Market Watch: Equity groups give owners a second bite at growth

In the last five years, private equity groups have discovered the federal services industry. Specifically, they're finding that it provides owners, managers and employees with an attractive alternative to a sale to a strategic buyer.

Among recent buildups in the federal services industry backed by private equity groups are: Anteon International Corp. (Caxton Iseman); Apogen Technologies Inc. (Arlington Capital); Apptis Inc. (New Mountain Capital); DigitalNet Inc. (GTCR); DynCorp International Inc. (Veritas Capital); ICF International Inc. (CM Equity); Netco (Cerberus), which recently bought Multimax Inc.; QinetiQ plc (Carlyle Group); Resource Consultants Inc. (CM Equity); SI International Inc. (Frontenac); and Veridian Corp.(Texas Growth Fund).

A few funds and merchant banks, such as the Carlyle Group, successfully invested in federal IT companies in the 1990s. But when the telecommunications and Internet bubbles burst in 2000, most such private equity groups had a lot of dry powder and were seeking safe havens to invest.

They discovered our sector, attracted by its predictable and transparent revenue, growing profit margins and federal government receivables, as contrasted with commercial company receivables, as well as government's increase in outsourcing to private companies.

Investors and owners have been very successful with most equity-backed buildups, among them: the sale of Veridian to General Dynamics Corp.; the sale of DigitalNet to BAE Systems Inc.; the sale of Apogen to QinetiQ; and the sale of Anteon to General Dynamics Corp. All these transactions were at attractive multiples producing large internal rates of return to investors.

When a private equity group invests in a company to be its platform, it's considered to be a recapitalization as opposed to a merger or acquisition. It is a nice alternative for owners who want to grow their companies more rapidly while incurring little risk, and to take some cash while preserving some ownership rights. It is also a way to maintain corporate identity and culture, and to avoid rifts that occur when a company is acquired.

Moreover, private equity groups bring credibility and value to the platform company, including access to public capital markets.

General characteristics a private equity group will seek in a platform company are:

  • At least $50 million in revenue;
  • Owners and managers willing to roll over 15 percent to 25 percent of their ownership;
  • A vision to grow organically and by acquisition;
  • A compelling growth plan; and
  • A management team that can manage growth.


Private equity groups are not interested in companies that require serious restructuring, although they will match up an experienced chief executive or chief financial officer with a platform company.

A recapitalization with a private equity group is a complicated transaction. The group will leverage its equity with senior and subordinate debt to help reach a high internal rate of return. Each group has a different tolerance for debt.

A typical structure would be for a private equity group to buy 80 percent, while the owners keep 20 percent. The capitalization would be 30 percent equity and 70 percent debt.

Debt would comprise senior debt and subordinate debt. Senior debt would be 2.5 to 3.5 times current year earnings before interest, taxes, depreciation and amortization, with subordinate debt making up the difference. Subordinate debt typically would include warrants for 5 percent of the issued and outstanding stock.

In assembling the complicated capital structure of these transactions, there are many formulas for valuing rollover equity and many different performance and incentive packages for the management teams. Professional representation is essential.

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