December 11, 2018
By Curt Moldenhauer, PwC Cross-Border Deals Leader
After decades of being a driving force behind globalization, the United States in the past two years has retreated from the world stage. President Donald Trump’s “America First” doctrine carried over from his campaign to his administration, withdrawing the US from the Trans-Pacific Partnership immediately after he took office and criticizing the World Trade Organization and NATO. Just last month, the distance between Trump and other Western leaders at World War I remembrance events in Europe was evident. Even more recently, Trump spent only 48 hours at the Group of 20 (G20) summit in Argentina, where the US was the only nation to not sign a statement reaffirming a commitment to the Paris climate agreement.
When you add new tariffs on foreign goods and Trump’s tough stance on immigration, this isolationist approach has become a major political and cultural issue, including in the 2018 midterm elections. Although Democrats will control the US House of Representatives in January, they didn’t make tariffs and trade wars a top campaign issue. This lack of a determined countervailing force domestically suggests that the government’s protectionist approach to trade is likely to be with us for some time.
This new government “industrial policy” has forced many US companies and investors with ties to other countries to begin to adapt. Some have reported adverse short-term impacts related to cost structure, and some are considering revising segments of their supply chain. But reacting and retrenching isn’t enough. Companies and private equity (PE) firms should be more proactive and explore investments that not only protect their organizations in the current landscape but put them in a stronger position for years to come. This includes M&A and other deals that may depart from their traditional strategies.
Seismic shifts in US trade policy
The Trump administration has been vocal about trade on multiple fronts, with negotiations between the US and various nations in different stages. Trump joined the leaders of Canada and Mexico at G20 to sign a trade deal intended to replace the North American Free Trade Agreement (NAFTA), but the deal still must be approved by each country’s legislature.
Tariffs on steel and aluminum imports from Europe, which the US instituted suddenly early this year, have been rolled back. But Trump has threatened tariffs on European-made automobiles and auto parts and generally bemoaned the US trade deficit and restrictions on some US goods.
Then there’s China. At G20, Trump and Chinese leader Xi Jinping agreed on a truce that will prevent additional tariffs for now. Trump had threatened to raise tariffs on $200 billion of Chinese goods from 10% to 25% starting Jan. 1. Now the two countries have until March 1, 2019, to negotiate a trade agreement. But existing US tariffs remain, and their respective statements highlight different elements of the truce, raising questions about how long it will hold.
The US would seem to have more leverage based on the current import-export balance, but American businesses and consumers will still feel pain – including lower profits, higher prices and reduced global competitiveness – if the trade war continues. China also could escalate the situation by implementing non-tariff barriers – such as depreciation of the yuan, delays at ports of entry, boycotts, rules of origin and other barriers to investment – that could further punish US companies.
Reassessing value in a changing deal environment
In the months immediately after the new tariffs, many companies understandably took a wait-and-see approach on the potential for a full-on trade war. That’s now over, as cost impacts are starting to emerge more clearly. So far, US companies have explored supply chain adjustments as tariffs in steel and other areas ripple through different sectors and raise prices. Foreign exchange rates also have been affected, with the trade war contributing to the appreciation of the dollar since early this year.
This impact on the cost environment is also spreading to M&A – deals being negotiated now and contemplated for later. On the sell side, companies wrestling with tariffs are at risk of lower valuations if acquired in a potential deal, which could require additional pricing adjustments between parties. With PE firms, tariffs could affect the value of some current investments and extend time horizons for return on investment (ROI).
For buyers, the growing challenge is capturing value after the deal. Tariffs add another level of complexity in assessing an asset when calculating the projected ROI. When considering an acquisition – especially cross-border transactions – dealmakers will need to reassess value in multiple areas:
- Understanding more precisely the value chain in which a company participates and quantitatively defining low-, medium- and high-tariff scenarios within that value chain. Using this analysis, acquirers can calculate potential impacts on valuation.
- Defining the current percentage of a target’s overall direct material spend that is – or could be – targeted for tariffs.
- Articulating new make or buy strategies for procurement that could access alternative supply chains with less vulnerability to tariffs.
- Exploring value-engineering opportunities that replace materials targeted by tariffs with acceptable alternatives.
Turning an eye inward
Even before the recent rhetoric, some companies questioned how global they need to be. In certain industries, adding scale locally is more important than being a worldwide organization, and The Economist found earlier this year that since 2015 companies that had a significant portion of their sales outside their home nations were less profitable than those with mostly domestic sales.
The ongoing trade tensions could tempt some to pursue in-country deals – either a competitor if the goal is building scale or a business in a different sector that could expand a buyer’s offerings. Cross-border deals have typically been only about one-fourth of US deal volume in recent years, according to a PwC analysis of Thomson Reuters data, and some companies already may be eyeing domestic possibilities more closely. After growing steadily for a year, the number of outbound US deals dipped by about 20% in the third quarter of 2018.
Adapting cross-border deal strategy
Yet the allure of overseas markets endures for some investors. We’ve noted before that there’s potential to mimic past trade squabbles and pivot from trade to tariff jumping and cross-border deals – M&A, alliances and JVs, and other investments. But that could be difficult for companies in some industries as the US and other nations have increased scrutiny of foreign investments.
To navigate this hazier environment and stay on a growth path, US companies and investors should be both flexible and diligent with cross-border ventures. We could see growing interest in other types of deals, such as alliances and joint ventures, as well as greenfield investment in the months ahead. And while M&A may be less prolific than before, there are areas of opportunity below the radar:
- Reconsider deal size. Many deals blocked recently by the US and Chinese governments have been at least $1 billion in value, and in some cases much more. That magnitude may have been a factor in government scrutiny. More moderate acquisitions may raise fewer concerns and still allow a company to move forward with its growth strategy.
- Smaller countries out of the tariff spotlight may yield possibilities. Some emerging markets have emerged, and economic power is dispersed. With information barriers largely gone, cities are more connected than ever. An urban hub in a less developed nation could offer similar quality investments to traditionally targeted countries.
- Some sectors don’t rise to a high level of regulatory scrutiny by the US and other countries, or they don’t involve as many atypical risks, even with expanded government reviews. Yes, technology has been the hottest sector for cross-border deals, accounting for 30% of volume through mid-November this year, according to a PwC analysis of Thomson Reuters data. But that leaves 70% across a wide range of industries, including some – such as consumer products, real estate and certain manufacturing – in which the security and intellectual property concerns likely aren’t as great.
There’s little doubt that the current trade tensions have made some aspects of M&A more tenuous. But with the right adjustments, corporate and private investors can navigate the turbulence and keep tariffs from torpedoing their growth efforts.