August 9, 2023
By Elena McGovern, Daniel Silverberg, and Thomas P. Feddo
What’s the News:
The Biden Administration released its long-awaited Executive Order (EO) today, August 9th, 2023, titled “Addressing United States Investment in Certain National Security Technologies and Products in Countries of Concern.” The move marks the most significant US government oversight to date of how US institutional investors may deploy capital into key sectors of the Chinese economy. The EO and the accompanying Advanced Notice of Proposed Rulemaking (ANPRM) issued by the Treasury Department target a small number of Chinese strategic sectors—semiconductors and microelectronics, quantum information technologies, and certain artificial intelligence systems—the advancement and indigenization of which within China would have implications for US national security.
The ANPRM provides for a 45-day notice and comment period, which will allow industry participants, including Capstone’s clients, to share feedback and seek necessary clarifications. Importantly, it does not implement the EO and should also not be considered draft regulatory text, per the Treasury Department.
This is the latest move by the Biden administration to advance its goal of “de-risking” the United States economy from China and, in the words of US National Security Advisor Jake Sullivan, “ensuring that US and allied technology is not used against us.”
Our Take:
Capstone believes the EO represents the start of more emerging long-term, looming Chinese investment risk. The contours of the EO are consistent with Capstone’s previous call—specifically, that it would apply to investments in key sectors already receiving significant regulatory attention – advanced semiconductors and microelectronics, AI, and quantum computing. We believe that these proposed regulations—while not in effect right now—will still have an immediate chilling effect on private equity, venture capital, and corporate investment into these named sectors, and likely beyond. Indeed, we reinforce our position that these proposed regulations, while consequential in and of themselves, should also be seen as a shot across the bow to the broader US investment community invested in strategic and high-tech sectors of the Chinese economy.
The Treasury Department, via its ANPRM, is specifically seeking public comment on the proposed scope of the program, which includes the following:
These regulations would be applicable to the US institutional investor community, given that it defines “covered transactions” as those that “could convey intangible benefits, specifically: acquisition of equity interests (e.g., via mergers and acquisitions, private equity, venture capital, and other arrangements); greenfield investments; joint ventures; and certain debt financing transactions that are convertible to equity. The Treasury Department is seeking feedback on certain types of carve-outs, including publicly-traded instruments and intracompany transfers from US parents to subsidiaries.
The nuance in seeking to prohibit investments in semiconductors and quantum computing while only seeking notification regarding AI investments was also notable.
We are still looking to unpack certain elements of the proposed rulemaking, including potentially how far it could extend to foreign entities, namely by the inclusion of “notification to the Department of the Treasury of any transaction by a foreign entity controlled by such United States person that would be a notifiable transaction if engaged in by a United States person.”
Comparing the EO to Congressional Efforts and Expectations
The EO differs in meaningful ways from the current Congressional effort to restrict US outbound investments—the bipartisan Outbound Investment Transparency Act (OITA) in terms of the sectors covered and the restrictions sought. OITA merely imposes a reporting requirement, whereas this EO expressly prohibits US capital flows to semiconductors and quantum computing. However, OITA covers additional sectors beyond the EO, namely hypersonics, satellite-based communications, and networked laser scanning systems with dual-use applications.
While unprecedented, the scope of the EO and the ANPRM is still far weaker than what congressional hardliners on China would have preferred, as indicated in part by the evolution of draft legislation over the last two years. At one point, there were calls for establishing a CFIUS-like interagency review process to approve transactions. For its part, the OITA is an even more circumscribed version of the 2022 National Critical Capabilities Defense Act (NCCDA) introduced by Sens. Bob Casey (D-PA) and John Cornyn (R-TX) as a standalone bill and that came with significant questions around scope and enforcement.
Investment Implications to Grow
Capstone believes that investors should not take much comfort in the fact that the EO is more limited than what Congress had previously contemplated. The political pressure to build upon these new authorities, once finalized, will only grow, and we could see its scope expand in the not-to-distant future—particularly in the areas aligned with the White House’s Critical and Emerging Technologies List, which goes far beyond semiconductors and AI to include communications and networking, renewable energy, space technology, biotechnology, autonomous systems and robots, and others. Indeed, the EO specifically calls for an assessment of the regulations within a year after they become effective with the goal of adding or removing technologies and products subject to the regulations.
More broadly, we expect US-China “de-risking” or “decoupling” to further accelerate after the 2024 elections, both in Congress and in either a Democratic or Republican White House.
What’s Next:
The EO will have an associated notice and comment period before it is implemented, which will provide an opportunity for those impacted—including potentially Capstone’s clients—to weigh into the process. Capstone will be closely monitoring that process.
Capstone is also monitoring the current NDAA process and the extent to which the OITA survives the reconciliation process between the House and Senate versions of the bill. Congressional reaction to efforts at restricting US investors from these strategic, potentially dual-use technologies in China highlights that anti-China sentiment is not monolithic. Six Senators voted against including the OITA as an amendment to the Senate version of the 2024 National Defense Authorization Act (NDAA), including GOP Sen. Tom Tillis and Independent Senator Kyrsten Sinema. Congressman Patrick McHenry, a prominent Republican leader, likewise railed against efforts to restrict investment in the past, in part based on a free speech argument. Capstone expects a final NDAA by December and will be tracking the OITA amendment as a part of that process.
The administration will likely issue an update to the Export control restrictions on semiconductor technology from last October, which we are also closely monitoring. Finally, the administration has made clear that preventing China from benefitting from external knowledge and investment will not be effective without a coordinated effort among US allies. The G7 has already said that such efforts “could be” part of the solution. Capstone will continue to monitor the diplomatic efforts to restrict outbound investments by other countries.
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