Conditions are right for private equity buyers
Government market is increasingly attractive to buy out firms
John Hagan is co-head of the defense and government services group at BB&T Capital Markets | Windsor Group.
How quickly the dynamics of a market can change.
Traditionally, larger, high-profile transactions in the government technology services sector were dominated by the larger strategic buyers. Although private-equity groups were active, their participation was best characterized by starting relatively small and growing in scale by financing multiple acquisitions over time.
Given the attractive cost of capital in the public markets since the 2001 terrorist attacks, these private equity-backed firms often went public and eventually sold to strategic buyers that were typically able to outbid other private-equity groups competing to acquire those same companies.
Examples include: Anteon (Caxton-Iseman) and Veridian (Monitor Clipper) both acquired by General Dynamics; DigitalNet (GTCR) acquired by BAE Systems; Apogen (Arlington Capital Partners) acquired by QinetiQ; and SI International (Frontenac Capital) acquired by Serco.
More recently, we have seen large private-equity firms succeeding in securing a large number of high-profile transactions once dominated by strategic buyers. Examples include: SRA International’s recently announced sale to Providence Equity; Global Defense Technology and Systems Inc.’s sale to Ares Capital; Lockheed Martin’s divestiture of its Enterprise Integration Group to Veritas Capital; and Northrop Grumman’s divestiture of TASC to KKR and General Atlantic Partners.
Three recent factors have converged to contribute to the increasing prominence of private-equity buyers in the market. The first is the decreasing level of interest in large government services companies from the large prime contractors. Increasingly stringent organizational conflicts of interest regulation on the part of many government agencies has made acquiring a services business more difficult. Consequently, such companies are less likely to bid aggressively, if at all, for large, diversified services companies.
A second factor is the relatively low valuation levels of publicly held government services companies.
At the time of this writing, for the nine companies in our government technology services stock index, the median enterprise value to latest 12 months earnings before interest, taxes, depreciation and amortization was 7.6x. On a forward-looking basis, the median enterprise value to 2011 estimated EBITDA was 6.8x and the enterprise value to 2012 estimated EBITDA was 6.3x. These levels are well below the valuations enjoyed during the past decade, and the resulting high cost of capital negatively influences the ability and willingness of the publicly traded services companies to aggressively acquire.
Lower public valuations are largely because of budget pressures, budget uncertainty, procurement delays and other industry headwinds that led to a median projected organic growth rate for the group in the 7 percent range.
The third factor is the increasingly favorable credit environment. The credit markets started improving dramatically in the second half of 2010 as both bank and institutional investor interest accelerated to the point that many observers believe the market is beginning to rival the one experienced in 2007. For example, some of the more recent transactions highlighted above enjoyed leverage of 6 to 6.75 times last 12 months EBITDA. With debt available at those levels, in concert with their equity infusion, private-equity groups can be as aggressive, if not more so, as small and midsize strategic buyers.
In fact, the two most recent transactions, SRA and GTEC, secured multiples of pro forma EBITDA approximating 11 to 11.75 times, generating a very attractive premium for shareholders at valuations well above the 7.6 times EBITDA median for the industry currently.
Although we believe the future is bright for government services companies despite the headwinds, those three factors are not likely to change materially in the near future. In combination with the higher cost of public equity and the lower cost of debt, this is resulting in the continued susceptibility of publicly held government contractors to a private-equity buyout.