Market Watch: Will 2005 surpass 2004 as best M&A market ever?

The pace of merger and acquisition activity in the federal IT and defense technology sector established a new record in 2004 ? more than 100 announced transactions. This level is 25 percent to 30 percent above the 2003 pace, and more than twice the 45 deals in 2001. Although some clouds potentially affecting deal volume and valuations have appeared, we expect 2005 to be another strong year. The factors driving robust M&A activity in 2004 will continue to do so in 2005. About $6 billion of revenue was purchased in the 2004 transactions, reflecting average revenue of $60 million for each target company. Although the 10 largest acquired companies had combined revenue of nearly $3.6 billion, roughly two-thirds of the acquired companies had trailing revenue under $60 million each. In fact, the median revenue of target companies was in the $20 million to $25 million range, well below the $60 million average.Viewed in the context of industry demographics, the concentration of deals in the $15 million to $30 million revenue range makes sense. This is where the companies are.The most active buyers in 2004 were BAE Systems North America Inc. (five deals, including four government-related), Science Applications International Corp. (four deals) and Qinetiq Ltd. (three deals).Also significant were buyers with private equity backing and U.K.-based entities. U.K. buyers included BAE and Qinetiq, which was spun off from the Ministry of Defense with backing from the Carlyle Group of Washington. Transactions with private equity buyers included Veritas Capital Fund LP's purchase of McNeil Technologies Inc. and the ITS Services Inc.'s combination with Science and Engineering Associates Inc., backed by Arlington Capital Partners. Smaller, privately owned acquirers also were active in 2004. Examples include Gray Hawk Systems Inc., Apptis Inc., NCI Information Systems Inc. and Dimensions International Inc. The abundant supply of debt capital at low cost helped facilitate many of these acquisitions, some of which were done without institutional equity support.We are not likely to see a slowing of deals in 2005.Consider the major drivers behind this year's strong M&A market. First, public company growth objectives frequently exceed their organic growth rates, making acquisitions necessary to fill the gap. Second, evolving customer priorities require buyers to fill in holes, adding missing customers or capabilities. Third, high valuations of stocks provide the basis for more aggressive pricing, while allowing deals to be accretive. Fourth, ready availability of capital, at favorable cost in both public and private markets, provides the fuel for buyers. Fifth, the acquirers' strong performance, including successful integration of prior purchases, provides confidence to executives and investors.Looking ahead, some concern arises from the increased cost of capital for the industry -- debt rates are up by 1 percent to 2 percent. Public valuations for many buyers also have declined 10 percent to 15 percent. And large federal deficits have spawned proposed reductions in certain defense programs and are expected to reduce the growth in federal spending going forward.On the plus side, however, expected reductions in federal spending will require many buyers to seek a greater proportion of their growth from acquisitions to offset slowing organic growth. The cost of capital, although higher than last year, remains inexpensive by historical standards. And the year is off to a great start with the number of deal announcements running well ahead of 2004's pace.We're looking for another record year. Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.