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Due Diligence for Trade Risk

When conducting due diligence on a multinational company, consider the heightened risk of trade disruptions and loss of goodwill with foreign customers resulting from our ongoing trade negotiations.

On November 30, 2018, the United States, Canada, and Mexico agreed to replace the North American Free Trade Agreement (“NAFTA”) with the United States Mexico Canada Agreement (“USMCA”).  The new agreement has been marked by fraught negotiations provisions, resulting in a heightened sense of trade uncertainty for the middle market. While the new USMCA still largely resembles NAFTA and includes positive elements drawn from the Trans-Pacific Partnership (“TPP”), it remains to be ratified by a deeply-divided Congress.

Assuming USMCA is ratified, the trade agreement would not eliminate Section 232 national security tariffs on steel, aluminum, and potentially vehicles from our closest trade partners, Canada and Mexico. Beyond North America, the United States is engaged in a trade tiff with China, involving tariffs and retaliatory tariffs on hundreds of billions of trade between the US and China.

Now, a recently introduced bill in Congress dubbed the “Reciprocal Trade Act” is threatening to increase trade uncertainty.  The Act would expand the President’s statutorily delegated authority to impose tariffs. Moreover, it would enable him to match any tariff applied to products by trading partners.  While last week’s State of the Union touted the bill’s stated goal of encouraging foreign markets to open up to US producers, the practical effects of the bill could make trade turmoil more severe.

The Reciprocal Trade Act is only the latest salvo in the battle between Congress and the President for expanded control over tariff power.  With no resolution in sight, the market is likely to continue to experience trade insecurities that could impact deal considerations. As the uncertainty of the current trade climate deepens, middle market companies should take into account the trade risk.

As part of due diligence, consider a US company’ customer mix, and their reliance on exports as a percentage of total revenue.  If a company’s revenue is heavily weighted in foreign earnings, the company may have some political risk if trade negotiations get ugly.  Not only could the company face retaliatory tariffs, but trade hostilities may impact the US company’s goodwill with its foreign customers.

Next, look at the company’s reliance on imports of intermediate components or raw materials used in its US manufactured products.  Considering close to half the value of imports into the United States is made up of inputs into the production process, a company is unlikely to completely avoid the political risk of an international supply chain.

Bear in mind that some US producers, such as US steelmakers, are taking advantage of tariffs on their foreign competitors by raising the cost of their US made products.  This has already begun to be seen in the steel industry. While US steel makers are benefiting from President Trump’s protectionism, US manufacturers using steel inputs are facing higher costs and tighter margins near to mid-term.

It’s not clear if temporary trade risk will negatively impact the level of mergers and acquisitions activity.  However, trade uncertainty may affect deal structures, pushing more consideration to earn-outs. Knowing the right questions to ask about trade will give middle market companies better footing for managing current political and economic risks.

Companies need to keep sight of how a shift in tariff power may impact not only the cost or availability of imported inputs, but the cost of domestic components as well.

Making decisions on capital expenditures, plant construction, and acquisitions often rests on the reliability of long-term financial forecasting.  However, no one can accurately predict the mood of the American voter. For now, boards of directors in corporate development teams should watch policy developments closely to get a sense of whether the US is reverting to a protectionist approach for the foreseeable future, or whether the current protectionist mood will pass in the near term.

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