The future looks bright for M&A in '08

As we end another strong year for merger and acquisition activity in the government services industry, it's time to look ahead to trends that could affect the market in 2008. Next year, the industry should continue to benefit from many of the positive factors that helped valuations in 2007, including significant liquidity available to strategic and financial buyers for acquisitions, the emergence of new buyers interested in the defense and government services market, and greater competition for deals because fewer quality companies were interested in selling.

Although M&A valuations remain strong for attractive companies, a period of increasing uncertainty may be on the horizon for the government services market. Watch out for: Recession concerns. The public markets have recently experienced significant volatility because of a slowing housing market and subprime-mortgage concerns. The Dow Jones Industrial Average dropped 6 percent between Oct. 15 and Nov. 1, and many Wall Street firms have been forced to take significant write-offs because of their subprime exposure.

Although middle-market M&A activity has been somewhat insulated from these concerns, there is a fear that we could be approaching a full-blown recession in 2008. If the economy were to continue to struggle next year, the defense and government services marketplace would be one of the few industries that investors would view favorably.

The impact of small-business contract rule changes

As 2007 closes, the year's small-business rule changes are having a discernable and negative effect on M&A activity. It appears that the regulation — recertification in the event of a sale — is being stringently implemented and reducing valuations.

Some serial buyers will not consider companies with more than 15 percent of their revenue from small-business contracts. Some emerging liquidity options for these companies are to sell to high-networth individuals, Alaska Native corporations, employee stock ownership plans or small-business investment companies.

Political uncertainty

Historically, there has been significant volatility in public company valuations during an election year. For example, an index of publicly traded government services companies had an average valuation of about 13x (trailing 12-month enterprise value to earnings before interest tax depreciation and amortization) in January 2004. By August 2004 the average valuation for those companies had dipped below 10x because of the uncertainty over the pending election.

Yet by the end of the year their stocks' average valuation was about 16x.

Many buyers are now assuming that regardless of the outcome, there will be a realignment of budget priorities favoring non-Defense Department agencies. Thus, we are seeing acquiring companies beginning to focus on industries and capabilities that have been recently out of favor, such as environmental sciences, energy and health care.

Capital gains change

Currently, the owner of a company selling his business is taxed at a capital gains rate of 15 percent. Legislation is pending in Congress that could increase the capital gains tax rate to as high as 28 percent.

I suspect some business owners will look to sell in 2008 to avoid the tax rate increase.

The fundamentals are in place for 2008 to be another good year for M&A activity in the defense and government services market. But with the changing economic and political winds, sellers and buyers will have to pay close attention to the impact of those climate changes on our industry.