Changes to the tariff environment over the course of this year have presented challenges to businesses and dealmakers. Since Jan. 20 of this year, there have been over 100 changes to trade policy in the United States. Numerous other countries have imposed reciprocal tariffs on products from the United States. Significant challenges in the M&A market have resulted, and these challenges have trickled into RWI underwriting. Buyers and underwriters need to quickly adapt to these changes and prepare for additional changes in trade policy.
What challenges do tariffs pose for deals? While there are indirect impacts, such as a potential economic downturn and increased inflation, buyers and underwriters are focused primarily on direct impacts. Direct impacts primarily relate to increased costs of a target's products, which can result in reduced margins and reduced demand for the target's products caused by increased prices. These impacts vary depending on the exact nature of what is being imported. Consumer businesses with international supply chains will likely be affected; businesses whose supply chains cross U.S. borders multiple times are likely to be severely affected. Other businesses, such as "software as a service" providers or many healthcare businesses, will face very limited, if any, impact from tariffs.
Consider a steel mill located along the U.S. border with Canada. While there are tariffs imposed on imported steel, given that the business appears to fabricate steel in the United States, a buyer would reasonably assume that there would be little tariff impact on this business. However, as diligence progresses, the buyer discovers that the target's steel production process has several steps in Canada. These steps must be conducted in a specific order and, unfortunately for both the buyer and the target, these steps necessitate crossing the U.S. and Canadian border several times. Each crossing requires a tariff to be paid either to the U.S. or Canadian government, as Canada has threatened and implemented reciprocal tariffs on U.S. exports. Very quickly, the target's costs skyrocket. The target is forced to attempt to increase its prices; however, it is not certain that they will be able to do so. What is a buyer to do in this situation? There are three potential options: (i) walk away from the transaction; (ii) revise the valuation of the business to reflect reduced cash flow resulting from materially higher costs; or (iii) trust that the target will be able to offset tariff costs and not revise its valuation. Each approach has different levels of risk; however, we will focus on (ii) and (iii) in the context of a RWI transaction.
Before discussing strategies underwriters have been implementing to mitigate tariff risk, we must first discuss how tariffs affect an RWI policy. The specific impact is entirely dependent on the language of the representations in the purchase agreement. In a fairly negotiated transaction, it is likely that the impact of tariffs on the target will breach at least one of the representations. Which representations will be implicated varies depending on the specific facts and circumstances; however, given the far-reaching impact of tariffs, there are many potential breaches. These potential breaches include breaches of the customer and supplier representations, material contracts representations, the no undisclosed liabilities representation, the absence of material changes representation, and the financial statement representations.
How are underwriters addressing tariff risk? Generally, underwriters are working to understand how these potential impacts have been factored into the buyer's valuation of the target. If a buyer has underwritten a transaction at a discounted level of EBITDA resulting from increased costs, the likelihood of a loss resulting from tariffs is substantially lessened. This is because buyers may not suffer a "loss" if tariffs do in fact discount EBITDA, as the impact has been fully accounted for in the purchase price. There is still potential for a loss if the buyer does not fully discount EBITDA for purposes of its valuation; however, the magnitude of the loss is lessened by any discount included in the buyer's valuation. Sellers are reticent to accept a lower valuation for their business as a result of tariffs; consequently, not all buyers are able to fully reduce purchase price for the expected tariff impact. Sellers often suggest various tariff mitigation strategies and will argue that these address any material impact from tariffs. These strategies can vary from passing along price increases to customers, to negotiating with the target's international suppliers to split the tariff costs. To accommodate sellers, buyers will assess these strategies, determine which they believe are likely to be effective, and revise their valuations to reflect successful tariff mitigation. Whether or not an RWI underwriter will underwrite the risk depends on a number of factors, including the underwriter's individual risk tolerance and how successful the target's tariff mitigation strategies have been to date.
If the buyer has not factored any tariff impact into their valuation, underwriters have been digging in further. Initially, underwriters will ascertain what percentage of the target's products are subject to tariffs. They will also seek to ascertain the imported items. If the target is importing raw materials or components of its products, the impact of tariffs on the overall price of the target's product may be limited. For example, if imported items constitute a small portion of the cost of the target's products, underwriters are more likely to view tariff price increases as immaterial. If the target imports finished goods, or the increase in the cost of components/raw materials is material, underwriters will seek to ascertain the likelihood of tariff price increases being passed along to the target's customers. If the target has already increased its prices to pass along tariff costs and customers have been paying increased prices, underwriters are likely to view tariff impact as low risk. Underwriters will also seek to understand whether these increased prices will result in reduced demand for the target's products. If the target's products are "non-discretionary," underwriters are likely to view the risk of reduced demand as low. To the extent that the target's products are discretionary, underwriters will want to understand how increased prices will reduce the demand for the target's products. Customer calls are likely to be a key point for underwriters in measuring the risk of reduced demand.
If an underwriter views tariff impact as material, underwriters have been primarily addressing tariff risk in two ways. The first is an exclusion related to tariffs and the second is a deemed disclosure of the tariff impacts on the target. A majority of markets have avoided using exclusions given both buyers' and brokers' preferences. There is also concern regarding the effectiveness of any exclusion related to tariffs, as underwriters have concerns about being able to prove that any breach of the representations is tied to tariffs. For example, it may be difficult to prove that the loss of one of the target's customers is tied specifically to tariffs. The more common approach has been to put together a relatively broad deemed disclosure, which describes the specific tariff impact. This approach is often more palatable to the buyer, as the language of the disclosure is often heavily negotiated. Underwriters also attempt to avoid limiting the disclosure to a specific representation; however, they will often accept limiting a disclosure to a specific representation both parties agree is the most likely to be breached. In such circumstances, underwriters will rely on customary cross-referencing language for the disclosure schedules, which provides that a disclosure shall be deemed disclosed to any other representation to which the applicability of the disclosure is reasonably apparent on its face, to mitigate the risk of breaches of other representations.
While the approaches discussed above do not entirely preclude a buyer from bringing a claim relating to tariff impacts, they generally lessen the risk to an acceptable level. It is important to note that every transaction is unique, and that the approaches discussed above are common but not ubiquitous. Every underwriter has different risk tolerances, and every transaction involves a different level of tariff risk. Underwriters will be as commercial as possible in addressing tariff issues; however, it is important that buyers recognize tariff risks in their transactions. Changes to the tariff environment have shown the adaptability of buyers, sellers, and underwriters. While there are likely other potential changes to tariff policy, using the strategies described above, tariff risks can be mitigated in an RWI transaction.
