Market watch: Evolving mix of deals reflects contracting environment

The pace of federal IT and defense mergers and acquisitions in the first quarter of 2006, based on deal announcements, was in line with those of 2005. However, a comparison of the first quarter of 2006 with that of 2005 reflects significant changes in the mix of transactions.In the first quarter of 2006, transaction activity accelerated in the defense products segment and declined in government services. Announced deals for acquired companies characterized as homeland security businesses doubled in the first quarter relative to the same quarter last year.In business, quarterly results and measurements do not necessarily reflect long-term trends and should be viewed accordingly. On the other hand, increasing transaction activity in defense products and homeland security companies is in line with evolving government priorities.Defense Department policies since 2001 have focused on transformational activities, net-centric warfare and mobility of assets and personnel. These priorities have increased demand for several product segments, including communications, embedded electronics, sensors, infrared devices and software-defined radio.Transaction activity in the first quarter reflects large increases in the number of acquired companies in these product areas. For example, in the first quarter of 2006, there were seven acquisitions of communications product companies, 11 of businesses producing sensors and optical products, and four of embedded electronics companies, for a total of 20 in these product categories.For the first quarter of 2005, the numbers of target acquisitions in these product areas were four, four and one, respectively, for nine in these same categories. The increase appears significant enough to be partly reflective of market trends.In homeland security, there were 10 M&A transactions announced in the first quarter of 2006, compared to five in the first quarter of 2005, a 100 percent increase. Again, a quarterly measurement doesn't necessarily indicate long-term trends.However, the Homeland Security Department has ramped up its contracting activity in line with the establishment and refinement of its procurement organization. Its strategy is more fully developed, and it has directed more resources at evaluating products and technologies put forth by prospective suppliers.Although much work remains to be done on communications protocols, software and hardware standards and emergency response procedures, DHS has begun to buy products and services beyond the scope of the 22 agencies pulled together to form the agency.M&A volume in federal IT, defense and homeland security remains robust, but there are issues that may influence both the volume and mix of deals going forward. These issues include congressional and public concern about border security and, by association, the regulatory review process established to evaluate foreign investment in the United States; proposals to mandate recertification of small-business status either periodically or when option years are exercised on contracts; and prospective organizational conflicts of interest, in addition to many others.How the foreign ownership issue and the attendant review processes are adjusted, if at all, could affect the enthusiasm of buyers and sellers in cross-border transactions. Over the past three years, 30 percent to 35 percent of industry M&A transactions have involved foreign buyers or sellers. In the first quarter of 2006, nearly 30 percent of transactions had an international component. Clearly, a regulatory environment that accommodates cross-border activity has facilitated the significant proportion of foreign deals.Small-business contracts and OCI considerations continue to be focus areas for industry buyers. Regulatory positions on these matters will be watched closely. As 2006 unfolds, more clarity on these issues would provide a better sense of their impact on industry M&A strategy and deal volume.Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin, McLean, Va. He can be reached at jgrossman@hlhz.com.