The recession hasn’t stopped the M&A train in the federal sector.
Despite the economic turmoil of the second half of the year, 2008 was an active year for mergers and acquisitions in the federal sector. And experts expect more of the same in 2009.
“2008 was a pretty solid year,” said Gregory Van Beuren, managing director of investment banking at BB&T Capital Markets/Windsor Group’s Defense and Government Services Group. “If you look at the amount of capital that is available and you look at the new priority areas that have been created, it’s likely that ’09 is also going to be a strong year from an M&A perspective.”
William Mutryn, co-leader of the Corporate and Mergers and Acquisitions Practice Group at Holland and Knight, agreed, but he predicted fewer deals in the first part of 2009 than in the same period in 2008. “Financing is expensive, and in a lot of cases, it is unavailable. And valuations are down.”
Mutryn said M&A activity will likely accelerate in the second half of the year when the financial markets stabilize. “There will be pent-up demand because contractors still want to grow, [and] private equity firms still want to spend their investors’ money,” he said.
Van Beuren said he would not be surprised to see companies such as Affiliated Computer Services Inc. or EDS Corp. re-emerge as buyers this year.
“The primes, the large defense primes and the tier ones -- they have cash,” Mutryn said. “They don’t have financing problems. They’re seeing valuations that are favorable to them. So I think they will continue to be active purchasers.”
Active buyers, active areas
Specifically, Van Beuren said he expects Boeing Co. and Lockheed Martin Corp. to continue to be active acquirers. They are both sitting on billions of dollars in cash, according to a BB&T survey of the top 30 publicly traded companies in the government market.
“On a combined basis, those two companies have over $7 billion in cash on their balance sheets,” Van Beuren said.
Overall, the 30 companies on the list have about $27 billion in cash. “That’s just [their] cash,” he added. “If you looked at what the leverage capability is for those companies, at an easily leveraged level – call it three times cash flow – you’re looking at well over $100 billion of acquisition capability among just those 30 companies.”
Mitchell Martin, a principal at Merrill Advisory Group, a McLean, Va., consulting firm for small and mid-tier companies, predicted that 2009 will be a good year for buyers. “We see the credit markets loosening,” he said. “We’re starting to see that already. But companies that aren’t going to be relying on a lot of debt we think have a lot of options” when it comes to making acquisitions.
Larger companies such as CACI International Inc., SRA International Inc. and Stanley Inc. are becoming interested in smaller companies that have the technologies they need for specific contracts or as additions to their current services, Mutryn said. “That’s kind of a new trend,” he said. “So if you have a very good small company, there is going to be high demand for it.”
In addition, small businesses will be prime acquisition targets because their owners have a number of important concerns about the future, Martin said. They are concerned that the Obama administration might eliminate some large programs, federal funds might decline significantly and the capital gains tax might increase. And older owners are worried about compensating for the steep loss in value of their 401(k) retirement investments, he added.
“The big question is: Will the supply side hold up and meet the demand?” Van Beuren said. “I would suggest that it would.”
He said buyers’ interest in technology has not diminished and the Obama administration’s priorities have added some new, attractive areas for investment, such as infrastructure, health care and energy. “It just widens the aperture of the types of companies that are going to be interesting to buyers,” Van Beuren said.
Mutryn said he is seeing a change in the terms of transactions. “Two years ago, almost everybody would characterize current transaction terms as being very seller-favorable. I think they are migrating now from seller-favorable to buyer-protective.”
Also, there now appears to be a two-tiered market. Companies with unique or especially desirable technologies have high valuations, but valuations have fallen for companies that do not offer specialized expertise or contracts, Mutryn said.
Regarding the due-diligence process, he added, “I would say right now it’s more extensive than I’ve ever seen it.” Companies are looking closely at future projections of revenue and expenses for the next year or two.
“Cybersecurity is a great place for those companies to play because of the applicability in both the commercial and the government sector,” Van Beuren said.
He cited as examples Tetra Tech Inc.’s acquisition of Energy Department contractor Hazelwood Enterprises, a nuclear science and engineering company, and L-3 Communications’ purchase of International Resources Group, a U.S. Agency for International Development contractor that helps governments and the private sector manage critical resources.
Scott Hommer, co-chairman of the Government Contractor Services Group at law firm Venable LLP, said he doesn’t expect M&A activity to improve until perhaps the second half of 2009, when the Obama administration’s top priorities – or flagpole programs – become apparent at each government agency. “Then you’ll see the contractors try to get close to the flagpole,” he said.
However, he added, “If we get to [the third quarter] and there hasn’t been movement toward a recovery, I’m not sure the government continuing to spend [Troubled Assets Relief Program] dollars is going to help so much. We’ll just be at the mercy of the market forces at that point.”
Strong equity activity
Private equity firms remained active throughout 2008, Van Beuren said. “For the most part, they really muscled through the credit [crisis] issues that were affecting other industries much more than ours.”
Although they might not be lending at the same levels they were five months ago, those firms are still lending in this market because it’s a safe place where they can justify their investments to their limited partners, he said.
“In times of turmoil like this, the government still pays its bills, it has a budget that is very predictable for at least 18 to 24 months out, it has long-term contracts, and it is much more appealing than most other segments of the economy right now,” Mutryn said.
That situation has led to more commercial firms, foreign entities and private equity companies entering the federal marketplace, he added. “So the demand for government contractors is still high.”
For example, in May 2008, the Italian firm Finmeccanica, a supplier of electronics equipment and defense and security systems, bought DRS Technologies Inc., a supplier of integrated defense electronics products and services, for $5.2 billion.
There has been virtually no decline in demand, even though two major purchasers were themselves bought in 2008, Van Beuren said, citing BAE Systems’ purchase of MTC Technologies Inc. in June and Serco Group’s acquisition of SI International in December.
Private equity groups will recapitalize when the credit markets improve in a year or two, Van Beuren said. “Or they may recapitalize the business as they do acquisitions and use their unleveraged balance sheets to make acquisitions with debt as they go forward and ultimately recapitalize the business in that manner.”
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