Buyers bullish on government market acquisitions

Last year, there were 96 transactions involving the acquisition of government services companies focused on federal IT and defense services segments. This total is only 2 percent above the level of activity in 2004, and reflects a modest growth rate in deal flow in contrast to the 15 percent achieved in 2004.Although the increase in closed transactions was modest, the 2005 results establish a new record.Investors, analysts and other industry observers continue to ponder the sustainability of this mergers and acquisitions market. Minus some significant changes in capital market support, it seems unlikely that the transaction pace will slow meaningfully in the near term. Key drivers of M&A activity remain solidly in place as we move into 2006, suggesting that another year of robust transaction volume is coming.A more in-depth review of the 2005 closed transactions gives insight into the trends driving government services M&A activity. A broad array of buyers, available and relatively inexpensive capital, government procurement trends and public market growth expectations together support significant transaction volume going forward.Most industry participants also expect defense expenditures to slow in response to budget pressures, and a concomitant reduction of organic growth potential in many companies. For those publicly traded companies seeking to sustain growth rates in this environment, acquisitions may play a larger role.The number of interested buyers continued to grow through 2005. Non-U.S. companies have been buying or are looking for good opportunities here, as the United States remains the most attractive government services market in the world. Nortel Networks Corp., QinetiQ plc and Serco Group plc in 2005 completed purchases of U.S. businesses. It is anticipated that these buyers, along with many other foreign buyers, will continue to be active this year.In 2005, 10 closed transactions, about 10 percent, involved foreign parties. Several other categories of buyers are in the market, including aerospace and defense primes, pure-play federal IT companies, engineering firms, special purpose acquisition corporations and private equity firms, as well as commercial technology companies seeking access to federal customers.The cost of capital rose in 2005 as short-term interest rates increased by 150 to 200 basis points, while the cost of equity capital rose as evidenced by, on average, a 15 percent to 20 percent decline in stock market pricing multiples in the industry sector.However, after taking these increases into account, the weighted cost of capital in the sector remains at or below longer-term norms.Government procurement trends continue to reward scale on the one hand and small-business preferences on the other. Evolving government technology needs, coupled with changing spending priorities at many agencies, necessitate acquisitions by midsize and larger contractors to position themselves better relative to service offering and customer mix.Public market investors are pricing industry stocks with the expectation of 15 percent to 20 percent compounded annual earnings growth. For many companies, reaching this growth rate is unlikely without acquisitions.The 96 completed deals last year involved 79 buyers, 11 of which completed more than one transaction. All these buyers have ample capacity to continue their acquisition programs in 2006.As in previous years, the median acquired company in 2005 had revenue of less than $50 million. Although most transactions in 2006 will be of a similar size, a handful of much larger transactions are possible, given the target criteria established by many of the large acquirers.Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hhlz.com.