Tariff uncertainty and M&A deals

Overview

The current tariff environment presents merger and acquisition opportunities in some sectors and jurisdictions. The risks and uncertainties of the present economic climate, however, necessitate nimble and creative approaches to identify and negotiate these opportunities successfully. In this context, M&A dealmakers are looking closely at:

• pricing and valuation;
• enhanced supply chain diligence; and
• deal protection measures such as walk away rights and warranty and indemnity cover.

Pricing and valuation

In frothy markets, sellers and buyers may find themselves far apart on valuations. To resolve valuation uncertainties, we expect to see the following in transaction agreements:

• a preference for purchase price assumptions to be underpinned by completion accounts rather than to be based on a locked box price mechanism. This would allow the buyer to adjust the purchase price to reflect any negative impact of tariffs on the business in the period up to completion. Of course, this may lead to more negotiations around specific line items in the completion accounts. Also, whilst completion accounts may advance the date on which the target’s financial position is assessed (when compared to a locked box deal), the financial position of the target will still be largely historic.

• retentions or deferred consideration provisions if the parties can agree on the conditions for release or payment and timescales.
• contingent consideration or earn-outs based on future performance. Such provisions have, in the past, been more common in deals which depend on the continued involvement of owner managers. In uncertain economic times, where there are likely to be more differences in the calculation of valuation, earn-outs can be used in transactions where parties agree to "wait and see" what the tariff effect will be on the target business. That said, in volatile economic conditions, earn-out provisions (and the related calculations) will need to be carefully negotiated and drafted, in case they defer and magnify disputes rather than actually resolve valuation differences.

In funding a deal in the current economic climate, all cash buyers, as ever, will have the advantage in terms of speed and flexibility without relying on borrowing from financial institutions or issuing equity-based consideration to a seller in an unpredictable market.

Due Diligence

For targets with complex cross-border supply chains, whether as exporters or importers of goods or parts of goods, the ability to assess and evaluate tariff exposure is crucial. Buyers will want to review contracts to determine whether:

• existing contractual arrangements incorporate explicit provisions dealing with the allocation of responsibility for tariff payments (and a process for dealing with any changes); and 
• to the extent there is allocation, the allocation remains appropriate or economically sustainable.

From an English law perspective, in contracts, a tariff is often bracketed as a form of tax. Since this approach is generally not consistent across agreements, buyers will seek to adjust the purchase price to account for any residual contractual tariff risk.

Warranties and indemnities

While warranties are rarely aimed at protecting against future events or the outcome of developing circumstances, buyers may require specific warranties from a target that address the impact of tariffs on the target’s financial position. Buyers will likely focus on warranties that test the robustness of the target’s financial information and regulatory compliance, and those which seek to draw out any tariff-related risks (e.g., warranties covering the absence of termination rights/renegotiation rights in contracts with suppliers/customers which could be triggered as a result of increased tariff rates).

While buyers may seek to cover the risk with representation and warranty insurance (RWI), insurers have typically excluded geopolitical or similar risks, such as the COVID-19 pandemic and the war in Ukraine, from the scope of coverage.

In some cases, the inclusion of specific indemnities may be appropriate but sellers are likely to resist exposing themselves to risk transfers in an unpredictable environment. 

Walk away rights and risk allocation between signing and closing

The rapid onset of the COVID-19 pandemic heightened focus on the buyer’s ability to terminate private M&A transactions before closing or to delay the point at which transaction risk passes. Judicial consideration of material adverse change (MAC) termination provisions in the North American courts somewhat favoured buyers with a small number of cases upholding the buyer’s right to terminate an M&A transaction by reason of the economic shock caused by the pandemic. This trend was not replicated in the English courts where there remains little judicial authority for a buyer’s right to terminate a purchase agreement as a result of a MAC. In any event, MAC clauses typically exclude the buyer’s right to terminate for common economic or market conditions unless the target business is disproportionately affected by them. Buyers must argue that a new event has occurred or there is a significant change which was not part of the risk environment at signing. This may be difficult to establish in the context of tariff imposition and escalation.  In order to address these risks, buyers and sellers will negotiate the purchase agreement with special attention to what tariff-related matters will constitute a MAC. Sellers, of course, will wish to specifically exclude the effects of tariff imposition/escalation from the scope of the MAC. Buyers and sellers, however, could agree on a more nuanced approach to drafting a tariff-related MAC provision, such as, for example, a clause that provides that a MAC will occur if tariffs relating to certain goods/contracts/jurisdictions are imposed above a certain level or if the impact of tariffs on the target’s revenues exceeds certain defined financial limits.

The pandemic also saw the rise of so-called ‘back-door MACs’, centred on operational warranties impossible to repeat (or ‘bring down’) on completion due to catastrophic changes in economic conditions. Pre-closing undertakings designed to protect buyers from sellers taking extraordinary business decisions were also scrutinised. Affected businesses argued that extreme trading shifts were forced by emergency conditions and legal obligations and therefore sellers should not be held to be in breach for necessary actions taken to protect the target business. In light of this experience, sellers may seek to include specific provisions allowing them to deviate from past ordinary course practice where required to adapt to the evolving tariff environment.

Timelines

It is likely that some deals will proceed on protracted timelines with buyers requiring more time to get comfortable at the investigation/negotiation phase and/or seeking to delay deals until the tariff environment becomes more settled. Although not directly related to tariff changes, deal timelines may also be affected by increased regulatory scrutiny of deals, especially on national security grounds, driven in large part by suspicion of non-domestic acquirors.  Where merger control clearances are required, even if the target business comprises distressed assets as a result of the current economic uncertainty, UK and EU timelines and regulator requirements are unlikely to be reduced other than in exceptional circumstances.

The Bottom Line

The current economic climate presents both risks and opportunities for buyers and sellers. With thoughtful negotiations and experienced counsel, deals can get done.