Wall Street beckons government contractors

 The stock market debut of Global Defense Technology and Systems Inc. (GTEC) last November was notable as the first government-services initial public offering in three years.

Is the GTEC IPO the start of a trend? It’s possible. Many contractors have grown substantially since the last wave of federal IPOs in 2005-06, and with the equity and debt markets continuing to recover from the 2008-09 financial-sector crisis, the time could be right. Also, new organizational conflict-of-interest (OCI) rules narrow the field of eligible buyers, making an IPO more likely as a path to liquidity.

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2009 M&A Roundup

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But while the near-term IPO outlook is a little cloudy, the longer-term signs are brighter than ever – thanks to the strong, sustained and ever-expanding role of private-equity groups in the federal sector.

These groups are outside investors that typically rely heavily on borrowed money to buy majority stakes in companies. They then use their financial and managerial discipline to build growth, profitability and the return on their equity investment.

Private equity groups help companies reach IPO size faster by relying heavily on mergers and acquisitions to build value, and they commonly look to IPOs as a way to recoup their investments, usually after three to five years. So, recent private equity activity is a leading indicator of future IPO activity.

Right now, that indicator is pointing straight up.

Washington Technology’s roundup of the top M&A deals of 2009 shows that private equity groups are more involved than ever in the government-services sector. About 20 percent of the deals involved buyers which are private equity platforms or private equity groups themselves – most notably, the $1.65 billion acquisition of TASC by General Atlantic and KKR.

Looking back, the 2008 Washington Technology list also featured substantial private equity activity, including Carlyle Group's  standout $2.54 billion acquisition of Booz Allen Hamilton.

Private equity acquisitions over the past few years have created a massive installed base of M&A-fueled federal services companies. Looking ahead, expect that base to drive substantial acquisition volume in 2010 and 2011, building a new, perhaps bumper crop of IPO candidates.

Platform companies with multiple acquisitions already completed – such as Camber, A-T Solutions and Six3 Systems –will continue to build toward a possible IPO. Booz Allen and TASC – relative leviathans already – also will look at deals while keeping an eye on the equity market to see whether the time is right for an IPO. Recently formed private equity-backed management groups, such as Salient Solutions LLC, will find the platforms on which to build their own future IPOs. And established private equity groups – some new to the sector – will continue working on unannounced searches for platform deals.

What’s behind all of this activity?

The favorable view that the stock market conferred on the government-services sector back in 2002 has never really gone away. After all, IPOs in the sector over the past decade have almost uniformly done well (several, such as Anteon and SI International, have since been acquired).

Public equity valuations, while below the highs of 2002-2007, have recovered somewhat from their 2009 lows. Debt – an essential ingredient of private-equity activity – is becoming steadily more available and on better terms.

Private-equity capital that was invested in the sector, grown and then returned in IPOs or private sales is being cycled back into the sector to do it all again – often in partnership with company executives who were critical to success the first time around. Many of those executives are using the personal fortunes they amassed through successful mergers and acquisitions to become private-equity investors themselves.

And private equity groups from outside the sector continue to be drawn by the sector’s success stories.

The influence of private equity in the government-services sector is self-reinforcing. It is stronger than ever. And it shows no signs of slowing. If recent history is a guide, that means more M&A – and eventually, a new wave of IPOs – in years to come.