M&A activity among midtier companies likely to pick up

The first quarter of 2009 represented a period of increasing concern that the broad economic recession was deep and likely to require substantial time to recover. The S&P 500 index fell 27 percent to its low March 9 and shares of BB&T Capital Markets/Windsor Group’s Government Technology Services index fell 19 percent. The mergers and acquisitions market was down significantly year over year, and the GTS sector was no exception. Of the companies represented in our GTS index, only two — ICF International Consulting Inc. and ManTech International Inc. — have announced or completed an acquisition in 2009. A number of companies that historically have been active in the M&A market have yet to announce a deal in 2009.

Since hitting that market low in March, the S&P 500 has rallied 30 percent through mid-May. The recent strength of broader market indices, the improving health of the banking system, stabilizing credit markets, and strong industry fundamentals are generating an improving climate for deals in which more market participants are actively and seriously re-engaging in the defense and government services M&A markets.

The transactions that have been announced or completed this year trend toward several sectors. Cybersecurity continues to be an area of significant emphasis as exemplified by the following announced or completed transactions: ManTech’s acquisition of DDK Technology Group Inc.; Cobham plc’s acquisition of ArgoTek Inc.; QinetiQ Group plc’s acquisition of Cyveillance Inc.; and Harris Corp.’s acquisition of Crucial Security Inc. Other areas of emphasis are intelligence, surveillance and reconnaissance (ISR); intelligence systems; information operations; data fusion and interpretation; logistics; and health care.

In addition, private equity firms have become more active in seeking acquisitions and exploring divestitures. Although the leveraged lending market is still challenging, there are enough lenders willing to finance deals to make private equity firms credible buyers. In addition, private equity firms are attracted to this industry as a hedge against their other investments in industries that are tied more closely to the overall economy. Many private equity firms cite the predictability and stability of this industry’s cash flows relative to others as a rationale for aggressively pursuing acquisitions in the defense and government services sector.

Furthermore, recent ISR and training transactions by large prime contractors such as Boeing Co., which recently acquired Digital Receiver Technology Inc., and Insitu Inc. and Lockheed Martin Corp., which recently acquired Universal Systems and Technology Inc., demonstrate the continuing interest and capability of prime contractors to aggressively pursue strategic acquisitions in the face of cuts in major weapons systems programs. In light of the changing budgetary environment, we expect to continue to see a great deal of M&A activity, both acquisitions and divestitures, as larger defense contractors reposition their offerings to customers. Foreign-owned buyers have been active as well.

We expect many publicly traded midtier GTS companies will be in a position to raise equity capital in the public markets in late 2009 or early 2010. That round of secondary equity offerings would go a long way toward recapitalizing midtier players that historically have been a key driver of M&A activity.

These examples signal an improving M&A environment, particularly for growing, well-positioned companies. In addition, those who sell their businesses in 2009 are likely to benefit from a more favorable capital gains tax environment that should remain unchanged in 2009. Consequently, more sellers are working with us today to assess the feasibility of structuring a process to successfully sell their businesses by year’s end to take advantage of this window of opportunity. A number of challenges to successful transactions remain, but the current outlook presents encouraging signs for companies seeking to access the M&A markets in the second half of 2009.