Market Watch: Federal IT merger and acquisition market stays hot

The pace of mergers and acquisitions in early 2004 continues to accelerate in the defense manufacturing and federal IT sectors. For the third consecutive year, activity has exceeded expectations.In the first five or so months of 2004, 47 transactions were announced in defense manufacturing and 49 in government services. Contrast this with announcements in the same period of last year: 25 defense deals and 36 federal IT deals, representing increases of 88 percent and 36 percent, respectively. These increases are not anomalous, the 85 federal IT transactions in 2003 exceeded by 30 percent those in 2002. This year's activity level in this sector confirms the fundamental role of acquisitions in growth strategies of tier-1 and tier-2 buyers.A closer look reveals that most of the activity is in the government services market's third tier: companies with annual revenues of less than $100 million. Of the 49 deals announced since January of this year, 22 included disclosure of revenue levels for the target companies. Companies sold during this period had annual revenues ranging from $1 million to $250 million, with the average hovering around $40 million. Ten of these companies were "small businesses," having less than $20 million in revenue, and only three of the selling businesses had revenues topping $75 million. The factors driving acquisitions remain substantially in place, but some course corrections are likely through 2005.The most obvious sustaining element is that the strategic imperative to sustain growth remains intact. Public market investors clamor for growth in earnings of between 15 percent and 20 percent, contrasted with single-digit demand-side growth in government expenditures. The cost of capital remains low, particularly senior debt. Private equity investors have warmed to the industry and in some instances have stepped up with higher acquisition prices to win a competitive auction for the right "platform" business. One likely catalyst of activity could be divestitures by large primes of SETA [systems engineering and technical assistance] contractors acquired in recent years. Some program offices in the Defense Department and intelligence agencies are concerned about potential organizational conflict of interest, or OCI. The question is: Under what criteria should the government let SETA business units remain under common ownership with the systems building and integration activities of the primes? When and where do these combinations serve both the government and the contracting community?There remains some chilly water out there, dampening the spirits of many prospective buyers and sellers. Among potential buyers are several companies that have yet to refine either their acquisition criteria or their evaluation and courtship process. Sellers confronting these buyers are discomfited in their efforts to assess either the buyer's genuine level of interest in their company or the likely valuation range at which these buyers will actually transact.Sellers also contribute to the chilliness of the waters. Too many owners and executives enter the market before their company is ready or with unrealistic expectations of the price they should expect to command. Both groups will discover in the rudest way that the premises upon which they based their drive to market, and the process they used to get something done, were not well grounded. Doing the homework and getting good advice continue to be essential elements in making good things happen.Without it, these misguided buyers and sellers, rushing to jump through a perceived window of opportunity, are doomed to disappointment. They may well discover that the window they are diving through is on the 10th floor.Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.