Ethics rules expected to spur acquisitions

Many of Washington Technology's Top 100 companies have been built on the strategy of assembling broad capabilities and achieving scale. Although that strategy has expanded the scope of the technology and systems that these lead systems integrators can bid and potentially execute, it has resulted in business challenges from perceived organizational conflicts of interest (OCI).

Within the industry, there has been extensive discussion and uncertainty surrounding the government's stance on OCI. The prospective consistency and clarity of new rules will determine the effect that OCI will have on merger and acquisition activity in the government services sector. The reality is that nearly all prime contractors, major hardware providers and services companies have contracts and/or business in which they act as an adviser to government on topics such as acquisition support, program management, and systems engineering and technical assistance (SETA) services. With emerging new rules and contracting officers taking tougher stances on OCI mitigation, OCI-driven M&A is likely to increase in earnest in 2010.

On April 22, the Defense Department released its long-awaited proposed rules on OCI, as required by the Weapon Systems Acquisition Reform Act of 2009. In its draft form, the proposed rule has significant implications for industry because it will cover all DOD procurements, not just defense acquisition programs. For example, the proposed rule treats contractors as a single entity, referring to the total contractor organization, which includes all subsidiaries and affiliates. It also places responsibility for identifying any potential OCI on the contractor prior to award and on a continuing basis subsequent to award. It isn't apparent that the rule will engender more consistent application among contracting officers, making the obligation of contractors to self-identify their OCIs challenging, to say the least. These are only a few of the concerns that industry has identified with the proposed rule.

The government's heightened concern about OCI and now DOD’s proposed rule has several implications for the M&A activity in the government services market.

• Shift in the strategic buyer mix. In the early to mid-2000s prime contractors completed a number of sizable product/service acquisitions in the industry, including Veridian Corp., Anteon International Corp. and MTC Technologies Inc., each of which required meaningful mitigation actions — divestiture of contracts — before or after closing to obtain DOD approval. Looking ahead, OCI concerns will likely reduce prime contractors’ large services acquisitions. Instead, we are more likely to see the hardware providers focus on niche government services acquisitions aimed at filling gaps in their customer base or capability set rather than pursuing bigger deals that will require component divestitures or contract carve-outs.

• Increasing divestiture activity. It's unlikely that we'll see divestitures that rise to the level of Northrop Grumman Corp.'s sale of its TASC unit, but hardware and services contractors alike are considering business or contract divestitures. Agencies and contracting officers drive company-oriented OCI analyses, effectively requiring divestitures of business with perceived conflicts. Contract sales can be mandated to occur quickly and without public announcement. In addition to contract sales, companies are also swapping contracts, presumably for more favorable tax treatment.
• Platforms built around OCI strategy. We'll see more private equity platforms of businesses with significant government advisory components. Examples include KKR/TASC, Carlyle Group/Booz Allen Hamilton Inc., Court Square Capital Partners/Wyle Holdings Inc. and New Mountain Capital LLC/Camber Corp. This follows a broader trend of companies strategically positioning themselves as a provider of advisory services to the government or as a builder and manager of systems. We expect these private equity platforms to be active acquirers of government advisory businesses.

Regardless of which side of the line you're on, it's important for companies to build a business strategy that incorporates the realities of the government's OCI posture. With OCI mitigation becoming more difficult for the prime contractors, some additional portfolio shaping may occur. For midsize companies, straddling the adviser/provider role will affect both valuation and feasibility of exit alternatives.