalent interest in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund (in each case where the fund is not a U.S. person) that a U.S. person knows at the time of the acquisition likely will invest in a person of a country of concern that is in the semiconductors and microelectronics, quantum information technologies, or AI sector, and such fund undertakes a transaction that could be a covered transaction if undertaken by a U.S. person.¹

Covered foreign persons

Covered foreign persons are persons of a country of concern (defined as China, Macau or Hong Kong) engaged in a “covered activity” and other persons with significant financial ties to such persons. Persons of a country of concern include:

1. any citizen or permanent resident of a country of concern who is not also a U.S. citizen or permanent resident;
2. an entity with a principal place of business in, headquartered in, or incorporated in or otherwise organized under the laws of a country of concern;
3. the government of a country of concern, including any person acting for or on behalf of the government of a country of concern, and entities in which such government holds, directly or indirectly, individually or in the aggregate, 50% or more of the outstanding voting interest, voting power of the board, or equity interest or otherwise possesses the power to direct or cause the direction of the management and policies of such entity;
4. any entity in which a person or identified described above holds, directly or indirectly, at least 50% of the outstanding voting interest, voting power of the board, or equity interest; and
5. any entity in which one or more persons identified in (iv) above holds, individually or in the aggregate, directly or indirectly, at least 50% of the outstanding voting interest, voting power of the board, or equity interest.

In turn, covered foreign persons include:

1. person of a country of concern that is engaged in covered activities; and
2. any person (including, e.g., a U.S. entity or a U.K. entity) that directly or indirectly holds a board seat on, a voting or equity interest in, or any contractual power to direct or cause the direction of the management or policies of any person of a country of concern from or through which it derives more than 50% of its revenue or net income or incurs more than 50% of its capital expenditure or operating expenses, individually or in the aggregate across such persons from each of which it incurs at least $50,000 of the relevant financial metric.

Covered activities

The industries targeted by the Program are: (i) semiconductors and microelectronics; (ii) quantum information technologies; and (iii) certain artificial intelligence systems. U.S. persons’ covered transactions involving covered foreign persons engaged in certain specified activities within each of these industries are prohibited, and such transactions involving covered foreign persons engaged in a subset of activities in the semiconductors and microelectronics and artificial intelligence sectors are notifiable. As noted above, President Trump has signalled that these sectors may be expanded to also include biotechnology, hypersonics, aerospace, advanced manufacturing, directed energy, and other sectors.²

The knowledge standard

Although the Program only applies in situations where the U.S. person has “knowledge” of facts or circumstances that would mean the rules apply, “knowledge” under the Program includes actual knowledge, awareness of a high probability, or reason to know of a fact or circumstance.

Further, if Treasury assesses that an investor did not conduct a "reasonable and diligent inquiry,” the investor will be treated as if he or she had knowledge of the relevant facts and circumstances. The Program provides a list of factors (e.g., diligence, representations) against which Treasury will judge whether a U.S. person investor has engaged in a reasonable and diligent inquiry.

Excepted transactions

There are certain U.S. person transactions that effectively are carved out of the scope of the Outbound Investment Rules. For the purposes of this article, the relevant exceptions are satisfied if:

1. the LP’s committed capital is not more than $2,000,000 on an aggregate basis*;
2. the LP secures a binding contractual assurance at the time of its capital commitment that its contributions will not be used to engage in a transaction that would be a prohibited or notifiable transaction (as applicable) if engaged in by a U.S. person*;
3. the relevant investment is in a security issued by:
   1. Any “investment company” as defined in section 3(a)(1) of the Investment Company Act of 1940, as amended, at 15 U.S.C. 80a-3(a)(1), that is registered with the U.S. Securities and Exchange Commission, such as “’40 Act funds” managed by private equity sponsors, index funds, mutual funds, or exchange traded funds; or
   2. Any company that has elected to be regulated or is regulated as a business development company pursuant to section 54 of the Investment Company Act of 1940, as amended, at 15 U.S.C. 80a-53*; or
4. the transaction is entered into after 2 January 2025 pursuant to a binding, uncalled capital commitment that was entered into before 2 January 2025.

*With respect to 1.3(a), 1.3(b), and 1.3(c), the exception does not apply if the transaction affords the investor rights beyond standard minority shareholder protections (e.g., the power to prevent the sale or pledge of all or substantially all of the assets of an entity) with respect to the relevant covered foreign person.

The impact on secondaries

An LP secondary sale may not, on its face, appear to involve foreign technology investments. However, buyers who qualify as U.S. persons acquiring interests in funds with underlying exposures to covered foreign persons may fall within the scope of the Program, even if only indirectly, and could inadvertently enter into in a prohibited or notifiable transaction. Furthermore, buyers may encounter issues under the Program through their go-forward exposure to activities by the target funds – for example, through new portfolio investments or changes at existing portfolio companies.

