Market Watch: New buyers ratchet up demand in M&A market

Jerry Grossman

Transaction prices for attractive federal IT companies remain strong.

Transaction multiples paid in federal IT deals over the past two years at the median have been between 25 percent and 40 percent above longer-term averages. Prices paid for good companies in priority markets are pulling up average sale prices, while pricing for smaller companies not involved in priority segments has remained relatively stable over the past five years.

Although merger-and-acquisition pricing multiples have risen recently, valuation multiples of public federal IT companies are down from their peak levels. Still, most of these companies are buying at valuation multiples below their trading levels, enabling accretive acquisitions.

Three fundamental forces are pushing demand and driving these multiples higher: buyers, particularly public companies, need acquisitions to achieve their targeted growth levels; transformation of government priorities requires companies to reshape their offerings and capabilities in line with buyer priorities; and both the number and type of entities looking to buy are increasing. The entry of new buyer categories into the market is beginning to have a noticeable impact.

These interested buyers -- companies and investment groups -- are growing in number and variety. In most instances, they have more than adequate capital to back up their strong interest. Sellers of good companies in priority segments are benefiting from this high interest level.

The sources of buy-side interest in federal IT companies include pure play federal IT companies, tier one aerospace or defense prime contractors, non-U.S. aerospace or defense companies, domestic and international commercial technology companies and private equity investors.

Public pure-play federal IT companies such as Anteon International Corp., CACI International Inc., ManTech International Inc. and SI International Inc. continue active acquisition programs. Over the past five years, federal IT companies have raised nearly $2 billion in equity capital, most of which has been used to support their purchases. From 1999 to 2004, the 10 companies in this peer group grew their aggregate revenue from about $2.5 billion to almost $6.5 billion. Of this $4 billion increase in revenue, roughly $2 billion was acquired, and the other half was organic growth.

Collectively, these companies have, in addition to equity market access, between $1.5 billion and $2 billion of ready borrowing capacity to support continued buying.

Large domestic aerospace and defense prime contractors such as General Dynamics Corp., Lockheed Martin Corp. and Northrop Grumman Corp. remain active acquirers with substantial funding availability.

The significant developments in federal IT mergers and acquisitions are the active participation by strategic buyers outside the industry or the United States, and the steadily growing interest from financial investors.

Also more active over the past few years are many nondomestic aerospace and domestic companies, including BAE Systems Plc, QinetiQ Ltd., Serco Services Inc. and Smiths Group Plc. Commercial technology companies in greater numbers are developing plans to get a foothold in U.S. government markets or actively buying companies in their target segments. The recently announced pending acquisition of PEC Solutions Inc. by Nortel Networks Ltd. is an example of a buying company that is outside both the United States and the industry sector.

The incremental interest of new buyers adds demand and liquidity to the market. There are not enough selling companies that have the size, service capabilities and customer mix that these buyers want. Consult Economics 101 for the effect of these market factors.

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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