A Moving Target
How tariffs between the U.S. and China are impacting M&A processes
Recent shifts in trade policies, particularly with respect to tariffs involving the U.S. and China, are impacting the current M&A environment. Although M&A dollar volumes have remained strong, the pace of activity in the U.S. M&A market has slowed in recent months, with ongoing uncertainty related to tariffs potentially a factor. Current and prospective tariffs may affect companies involved in existing M&A processes, particularly with tariff issues still unresolved as the latest round of trade discussions between the U.S. and China begins in earnest. Active consideration of any tariff factors is critical to the success of those processes based on where tariffs stand – both today and potentially tomorrow.
Increased Tariffs Weigh Down Corporate Results
Since mid-2018, tariffs have been enacted on an expanding set of products imported from China into the U.S. As summarized in the table below, these tariffs have been met with retaliatory tariffs for products imported from the U.S. into China, with additional large-scale tariffs being considered by government leadership in both markets. This combination of existing and pending tariffs has consequences for U.S.-based companies with supply chains extending to China. Such companies operate in a wide range of critical industries – including consumer, industrial, healthcare, and technology hardware – that comprise a large portion of the U.S. economy.
|Timeline of Recent U.S.- China Trade Developments
|U.S. announced first set of tariffs on $50 billion of Chinese imports at rate of 25%
|China announced retaliatory tariffs on $34 billion on U.S. imports, including agriculture products, at 25% rate
|$34 billion of U.S. tariffs on Chinese imports went into effect
|China’s retaliatory tariffs on $34 billion of U.S. imports went into effect
|U.S. detailed second set of tariffs on $200 billion of Chinese imports at rate of 10%
|U.S. trade representative confirmed potential to raise tariff rate on $200 billion round from 10% to 25%
|China announced planned second round of tariffs on $60 billion of U.S. imports if $200 billion round takes effect
|Remaining $16 billion of first set of U.S. tariffs on Chinese imports went into effect
|Remaining $16 billion of first set of China’s tariffs on U.S. imports went into effect
|U.S.D.A. announced aid package for farmers impacted by China’s retaliatory tariffs
|U.S. announced $200 billion round would have 10% rate from 9/24/18 through 12/31/18, followed by 25% rate
|Second set of U.S. tariffs, on $200 billion of Chinese imports, went into effect at 10% rate
|China’s retaliatory tariffs on $60 billion of U.S. imports went into effect at rates of 5% to 25%
|President Trump threatened tariffs on remaining $250+ billion of Chinese imports in early 2019 if no deal is reached in late 2018
|After G20 meeting between President Trump and President Xi Jinping of China, U.S. announced pause in planned 1/1/19 tariff increase from 10% to 25% on $200 billion of Chinese imports, with tariffs to be raised if no deal is reached in next 90 days
These tariffs are negatively impacting the margins of companies importing materials and finished products from China. In the latest round of quarterly earnings calls, many leading manufacturers, including Caterpillar and 3M, cited rising tariff costs as dampening profitability. In recent Manufacturing ISM reports, several surveyed respondents operating in industrial and consumer segments noted cost inflation related to tariffs for directly imported products and for their suppliers importing from China.
Although tariff impacts may eventually flow through partially or entirely to the prices paid by distributors, retailers, consumers, and other end users, any lag in price increases likely dampens profit margins during the interim period in this scenario. In some cases, companies may decide to absorb the drag on margins caused by tariffs due to the anticipated negative impact of higher prices on demand or competitive position. Further, companies with more limited pricing power may be unable to recoup additional costs with price increases.
On top of the direct impact on profit margins, tariffs have the potential to disrupt the operations of companies. Distributors and manufacturers uncertain about their ability to pass through the higher costs of imported products could alter their ordering patterns to minimize the level of inventory subject to tariffs. Manufacturing ISM reports have noted potential for delays in materials coming from China due to a glut of orders placed prior to the anticipated implementation of tariffs. Due to tariffs, some companies are also making or considering alternate supply sources in countries other than China, although any supply-chain shifts would take time. Such disruption to ordering practices and supply-chain operations could create greater month-to-month variability in results.
Tariff Impact on M&A Environment
With all of this as the backdrop faced by many companies, it’s fair to say that the current tariff situation is evolving and should be considered when launching a M&A process. This analysis focuses on how participants in M&A sale processes can manage the current environment with respect to tariffs.
Any M&A sale process involving companies impacted by tariffs should identify, forecast, and prepare for various future scenarios. Businesses impacted by tariffs should work with their advisors to outline short-term and long-term tariff management strategies and integrate those plans into their financial projections. To the extent advisable for pro forma comparability purposes, historical and projected results should be presented in marketing materials in a way to isolate any tariff impact, especially that which proves to be temporary.
Different Buyer Dynamics Alter Processes
For many targets, initial outreach efforts should prioritize potential buyers that are able to more easily manage and understand any near-term impact caused by tariffs. Among prospective buyers, strategics may be better positioned than financial sponsors to look past the reduced operational predictability caused by the tariffs faced by target companies. Corporates generally plan to make acquired targets a permanent part of their business. Accordingly, such acquirors take a longer-term view of potentially transitory issues such as tariffs and therefore can justify purchase price valuations that reflect minimal impact from dampened near-term results for targets. Furthermore, strategics already coping with their own challenges related to tariffs may have a good handle on the tariff situation faced by targets, whereas tariffs may represent less familiar territory for certain financial sponsors.
Relative to corporates, financial sponsors have a more condensed timeframe for realizing a sufficient return on acquired businesses. The initial 6-12 month period following an acquisition is particularly important for sponsor owners due to the need to meet covenants, execute investment strategies, and maintain leverage levels. Therefore, proper positioning of any impact of tariffs on a business, including detailed mitigation plans and strategies, is paramount.
Flexibility in Process Structure and Changes in Buyer Demand
Given the dynamic nature of the tariff situation, the sale process strategy and architecture should allow for a range of scenarios depending on how companies perform under tariffs and how trade negotiations play out between the U.S. and China. Targets able to pass through tariff-related price increases are able to demonstrate the strength of their value proposition and should generate widespread interest in the current M&A market. Further, an understanding of the buyer landscape and specific buyer views on the tariff situation is helpful when constructing a sale process and buyer outreach.
The current tariff situation is part of a broader set of challenges in U.S.-China relations. In recent years, foreign buyers (from China and elsewhere) seeking to acquire in the U.S. have faced increasing intervention from the Committee on Foreign Investment in the U.S. (CFIUS). As detailed in this article, CFIUS reviews have become more common, with extra scrutiny most likely for any proposed investments in the U.S. by Chinese entities. Largely as a result of this factor, the number of majority-stake acquisitions by China-based acquirors of U.S. targets decreased 30%+ on a year-to-date basis, extending a substantial downturn that began last year, when such deal activity declined 35%. Greater focus on inbound M&A from a national security perspective could likely continue, as legislation enacted earlier this year broadened the reach of CFIUS.
The potential impact of tariffs on M&A activity is meaningful and prompts consideration in today’s strong M&A market. This moving target of trade policy places an imperative on companies pursuing M&A and their advisors to consider more scenarios when performing forecasting and analysis, adjust focus on and messaging to specific buyers, and explore more flexible process structures. It is critical that companies have direct, robust discussions with their M&A advisors to ensure the ability to adapt successfully to the dynamic tariff situation.
For more information, contact a member of our Global Mergers & Acquisitions team.