Government policies fire up acquisition activity this year

John Hagan is co-head of the defense and government services group at BB&T Capital Markets | Windsor Group.

The year 2010 has already seen a significant increase in merger and acquisition activity in the defense and government services sector. We expect this trend to continue for the remainder of 2010 with increasing activity throughout the year as the impact of government policy, like it or not, plays a significant role in driving M&A transactions. Four key policies are likely to contribute to an increase in activity: tax and fiscal policies, defense budget policy, and policies related to preventing organizational conflicts of interest (OCI).

With respect to tax policy, two key elements merit consideration as companies consider a potential exit in 2010. The first is the expiration of President George W. Bush’s tax cuts which, starting in 2011, will increase the capital gains tax rate from 15 percent to 20 percent. Thus, for transactions closing in 2011, sellers would see 5 percent less relative to 2010. Furthermore, the prospects of further tax increases by the current administration are very real. In fact, the health care “fixes” bill increases the capital gains rate to 23.8 percent beginning in 2013 for individuals making more than $200,000.

Second, private equity groups, an active investor in the sector, will likely be affected by changes in tax policy. These groups earn a good portion of their return through what is known as a carried interest, which is currently taxed at the capital gains tax rate. The current administration is seeking to impose the ordinary income tax rate on carried interest which would nearly double the tax paid by private equity groups upon an exit. Consequently, both entrepreneurial-owned and private equity-owned businesses have strong economic reasons to consider an exit in 2010 in order to maximize their after tax proceeds from a sale or public offering transaction.

Fiscal policy and the defense budget are drivers in the sale decision process as well. Flattening to declining defense budgets make it more challenging for government contractors to grow. In addition, the pressure of increased overall government spending on things such as the new health care bill and a budget deficit that is growing at an unprecedented rate will certainly continue to place even more pressure on defense and civilian budgets over the coming years. While certain segments of the defense budget are expected to continue to grow, many are expected to contract and will affect the values of the entire sector. Larger government contractors, in particular, are aggressively evaluating their current business segments and evaluating those they may consider selling and those they believe they need to strengthen through acquisition, thus reshaping and reprioritizing those areas where they will deploy capital. The results, positive or negative, will continue to drive M&A activity in the sector.

Last, policies oriented toward preventing conflicts of interest are driving M&A activity as well. Historically, contractors could implement mitigation plans to address this issue within their own organizations. Increasingly, however, government agencies are driving contactors to select either the development side or technical assistance side, but not both. The most notable example occurred recently with Northrop Grumman Corp.’s sale of its TASC unit to a private equity group led by KKR and General Atlantic. A smaller example is the sale of Aerodyne to MCR, a government contractor specializing in building a premier systems engineering and technical assistance business through both organic and acquisition growth. Aerodyne provides SETA services to the federal government in the unmanned aerial vehicle market.

Although there are many factors that enter into the decision process with respect to a sale or other liquidity transaction, government policy in the areas of taxation, fiscal and defense budgets, and conflicts of interest are key drivers that have contributed, and will continue to contribute, to the increasing M&A activity in the market in 2010.