Federal IT consolidation spills over into 2007

Market Watch | Financial views of a competitive environment

Senior executives and owners of federal IT services companies should pay close attention to a changing environment that provides both opportunities and uncertainties in 2007.

As of June 30, when a new Small Business Administration rule goes into effect, a company buying a company that holds a federal small-business contract must recertify itself to prove that the acquisition has not bumped it up in size sufficient to exceed SBA's small-business size definition. The effects of the rule will dampen valuations for small-business set-aside contracts and require greater scrutiny of such contracts by the buyer.

Owners and executives of small-business contractors will need to position themselves to minimize valuation reduction and look at strategic alternatives. That could include putting small-business contracts in a separate subsidiary, transitioning set-aside contracts to full-and-open contract vehicles and converting from being a prime contractor to subcontractor on such contracts.

Strategic alternatives might include converting the company to an employee stock ownership plan, recapitalizing the company, selling to a high-net-worth individual, or selling 49 percent or less of the company to a strategic buyer. Some owners may also try to sell their companies with a closing before the new rule goes into effect.

The new Congress also will influence our industry. With Democrats in charge of both houses, look for more oversight of the government contracting industry, including procurement policies and outsourcing, attempts to reduce federal spending and the deficit, and changes in budgetary priorities. These changes, whether real or perceived, could both positively and negatively affect valuations and the ability to raise capital. Companies focused on homeland security could be prime beneficiaries of Democratic control of Congress.

Consolidation in the industry likely will continue in 2007. Perot Systems Corp. in December acquired QSS Group Inc. at an attractive valuation, further reducing the number of federal-services companies with revenues between $100 million and $1 billion. Veritas Capital Fund LP's acquisition of Pearson Government Solutions Inc. will create a new mid-market platform.

Those few remaining companies in the $100 million to $500 million revenue
category will become prime acquisition targets for both strategic and financial buyers. Several private-equity-backed companies also are nearing the end of their investment cycle and may seek a liquidity event in 2007.

The public capital markets might also be open in 2007 for those companies, but with somewhat more risk. The jury is still out on the special-purpose acquisition corporations in the government services sector. Generally, the public-capital markets for this sector have been somewhat volatile over the past year.

I expect that a significant amount of consolidation activity in 2007 will involve high-quality companies that have platform characteristics recapitalizing with private equity to get out of no man's land to better compete with large primes and fill the vacuum of $100 million to $1 billion revenue services companies. Recapitalizations avoid some of the risk and uncertainties of the public-capital markets, preserve corporate culture and better position the company for a larger liquidity event in the future. And there likely will be plenty of private equity, mezzanine financing and senior debt to effect such recapitalizations.

A final consolidation trend that I believe will continue in 2007 is consolidation of government contracting's technical-services sector. Two key developments in 2006 were Veritas Capital's IPO of DynCorp, which they acquired in 2005, and Lockheed Martin Corp.'s acquisition of Pacific Architects and Engineers Inc. This is the true, pure outsourcing part of government contracting. The bundling of contracts in this sector require primes to have greater geographic reach and more vertical skill sets.

While merger and acquisition, and capital market activity in the government services sector, likely will remain robust in 2007, they likely will occur in a changing and perhaps challenging environment.

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