Due to the Program’s knowledge standard, which requires investors to make a reasonable and diligent inquiry, buyers may now need to dig deeper into the portfolio companies of target funds, in particular, where fund documentation is silent on geographic or sectoral allocations. Buyers will likely need to perform enhanced “look-through” diligence on the portfolio companies of the relevant fund to identify any exposure to covered foreign persons. As described above, such covered foreign persons could include entities organized outside of China, Macau, or Hong Kong, and even could include portfolio companies that are organized in the United States (or anywhere else in the world). Such scenarios could occur if the portfolio company has sufficient financial ties to entities that are themselves covered foreign persons (e.g., a UK holding company that derives more than 50 percent of its revenue from a Chinese quantum computing company). A covered foreign person also could include a U.S. entity engaged in covered activities if it is majority owned or controlled by a person of a country of concern (e.g., a Chinese citizen living in the United States if such person is not a U.S. citizen or a U.S. permanent resident). These scenarios emphasize why conducting a “reasonable and diligent inquiry” is critical. In addition, a buyer may seek to obtain certain confirmations, which may increase the burden on both sellers and general partners (“GPs”) to provide transparency.

Practical considerations

Transaction Documents

In the market, some buyers are seeking to pre-emptively satisfy the requirement for an excepted transaction by building in binding contractual assurances in the transaction documents. During its negotiations of the transfer agreement, a buyer may ask for a direct warranty from the GP that none of the target fund’s portfolio companies is engaged in any covered activities or that none of the fund’s prior investments constituted “covered transactions.” The buyer also may ask for a separate covenant that none of the outstanding capital commitments inherited by the buyer would be used to engage in a “covered transaction,” that the fund not engage in any future investment that would constitute a covered transaction, or that the buyer be excused from any future investment that would constitute a covered transaction.

In order to allocate regulatory risk, a buyer may also insert language in the PSA that would effectively allow an interest to drop out of a sale if its inclusion may trigger prohibition or notification under the Program. Where certain interests seem more at risk of triggering the Program, this may also cause the buyer to adjust the weighting of the pricing.

Looking at this more widely, transaction documents may need to evolve to allocate responsibility for filings, notifications, or enforcement actions that arise post-closing.

Diligence

Buyers (and sellers, where appropriate) will need to update due diligence questionnaires (“DDQs”) shared with the GP to account for any potential regulatory triggers. Generally speaking, but especially where issues are identified through DDQs, buyers should review fund documentation and past capital call notices to identify any potential exposure to covered sectors or geographies. In order to satisfy the knowledge requirement (including the “reasonable and diligent inquiry” standard), buyers may also look to conduct desktop investigations into publicly available sources of information as part of their diligence process.

GP Engagement

As mentioned above, secondaries buyers may increasingly require GPs to provide representations or warranties concerning the fund’s exposure to countries and sectors covered by the Program. In addition, GPs may be asked to confirm (either in transaction documents or in due diligence) whether they anticipate making any investments that could trigger notification or prohibition under the Program (in the case of non-U.S. funds), if engaged in by a U.S. person. This could create tension between GPs’ investment flexibility and the compliance obligations of their U.S. investors, especially if the GP does not view the Program as applying directly to its strategy, and this could create difficulties for the overall transaction if the GP is unwilling to engage on this topic. GPs of funds that are themselves U.S. persons may argue that they have an ongoing obligation to comply with the Program, which will often be sufficient comfort for U.S. investors. However, for target funds that are not U.S. persons and therefore may not have ongoing compliance obligations themselves, additional comfort regarding go-forward compliance and/or investor excuse rights may be sought from the GP.

Investment Committee and Board Positions

Where the buyer will be obtaining rights to participate in the target fund’s investment committee and/or portfolio company board, additional attention should be paid to ensure that such participation does not trigger issues under the Program. Such participation may result in the buyer (or a U.S. person executive within the buyer) having ”knowingly directed” a covered transaction, unless the buyer satisfied the specific recusal requirements described in the Program. This is particularly a concern where the target fund is not a U.S. person and, therefore, may not otherwise have compliance obligations under the Program. Further, the buyer obtaining more than standard minority shareholder protections (e.g., a portfolio company board position) could negate the applicability of the potential exceptions described above.

Conclusion

The Program signals a new era of scrutiny on U.S. capital flows abroad, with implications that extend well beyond their national security origins. For secondaries market participants, the reach of this policy is being felt by U.S. buyers and it is important that transferring parties are alive to these regulations and the issues they may cause. By developing proactive diligence, risk management, and contractual frameworks, investors can continue to transact with confidence in an increasingly complex regulatory environment.

References

1. Although this provision applies only to investments in non-U.S. funds, an investment into a U.S. fund that holds an interest in a covered foreign person could be a covered transaction if it results in an “indirect acquisition of an equity interest . . . in a . . . covered foreign person.”
2. Some transactions that would be notifiable are instead treated as prohibited if the relevant covered foreign person is included on certain sanctions lists or meets certain sanctions-related definitions maintained by U.S. Government agencies.

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