Welcome to the bipolar M&A market

Market Watch | Financial views of a competitive environment

The government services mergers and acquisition market
has been consistently active since 2001. A growing population
of buyers, foreign and domestic, strategic and financial,
has provided a liquid market for sellers.

Contributing factors have included improving
margins; above-average growth in government
spending, particularly in national
defense and intelligence segments; aggressive
lending by banks; and expeditious regulatory
review and government accommodation of
contract transfers. Many of these factors have
begun to change, suggesting that the government
M&A market will be different in 2008.

Is it getting better or worse? In a nutshell, it's
better for some, worse for others.

We now have a bipolar M&A market driven
by the small-business recertification
requirements that took effect July 1. To simplify
and generalize, selling companies can
be placed in one of two categories ? battletested,
high-quality companies or emerging,
not-ready-for-prime-time companies.
On one side, high-quality companies with
no meaningful small-business preference
contracts are highly sought by active buyers,
often commanding premium pricing.

Transaction values in the range of 10 times
to 14 times trailing earnings
before interest, taxes,
depreciation and amortization
(EBITDA) are
being achieved in many transactions ? a
big gulp for buyers, as these pricing multiples
are often higher than the trading levels
of the acquiring companies.

On the other side, emerging businesses
are unable to transfer contracts and sustain
customer relationships. These businesses ?
many of them with quality attributes ? are
finding weak, or tentative, buyer interest
and suboptimal valuations, including contingent
payment transaction structures.

Besides recertification, other factors are
changing. The psychology of the capital
markets has migrated from widespread
greed to overarching fear. Spawned by the
subprime mortgage epidemic, where identifying
the bottom is difficult, financial institutions
are less aggressive, re-examining
their credit standards and returning to
more traditional credit parameters with
greater rate premiums for risk and tighter
covenants. These capital sources have been
active supporters of financial sponsors
(private-equity investors), enabling them
to be more competitive in government and
defense deals with strategic buyers in the
past few years.

Slowing growth in government spending
makes organic growth harder for many
companies to achieve, suggesting that
strategic buyers may be more aggressive this
year. The challenge for these buyers is on
the supply side, specifically, a diminished
population of quality companies ? those
with transferable, sustainable contracts ?
to choose from. Additional imponderables
add to the challenges for buyers. These
include election-year uncertainties relative
to the spending priorities that will
unfold in 2009, a slowing economy and
its influence on fiscal policy decisions ?
both tax and spending.

The expansion of industry EBITDA
margins, evident through 2006, ceased
for most active industry buyers in 2007.
Future earnings growth will be substantially
driven by revenue growth.

Continuing congressional investigations,
highlighting alleged misdeeds by
contractors, has the effect of distracting
investors from the fundamental strength
and stability of the industry. For example,
during the past three months market averages
? the Dow Jones Industrial Average,
NASDAQ Composite and the Standard and
Poor's 500 ? have declined between 11 percent
and 15 percent, while a capitalization
weighted index of federal information technology
companies has fallen only 4 percent.

Aggregate reported transaction value in
2007 was down slightly from the level in
recent years. Don't be surprised to see fewer
deals in 2008, influenced by lengthening
due diligence and regulatory review with,
perhaps, more headline transactions in the
mix.

Jerry Grossman (jgrossman@hlhz.com) is managing
director at Houlihan Lokey Howard and Zukin
in McLean, Va.

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