No credit woes in government services

The headlines this summer are dominated by talk of the "credit crunch." Many pundits are predicting that tightening in the debt markets will bring an end to the frenzied merger-and-acquisition environment. Although this may be the case in other industry sectors, I do not believe the current credit woes will curtail M&A activity in the defense and government services arena in the near term.

Despite the strong interest of private-equity groups (PEG) in this sector, strategic acquirers made more than 75 percent of acquisitions in the last year. The top 30 publicly traded companies that buy defense and government services companies have nearly $20 billion in cash on their balance sheets and more than $90 billion of buying power. Those buyers do not rely on the aggressive debt structures often employed by PEGs and are less influenced by turmoil in the debt markets.

Many of these strategic buyers — especially publicly traded federal information technology companies — are experiencing lower organic growth this year than in previous years — less than 10 percent versus 20 percent plus in previous years. They need to make acquisitions to supplement organic growth to meet the expectations of Wall Street.

Also, many strategic buyers need to buy companies with governmentwide acquisition contract vehicles and customer relationships to access areas where budgets are growing. Essentially, they are following the dollars in military and intelligence growth areas.

PEGs are loaded with cash, having raised more than $400 billion of capital in recent years. Their investors expect them to put that capital to work regardless of the state of the debt markets. PEGs will simply use less leverage. Otherwise, they would have to return committed capital to their investors, so waiting on the sidelines is not an option.

The defense and government services industry is attractive, fertile ground for PEGs because of its stable and predictable cash flow characteristics, large supply of potential acquisition targets and reliability of the federal government customer.

Moreover, PEGs and debt providers have educated themselves about this sector in recent years. There have been few, if any, bankruptcies and virtually every PEG-backed buildup in this sector has given the equity backers an attractive internal rate of return.

At present, more than 50 PEGs have one or more platform companies in the government contracting industry. These platform companies backed by PEGs have the capital to make add-on acquisitions and now operate more as strategic buyers, which means they are less dependent on debt for acquisitions.

Like their private-equity counterparts, commercial banks and mezzanine funds have been drawn to this industry since Sept. 11, 2001. These banks are more competitive than ever in financing M&A transactions in this sector.

Although they are in the business of making loans, the banks also benefit from the deposits, related bank services and retail banking for government contractor employees. Thus, there is not likely to be any reduction of interest in this marketplace even if the emerging general credit crunch becomes more severe.

The talk of a meltdown in the debt markets is focused on multibillion-dollar deals requiring a lot of leverage. The vast majority of M&A activity in the defense and government services arena takes place in the middle market, where the average transaction is less than $100 million. Many lenders and capital providers are still eager to participate in this segment. As such, the middle market remains a relative safe haven for acquirers.

Granted, some PEGs and lenders may be less aggressive and large transactions may have fewer bidders. But the bottom line is that the M&A environment for defense and government services companies should not be negatively affected to any great extent by the turmoil in the debt markets.