Market Watch: Are M&A deals in government services really high risk?

Jerry Grossman

In my view, the attributes of the government services industry reduce the risk in mergers and acquisitions to a level well below what is prevalent in other business sectors. The recent history and pace of industry transactions supports this thesis. With few exceptions, government services mergers and acquisitions have added value to the acquirers business, quantitatively, qualitatively or both.

The message here is not that acquisitions in this sector are without risk, but that these risks can be mitigated substantially with informed buyer due diligence, given the nature of the business.

Here's the thinking. First, it is intuitively logical that seasoned, successful industry executives would not continue making acquisitions if they were failing to add value. Since the end of 1999, nearly 350 mergers and acquisitions have closed in the government services sector. More than $25 billion of revenue has changed hands in these transactions. About 40 percent of the acquisitions, representing more than half the revenue volume, were made by the leading tier-one primes, pure-play federal IT companies and major engineering firms, among others. Most of these acquiring companies continue to perform well and pursue additional acquisitions.

Nearly all transactions are immediately accretive to the buyer. Naturally, the low cost of debt capital ensures that most purchases meet this test, without any significant cost synergies assumed. However, strategic business synergies producing added revenue are the leading factor motivating buyers in a high proportion of these transactions. Additions to the professional and technical staff, typically filling holes and augmenting capabilities, are important. But in many instances, it's the access to new customers and new contract vehicles that is most critical to the buyer.

The essence of my thinking is this: The "custom and practice" in the federal marketplace, combined with the "personnel fabric" common to the majority of companies, enables buyers to evaluate their target companies very well and, provides the basis for a successful post-transaction environment for most of the acquired company's employees.

The personnel fabric of the industry refers to the similarities across hundreds of companies in background, work environment, customer perspectives and benefit mix. Many employees in the industry have come from defense and government service careers. Accordingly, a change in ownership can be accommodated by employees of both buying and selling companies, as well as by the customers of the acquired business.

Of course, this integration success does not happen automatically. Thorough due diligence by the buyer reduces risks and surprises. A sound integration plan -- people, customers, and management structure -- paves the way and helps to reduce some of the anxieties that naturally accompany a merger.

During the past five years, the median seller in government services transactions had revenues in the $40 million to $50 million range, indicating head counts of more than 400 employees. For the most active buyers identified above, these typical deals are smaller in scope than many of their new contract awards.

Finally, for cash-flow generating companies in an environment with changing customer priorities and accelerating technologies, the opportunity cost of not doing acquisitions is very high.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

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