New breed of buyers expand footprint in federal market

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

The pace of merger-and-acquisition activity in the defense and government services sector has increased in recent months. There is one characteristic about this latest round of consolidation that is unique: the buyer universe.

Companies from within the sector have historically dominated consolidation in the defense and government services arena. These traditional buyers earn most, if not all, of their revenue from defense and federal government customers. Their ranks include businesses such as BAE Systems Inc., CACI International Inc., General Dynamics Corp., Lockheed Martin Corp. and L-3 Communications Holdings Inc.

For more than a decade, traditional buyers thrived on a model that included supplementing organic growth with middle-market acquisitions. The pace of acquisition activity among those buyers reached a peak in the years immediately before the recent recessionary period. As an illustration of the high volume of acquisition activity among traditional buyers, the five companies mentioned above completed 40 acquisitions in 2006 and 2007.

The pace of acquisition activity among traditional buyers has slowed more recently. Those same five companies completed just more than 20 acquisitions from the beginning of 2008 through the present. That represents a decline of nearly 50 percent during a period that is seven months longer. In addition to slowing their acquisition efforts, some of the traditional buyers are becoming sellers. For example, Lockheed Martin announced it would divest Pacific Architects and Engineers Inc., a business it bought in 2006, during the peak of the traditional buyer-led consolidation cycle.

Companies that focus on a broad range of markets and don’t earn a majority of their revenue from defense and government customers are increasingly filling the void left by traditional consolidators. Those nontraditional buyers are motivated by the opportunity to gain an expanded presence in the large federal government market. Although certain Defense Department and civilian agency budgets are facing pressure, many nontraditional buyers view the growth dynamics of the federal sector favorably relative to the commercial markets they serve.

Some illustrative examples of recent acquisitions by nontraditional buyers in the federal sector are:

• AECOM Technology Corp.’s pending acquisition of McNeil Technologies, announced Aug. 4.
• SAS Institute Inc.’s purchase of Vision Systems and Technology Inc., completed July 16.
• CGI Group Inc.’s pending acquisition of Stanley, completed Aug. 17.
• Jacobs Engineering Group Inc.’s purchase of Tybrin Corp. and TechTeam Government Solutions Dec. 18, 2009, and June 4, 2010, respectively.

Transaction activity among nontraditional buyers has not been limited to strategic buyers. A host of new private equity acquirers has entered the fray, and they are also aggressively pursuing defense and government services consolidation opportunities. The acquisition of TASC by General Atlantic LLC and Kohlberg Kravis Roberts and Co. at the end of 2009 is the highest-profile example of this trend. In addition to favorable growth dynamics, private equity buyers find the federal sector enticing because of the multiple liquidity options available to them when they are ready to exit. Those options include a sale to a strategic or private equity buyer, public offering or recapitalization.

Although nontraditional buyers are dominating acquisition activity in the federal sector, traditional buyers are by no means out of the acquisition business. For the most part, traditional buyers are focusing their efforts on more specialized, niche acquisitions in areas such as cybersecurity, energy and health care. Over time, traditional buyers are likely to expand their appetite and return to their roots of supplementing organic growth with a steady diet of acquisitions.

Given that buyer demand drives valuation, the emergence of nontraditional buyers into the defense and government services sector is a positive trend for would-be sellers. As traditional buyers restart their acquisition engines, valuation dynamics for middle-market sellers will become more favorable. To that end, the prospects are looking brighter for well-positioned companies that are considering a sale in the near future.