7 minute read 30 May 2019
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How escalating tension between the US and China impacts the deal market

By

US Americas

Multidisciplinary professional services organization

7 minute read 30 May 2019

The dispute has dampened the appetite for deals, especially large cross-border acquisitions, but companies are still making tactical moves.

On the surface, current disagreements between the US and China are about economics and business interests. But underpinning the conflict are fundamental ideological differences between the two nations.

A challenging environment for M&A

“The tense relations between the US and China, and their high degree of economic interdependence, create an operating environment that companies are finding increasingly challenging,” says Jon Shames, EY Global Geostrategic Business Group Leader. “Tariffs and increasing scrutiny of cross-border deals are impacting M&A timelines.”

In the third quarter of 2018, the value of announced transactions worldwide fell by 35% compared with the previous three months, with the number of new deals announced at its lowest level since 2013, according to analysts at Refinitiv (the new name for the financial and risk business at Thomson Reuters).

Furthermore, the large cross-border deals that have characterized the mergers and acquisitions market for the past five years are becoming increasingly difficult to seal as the trade dispute persists. JP Morgan, which advises on such “mega” transactions, reports that 2018 saw 16 deals worth more than US$10bn that had taken more than a year to complete.

The impact of tariffs on M&A

93%

Nearly all respondents to our January 2019 Trade Survey believe tariffs will impact their company’s M&A plans.

Rather than face this level of unpredictability, many affected by US-China trade tensions are choosing to follow a strategy of wait and see. London-based Steve Krouskos, EY Global Vice Chair — Transaction Advisory Services, says: “Geopolitical, trade and tariff uncertainties have finally caused some dealmakers to hit the pause button.”

Our January 2019 Trade Survey revealed that 78% of US C-level executives believe that a trade dispute would likely push the US into recession. Nearly all respondents (93%) believe that tariffs will impact their company’s M&A plans.

China encounters resistance

One big difference is that Chinese acquisitions of US companies fell by almost 95% in 2018 from a peak two years previously. Chinese spending on US companies fell from US$55.3bn in 2016 to just US$3bn last year, with American authorities rejecting several large deals.

Elizabeth Lim, Research Editor at global financial information provider Mergermarket, explains: “Intensifying trade disputes, political instability and increased regulatory scrutiny took their toll on the number of deals struck over the year, though deal values remained relatively high.” 

Deals are still happening but there are fewer and for less money than in previous years, with Europe and Southeast Asia taking center stage as China strives to reduce its reliance on the US.

One of the largest deals to be axed was the US$1.2bn acquisition of MoneyGram, a US money transfer business, by Ant Financial, a Chinese online payment company owned by Alibaba. It was rejected by the US Committee on Foreign Investment, which cited national security concerns. Ant Financial went on to raise US$14bn from a consortium of multinational investors.

Deals are still happening but there are fewer and for less money than in previous years, with Europe and Southeast Asia taking center stage as China strives to reduce its reliance on the US.

In July 2018, Chinese Premier Li Keqiang hosted European Union leaders in Beijing with both sides agreeing on the need for free trade and multilateralism. The two sides also agreed to work together on World Trade Organization reforms. China’s bids in Europe subsequently increased by 81.7%, from $33.2bn to $60.4bn over the year.

Still, it has not been easy sailing for the Chinese here either, with the UK, Germany and France carefully scrutinizing investments. Germany has blocked deals, including the proposed takeover of German machine-tool manufacturer Leifeld Metal Spinning AG by the Yantai Taihai Group — again, citing security concerns.

Companies seek to diversify

Meanwhile, the ongoing trade dispute coupled with China’s slowing economic growth is prompting companies to diversify their production and supply chains. Our January 2019 Trade Survey revealed that 57% of tech and 53% of automotive businesses were reviewing their procurement or sourcing strategies.

Demand from buyers for audits of companies in Indonesia and Cambodia rose by more than 50%, with increased demand throughout Southeast Asia. Bangladesh, a popular manufacturing base for clothing companies, saw a 37% growth in audits as a result of buyer interest, the survey reported.

Other companies are looking to keep their basic manufacturing in mainland China but move value-added activities to Taiwan or Singapore. This is because the site of the last substantial transformation — which can be an element of sophisticated assembly, software download or another large value-added activity — is considered the country of origin according to US Customs and Border Protection (CBP) non-preferential rules of origin, thus mitigating tariffs. 

India is what China once was, a cost-effective manufacturing base with direct access to a growing middle-class market. As such, it is already attracting attention.

Every trade dispute cloud brings with it a silver lining and investment opportunities with private equity companies on an Asian spending spree. Private equity houses Warburg Pincus, KKR and TPG all have made large investments in Indonesia and Vietnam, while Morgan Stanley Private Equity Asia raised more than US$440m for a Thailand-focused fund.

As Michael J. Ferrantino, Lead Economist and Global Product Specialist for Trade Policy and Integration at the World Bank, says: “If disputes continue, other developing countries, including India, may benefit from some diversion of foreign investment away from China.”

India is what China once was, a cost-effective manufacturing base with direct access to a growing middle-class market. As such, it is already attracting attention. During 2018, for example, retailer Walmart spent US$16bn to buy a stake in Flipkart, India's largest online retailer.

US companies have cash to splash

“The trade dispute has resulted in a slowdown in the US acquisition of companies manufacturing in China,” explains Lynlee Brown, a senior manager in the global trade practice at Ernst & Young LLP in San Diego. Although she adds: “The flip side is US tax reform.”

The tax reforms of 2018 left many US companies flush with cash that should help support the deal market in 2019. This might explain why US spending on foreign acquisitions was at an all-time high of US$30.1bn, three weeks into January — just not in China, according to Refinitiv’s data.

Mostly, though, US firms are spending at home with domestic mergers and acquisitions up by 41% in the first three weeks of this year compared with the same period last year. These figures are aided by Bristol-Myers Squibb’s planned US$74bn acquisition of pharmaceuticals rival Celgene Corp. However, the 2019 EY Trade Survey suggests this trend is set to continue, with 60% of companies reporting that they would pursue M&A inside the US.

US firms are spending at home, with domestic mergers and acquisitions up by 41% in the first three weeks of this year compared with the same period last year.

Tax has a central role to play, with several financial incentives helping drive interest in the US market. The new foreign-derived intangible income (FDII) deduction, which is a boon to US exporters, is boosting interest in US-based manufacturing plants with foreign outlets.

Action points

  • As moving production bases or changing suppliers takes time, it may be prudent to look at other strategies such as origin or customs valuation planning and tariff engineering to mitigate the effect of tariffs until the outcome of the trade talks is known.
  • Make sure you are using the correct harmonized tariff code and consider whether you can import a product in a different form (e.g., more built up or more knocked down) to change the codes.
  • Check the scale of production in mainland China and make use of Taiwan and Singapore (or other feasible locations) for country-of-origin purposes.
  • Look at import value, as this generally forms the base for customs duties calculations, and consider whether you can use the first-sale rule to your advantage into the US.
  • Consider establishing a foreign trade zone in which to store produce in case import quotas are filled — useful if you might get caught with a ship full of, say, steel outside a US port.

Summary

Deals are still happening but there are fewer and for less money than in previous years, with Europe and Southeast Asia taking center stage as China strives to reduce its reliance on the US. 

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US Americas

Multidisciplinary professional services organization