Key Takeaways
- Tariff volatility can distort traditional working capital benchmarks, requiring adjustments to ensure appropriate net working capital targets in mergers and acquisitions.
- Inventory valuation, sourcing shifts and receivables performance are key areas impacted by tariffs and must be closely evaluated during working capital negotiations.
- Tailored strategies such as dual working capital pegs, tariff escrows and performance-based earn-outs can help mitigate risk and support fair deal outcomes.
By Shilpa Bhandarkar, Director
Even after buyers and sellers on cross-border M&A transactions and import-dependent deals have evaluated and understood the impact of the tariff policies on profitability (EBITDA), closing deals as efficiently as before remains a challenge.
One area of complexity in the current trade environment is negotiating a working capital target that ensures an equitable settlement for buyer and seller. This aspect of the deal often presents unexpected nuances due to balance sheet volatility and tariff-linked working capital true-up exposures.
Understanding Tariff-Linked Working Capital True-Up Exposure
Working capital true-up is a mechanism within Sale and Purchase Agreements (SPAs) designed to ensure that the selling company delivers a normalized level of working capital at closing. Typically, normalized level of working capital is based on historical averages and is an absolute number characterized as a “working capital target” in the SPA.
However, tariff-induced disruptions necessitate a more thoughtful approach to determining the working capital target and to ensure an unbiased valuation outcome for the parties. This is because the recent tariff impositions make the trailing (i.e., historical) working capital a less reliable benchmark. As such, adjusting historical balances, and consequently the target working capital, to align with the forward-looking cost and operational expectations in a deal is imperative and may reduce the risk of costly post-closing disputes.
Key Considerations for Working Capital True-Up Amid Tariff Volatility
Achieving a successful deal outcome in today’s global trade environment calls for a nuanced understanding of the working capital dynamics and adoption of a tailored approach in assessing the working capital target. The following are three key areas that influence working capital dynamics in the context of tariff volatility and often lead to protracted deal discussions:
- Evaluating inventory valuation and procurement strategies
Tariffs have a direct impact on the landed cost of inventory. When tariffs fluctuate, it can temporarily increase inventory values which, if not properly normalized, may inflate the working capital target. This dynamic poses a risk of unintended value transfer to the buyer. Conversely, if historical inventory balances are not adjusted to include tariffs subsequently imposed and that are expected to be included in the closing date inventory value, there exists a risk of overstatement of value transferred to the seller.
In addition to the inventory valuation dynamic, companies seeking to mitigate exposure to tariffs and increased costs often adopt new inventory procurement strategies ahead of tariff implementation dates, such as demand-driven replenishment, or upfront large scale bulk purchasing.
A change in inventory procurement strategies can significantly impact inventory holding levels and turnover rates, necessitating normalization adjustments in working capital target calculations. Sourcing shifts and changes in vendor terms
Companies actively seeking to minimize the impact of tariffs on their business often consider strategic operational shifts whether it is an alternative procurement strategy or re-routing of operations to non-tariff countries. For example, shifting purchases from a vendor in China to countries like India or Malaysia or relocating a distribution hub catering to Latin America from U.S. to Mexico.
These strategic decisions involve a change to a company’s vendors and/or a re-negotiation of supplier terms. In the absence of an established relationship, new vendors may offer shorter credit terms, require advance payments, or payments against letters of credit, to hedge their counterparty or market risks. Similarly, changes to supply routes often introduce variations in freight, duty, and logistics timelines which may affect the timing and accounting for cost accruals. These changes directly influence the company’s accounts payable, liquidity and working capital profile.
Some companies offset tariff costs through programs like duty drawbacks or refunds under free trade agreements. These can create receivables that temporarily inflate working capital which may not be representative of steady or future state.
Inadequate consideration for sourcing shifts, changes in vendor terms, and temporary duty drawback benefits can lead to misaligned working capital targets or contention in post-closing true-ups.
- Receivables impact from tariff pass-throughs
Companies may also actively evaluate and make strategic decisions relating to their customer pricing strategy in an evolving tariff landscape.
Companies may succeed in passing tariff-related cost increases to customers, through higher prices or “tariff surcharges.” While this helps preserve gross margins, it can introduce friction in receivables collection. Customers may negotiate or unilaterally impose longer payment terms or respond by scaling back order volumes or reassessing their commercial relationships. Often, there is also a time-lag or mismatch in timing between cost increases because of tariffs and cost recovery through higher customer pricing.
Companies sometimes choose to absorb the additional costs or negotiate partial pass-throughs, develop a more complex invoicing strategy, or institute rebate mechanisms to preserve customer relationships and market share.
Overall, whether costs are passed-on or absorbed, both strategies can materially alter receivables performance by influencing how customers respond to changes in pricing, payment terms, and perceived value. If not properly reflected in working capital targets, these changes can distort the underlying economic value of the business in the context of a transaction.
Mitigating Tariff-Driven Working Capital Issues on M&A Deals
Here are five strategies for addressing tariffs in working capital negotiations:
- Due diligence considerations should include stress-testing cost structures and working capital for trade resilience under various tariff scenarios.
- Normalized working capital should reflect sustainable recurring operations. Adjustments to historical working capital should carefully consider the expected future cost base and operational characteristics of the business.
- Establishing alignment on the basis of recognition of tariffs between seller’s historical treatment and buyer’s post-close expectations can help avoid discrepancies and disputes.
- Structuring transactions to include contingent consideration or earn-outs tied to post-closing performance can offer a balanced approach that promotes flexibility and fair distribution of risks between the buyer and seller.
- Dual working capital peg (tariff adjusted and unadjusted), a tariff volatility collar, or even “tariff escrows” are emerging as innovative solutions in heavily import-exposed transactions.
We Can Help
Given today’s international trade dynamics, it is critical for buyers and sellers to proactively discuss and address potential tariff-driven volatility in their post-closing working capital true-up mechanism so that gaps in expectations can be bridged effectively, and risk, if not mitigated, is equitably shared. PKF O’Connor Davies works closely with business owners and private equity firms throughout the transaction lifecycle to manage risk and optimize outcomes. Our multidisciplinary team of consultants understands the diverse challenges across industries and delivers tailored solutions that enable businesses to navigate complexity and move forward with confidence.
Contact Us
For questions or to learn more about how we can support your transaction, contact your PKF O’Connor Davies client service team or:
Shilpa Bhandarkar
Director, Transaction Advisory Services
sbhandarkar@pkfod.com
Jonathan Moore
Partner-in-Charge, Advisory Services
jmoore@pkfod.com