Market Watch: Savvy investors uncover opportunities in government market

The last few years have been difficult for private equity investors. Many of their investments in the 1990s are underperforming the original expectations upon which funds were committed. This is particularly true for investments in commercial information technology, consulting, telecom and wireless.For many companies in these industry sectors, performance and growth have failed to return to 1999 levels. Market valuations have reflected both depressed performance as well as a lack of confidence in growth in the near term. One consequence of these circumstances is the inability of private equity owners to exit these investments at satisfactory rates of return.But a bright spot in all this gloom and doom is the government IT market. Savvy private equity professionals are taking a much closer look at this sector.Several successful public offerings in 2002 raised the visibility of government IT businesses. Well-publicized increases in government funding for defense and homeland security added to investor interest. Historically, most private equity firms have not invested in this sector. There are three principal reasons for the dearth of funding. First, government IT companies are cash flow producers, able to fund their growth with retained equity and bank debt. Second, growth rates have been at single-digit levels since the 1980s, reducing the need for subordinated capital. Third, most investors outside of the industry don't understand how the market works. Accordingly, this lack of understanding translates into a perception of higher risk. As investor understanding has increased, the solid opportunities in the sector are showing through. Typically, private equity firms purchase control or minority positions in private companies, with the goal of helping management grow the business and position the company for sale or initial public offering. Target investment-holding periods typically range from three to six years. Collectively, this category of investors has considerable influence in the middle market arena, given that there are nearly 2,000 private equity shops seeking opportunities to invest in strong, growing, mid-sized businesses.The magnitude of funding, available from these investment professionals is evidenced by the nearly $250 billion raised during the past six years. Of this amount, about $100 billion is presently available for investment. This amount is more than three times the aggregate market capitalization -- more than $35 billion -- of public companies serving government markets. Assuming that one-third of the private equity pool was targeted toward consulting, services and technology-deployment companies, then a meaningful portion of this $30 billion-plus pool could be deployed for government IT transactions.Confirmation of growing private equity interest is reflected in recently announced transactions involving government IT companies. For example, Arlington Capital Partners has announced a $75 million commitment to the federal IT sector. Their acquisition of ITS Services Inc., a government IT company, combined with a very successful, industry-savvy management team, provides the platform to build a mid-sized IT and network operations provider.These examples, added to the historical successes of a small group of seasoned industry investors -- Carlyle, CM Equity, Caxton-Iseman, and Monitor-Clipper -- indicate that several mid-sized federal IT companies are likely to be built by combining proven industry management with professional capital. More enduring investor interest in the sector should result, fueled by a strong market for strategic sales and a track record of successful IPOs. New candidates for the Top 100 federal IT rankings will be built. Enduring investment interest will help to support strong valuations over the longer term. *Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.