Deal-making to continue despite downturn

The government contracting industry, like the rest of U.S economy, is trying to ascertain what political change and the financial turmoil will mean for the industry. Specifically, how are the capital markets and the mergers and acquisitions environment for this industry affected?

The industry has experienced a number of economic and political cycles over the past 20 years. In the 1980s and early 1990s as defense spending increased dramatically, a proliferation of new contractors emerged financed by commercial firms and some public and private equity. During the dot-com era of the mid- and late-1990s, government services firms were viewed as too conservative by the capital markets and valuations were soft. Then, after Sept. 11 through the present — with a huge expansion in the federal budget for defense, intelligence and homeland security — a large new crop of companies has emerged, financed by the public and private capital markets, and a huge wave of consolidation has taken place. Valuations rose from 4 to 6 times earnings before taxes, interest, depreciation and amortization to 8 to 12 times EBITDA and, in some cases, higher for companies with strong growth prospects and barriers to entry.

I believe capital (primarily private capital) will continue to be available to the industry to fund organic and external growth and M&A activity will continue primarily in the lower-middle market (under $300 million), but on less favorable terms.

The government services industry is and always has been counter-cyclical, and it is viewed as a safe-haven insulated to a degree from economic forces. Valuations of government services companies currently exceed most commercial companies and defense primes.

Since the 2001 terrorist attacks, the capital markets and commercial and foreign companies have been educated about the unique growth drivers of the industry: the need to outsource more due to the retiring federal work force and technology change; the expanded missions of governments; and the high revenue and earning visibility, strong cash flow and solid balance sheets of government services companies.

Regarding the capital markets, the public capital markets for government services companies (initial public offerings and secondary offerings) remain as dormant as they are for the commercial economy, and I don't perceive any public offerings in the near term. Still, the private capital markets remain very much available for this industry. Banks continue to lend, and there are many private equity and mezzanine funds actually investing. During the past five to 10 years, those sources of capital have been educated to the attributes of the industry and, for the most part, the bets they have placed have paid off handsomely. Yet lending multiples have decreased to two to three times EBITDA versus 3 to 4. Also, some private equity groups are pulling back and conserving their dry powder until the financial markets stabilize; instead they are using their capital to buy back debt of their portfolios companies at a steep discount. Those that continue to invest in government service companies are using less leverage.

Furthermore, the large publicly traded companies, known as the "strategics," have considerable cash on their balance sheets and want to reposition themselves from large weapon systems to new emerging budget priorities. However, stock prices of some of the large primes have followed the broader market downward, resulting in their offers being at lower valuations so they could still be accretive.

The other factor keeping valuations relatively high in the industry is increased foreign investment. Three recent acquisitions at high multiples are Finmeccanica's (Italian) acquisition of DRS Technologies Inc. for $5.2 billion (just approved by the U.S. government), Dominion Technology Resources Inc.'s acquisition by QinetiQ Group plc (United Kingdom) for more than 20 times EBITDA and SI International Inc.'s acquisition by Serco Group plc (United Kingdom) at a premium valuation.

The results of the election are not expected to radically change the perception of the capital markets. Companies that provide non-discretionary, mission-critical services will continue to grow and be desirable. The capital markets also will favor companies that are well positioned for new budgetary priorities such as nation building, health care, cybersecurity, energy and the environment.

The capital markets for the government services industry are changing, but deals will still get done. Lenders, private equity groups and strategic buyers are active, but they are more discriminatory and somewhat more conservative.