U.S. / China Trade War: M&A Strategy for Manufacturers

The U.S. / China trade war has expanded to include $250B of goods (annual imports) across a wide variety of industries and threatens to increase the cost of production for many U.S. manufacturers[1]. From industrials, to food and beverage, agribusiness, and plastics, manufacturing subsectors face many potential challenges in navigating the current global business climate. What are the potential effects on M&A activity and valuations, specifically in the lower middle market, and what should business owners be considering in the next few months during the ongoing trade negotiations?

As a brief recap, the U.S. and Chinese governments are imposing retaliatory tariffs on an ever increasing variety of manufactured goods, as President Trump has sought to reduce the US/China import/export imbalance, increase market access to China for U.S. companies, and address the illegal appropriation of U.S. intellectual property. China, in turn, has responded with counter-tariffs on U.S. goods and has sought to protect other end markets for Chinese manufactured goods, including select European and Asian countries. U.S. tariffs currently cover $250B of Chinese goods, while China has responded with retaliatory tariffs applying to $110B of goods manufactured in the U.S.[1]. Currently, both sides have agreed to resume negotiations toward an eventual agreement, having met most recently on July 30th, 2019, with no timeline for a potential agreement being given. This ambiguity has not inspired confidence among investors or business operators.

Despite the turmoil of retaliatory tariffs, the M&A markets have continued to set records, as valuations remain high and exiting business owners enjoy a wider variety of buyers at the table, all competing for a shrinking pool of premium assets. Based on our view of the M&A market, here are three considerations for manufacturers, as they weigh their strategic options in light of the current trade environment:

  1. Resist making the assumption that demand for middle market companies and deals will dry up based on the most recent trade news and data. Although international trade risk generally tempers M&A activity, there are a number of other underlying dynamics in the capital markets that could dilute the effects of increased risk. As predicted in SC&H’s Manufacturing a Smarter Future report released in January 2019, M&A activity and valuations in the U.S. manufacturing sector have remained elevated due in part to the ready availability of capital financing, both from corporate profits and debt financing, and to the number and variety of active buyers. Flush with cash from the 2017 Tax Cuts and Jobs Act, U.S.-based strategic buyers are looking to aggressively compete by adding new capabilities, expanding into new geographies, and accessing new customers. Private equity and Family Office buyers are seeking to deploy record levels of cash (“dry powder”) to generate market-beating returns for their limited partners. Together these two groups are competing for a rapidly decreasing population of premium acquisition targets, pushing enterprise values higher even in the face of negative pressure from the ongoing trade conflict.
  2. Understanding the implications of your business’ exposure to international trade risk and having plans to handle these will affect the potential value of the business in a sale process. Defining this exposure and the counter measures to offset them will be a key aspect of the due diligence process for potential buyers. Any foreseen risk to the supply chain and resulting manufacturing operations could result in a higher contingent portion of the purchase price at a minimum, if not an absolute reduction in the overall price. Buyers will be focused on understanding, with as much depth as possible, the potential risks and contingencies associated with tariffs, including the full potential effects on the supply chain/manufacturing operations, any costs associated with making strategic adjustments, and the full menu of options available to them in different market scenarios. One area of particular focus will be determining price elasticity as an important measurement of trade risk exposure – i.e., which costs or how much of cost increases can be passed onto customers without negatively impacting customer tenure and overall market share. Highly differentiated products are more likely to result in more loyal customer relationships, with customers that may be more resilient in response to pricing changes, especially if the products or processes are undergirded by intellectual property. Properly emphasizing and proving out these concepts will be crucial in discussions with potential buyers.
  3. Evaluate major strategic and operational changes prior to beginning a sale process. In order to secure a premium value for your business, significant diversification planning and implementation within the supply chain or manufacturing operations should be well underway, or at least in the advanced planning stages prior to going to market or beginning conversations with buyers. Setting up new supply chains can be both long and expensive processes depending on the scale and scope of operations and could require 12-36 months from planning to execution. A detailed plan of attack that considers and effectively addresses these risks and timelines will help create a favorable impression in the market and accelerate the eventual diligence process. Such a plan should also address more granular strategies, including department level cost structure reviews, analysis of the cash conversion cycle, and customer pricing analyses (mentioned in no. 2), in addition to larger strategic initiatives. Confidently articulating coherent, company-wide strategies to address potential tariffs and mitigate the risks to interested buyers will go a long way in maximizing shareholder value and achieving shareholder objectives.

With the threat of a prolonged trade war, it is crucial for business owners to take steps now to evaluate the full menu of strategic options available to them, including M&A.

SC&H Capital works with companies early in the transaction process, often several years in advance, to help business owners successfully navigate highly volatile market environments and build value toward an eventual transaction. Our focus is on building long-term relationships with our clients by providing thoughtful, bespoke advice to clients, becoming the most trusted advisor to shareholders and management teams.

Contact us if you would like to evaluate your strategic options.

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[1]: The U.S.-China Trade War: A Brief Recap