Top federal market trends for 2009

Last year was a year like no other in the defense and government services market. The new year promises to be equally dynamic. Some of the key trends to look for in 2009 are:

● Large companies will capitalize on a volatile environment. Large companies in the defense and government services market are significantly underleveraged relative to other industries. The debt-to-equity ratio of the defense industry’s largest players is 10.8 percent, while the same ratio for companies that make up the Dow Jones is 65.5 percent. Given the balance sheet strength of large defense companies, they are well positioned to pursue acquisitions. Look for the industry’s largest players to continue to pursue niche-oriented transactions and to ramp up efforts to make larger deals.

● More mid-tier players will disappear. Many mid-tier defense and government services companies are carrying greater amounts of debt than they were several years ago. At the same time, public company valuation multiples for many mid-tier companies are approximately 30 percent below post-9/11 peaks. With credit markets tight and public equity markets shut, mid-tier players might be forced to slow their acquisition activities. That, coupled with potential slowing organic growth, could put tremendous pressure on the top-line of many mid-tier businesses. With the path to growth less clear, a sale to a larger company becomes more compelling.

● Private equity will still be a factor. Private equity groups made more than 90 investments in the defense and government services market in the past five years. Despite a less favorable credit environment today, PEGs remain eager to secure a platform in the government space. There are two primary reasons for this. First, PEGs raised large amounts of capital in the past few years and must put it to work. Second, there are very few industries outside the government market where PEGs can find healthy companies. With debt harder to come by, PEGs will be forced to use more equity with every acquisition. This will raise the bar for a satisfactory return and not every investor will clear it.

● Divestitures will return. Until recently there has not been much incentive for defense and government services companies to consider divestitures. With valuations at historically high levels from 2001 through 2007, it was hard for publicly traded companies to divest business at a multiple that wasn’t dilutive. At the same time, capital was plentiful. For these reasons, it made more sense to retain noncore assets. Now that multiples are down and capital is no longer a commodity, there is greater rationale for divestitures.

● Well-positioned companies will still generate attractive valuations. The valuation environment for merger and acquisition transactions is bifurcated. Well-positioned companies will continue to earn attractive valuations. They includes businesses with high-end skills in areas such as cybersecurity, a technology discriminator or serving customers in segments of the market that are expected to grow (e.g., energy, health, infrastructure, intelligence, and logistics). More generalist companies will find it difficult to complete transactions at valuation levels available one year ago. With buyers more discerning, creative positioning and buyer insight are critical.

● Capital gains tax rate will likely remain favorable. If there is a silver lining in these challenging economic times, it is that it seems likely capital gains tax rates will remain unchanged in 2009. A 5 percent increase in the capital gains tax rate would require a purchase price increase of more than 5 percent for a seller to yield the same after tax proceeds. This provides significant incentive for business owners to sell in a favorable tax environment.

● Some companies will stumble. The defense and government services market has been relatively immune from business failures. The tight credit environment will cause some companies in the sector – albeit a very small number – to stumble. The businesses mostly likely to face challenges are those with high amounts of leverage.

All in all, life in the defense and government services sector is far better than in other industries and the future remains bright.