Welcome to the bipolar M&A market

The government services mergers and acquisition markethas been consistently active since 2001. A growing populationof buyers, foreign and domestic, strategic and financial,has provided a liquid market for sellers.Contributing factors have included improvingmargins; above-average growth in governmentspending, particularly in nationaldefense and intelligence segments; aggressivelending by banks; and expeditious regulatoryreview and government accommodation ofcontract transfers. Many of these factors havebegun to change, suggesting that the governmentM&A market will be different in 2008.Is it getting better or worse? In a nutshell, it'sbetter for some, worse for others.We now have a bipolar M&A market drivenby the small-business recertificationrequirements that took effect July 1. To simplifyand generalize, selling companies canbe placed in one of two categories ? battletested,high-quality companies or emerging,not-ready-for-prime-time companies.On one side, high-quality companies withno meaningful small-business preferencecontracts are highly sought by active buyers,often commanding premium pricing.Transaction values in the range of 10 timesto 14 times trailing earningsbefore interest, taxes,depreciation and amortization(EBITDA) arebeing achieved in many transactions ? abig gulp for buyers, as these pricing multiplesare often higher than the trading levelsof the acquiring companies.On the other side, emerging businessesare unable to transfer contracts and sustaincustomer relationships. These businesses ?many of them with quality attributes ? arefinding weak, or tentative, buyer interestand suboptimal valuations, including contingentpayment transaction structures.Besides recertification, other factors arechanging. The psychology of the capitalmarkets has migrated from widespreadgreed to overarching fear. Spawned by thesubprime mortgage epidemic, where identifyingthe bottom is difficult, financial institutionsare less aggressive, re-examiningtheir credit standards and returning tomore traditional credit parameters withgreater rate premiums for risk and tightercovenants. These capital sources have beenactive supporters of financial sponsors(private-equity investors), enabling themto be more competitive in government anddefense deals with strategic buyers in thepast few years.Slowing growth in government spendingmakes organic growth harder for manycompanies to achieve, suggesting thatstrategic buyers may be more aggressive thisyear. The challenge for these buyers is onthe supply side, specifically, a diminishedpopulation of quality companies ? thosewith transferable, sustainable contracts ?to choose from. Additional imponderablesadd to the challenges for buyers. Theseinclude election-year uncertainties relativeto the spending priorities that willunfold in 2009, a slowing economy andits influence on fiscal policy decisions ?both tax and spending.The expansion of industry EBITDAmargins, evident through 2006, ceasedfor most active industry buyers in 2007.Future earnings growth will be substantiallydriven by revenue growth.Continuing congressional investigations,highlighting alleged misdeeds bycontractors, has the effect of distractinginvestors from the fundamental strengthand stability of the industry. For example,during the past three months market averages? the Dow Jones Industrial Average,NASDAQ Composite and the Standard andPoor's 500 ? have declined between 11 percentand 15 percent, while a capitalizationweighted index of federal information technologycompanies has fallen only 4 percent.Aggregate reported transaction value in2007 was down slightly from the level inrecent years. Don't be surprised to see fewerdeals in 2008, influenced by lengtheningdue diligence and regulatory review with,perhaps, more headline transactions in themix.