What's driving the new wave of M&As?

 According to Ashton Carter, deputy secretary of Defense and former undersecretary of Defense for acquisition, technology and logistics, the aerospace, defense and government services sector is poised to see significant consolidation during the next several years.

Unlike the consolidation associated with the spending cuts of the mid-'90s, which saw several industry mega-mergers that winnowed the field of prime contractors to five, it is expected that the vast majority of transaction volume for the current consolidation phase will take place below the $5 billion level.

There are several factors driving Carter to that conclusion. First and foremost is the fact that there is extreme pressure to cut government spending across the board, but the defense budget is most certainly at the forefront of many of those discussions. The Budget Control Act of 2011 established the Joint Committee on Deficit Reduction, also known as the supercommittee. The supercommittee is required to propose legislation by Nov. 23 that would create $1.2 trillion in budget savings between fiscal 2013 and fy 2021. Such a proposal would need to pass by January 15, 2012, or trigger cuts and mandatory caps on spending that would begin in 2013.

In any event, an overall reduction in the defense budget will no doubt occur and put pressure on all contractors, making it increasingly difficult to grow organically. This challenging and uncertain environment has translated into near historically low valuation multiples for the publicly held government contracting community.

While the budget picture remains foggy for now, buyers are placing their bets in advance of any clarity by seeking acquisitions in areas that they believe will be the winners, while at the same time seeking to divest subsidiaries and divisions exposed to more austere budget conditions. The result will be potentially greater separation in performance among companies in the industry as growth will be gained predominantly from taking market share from competitors.

Many industry participants are already more aggressively supplementing low organic growth with acquisitions focused on niche segments of the budget where growth and funding are expected to remain strong. Examples include cyber security, high-end intelligence, C4ISR, commercial aerospace, predictive analytics, cloud computing, identity management and health care-oriented companies.

In addition, the number of companies seeking liquidity through a sale is likely to increase for several reasons:

• Owners of government contractors may conclude that it's best to sell now versus operating in what they predict could be a much more austere environment.
• Owners may wish to take advantage of current capital gains tax rates before any potential future increase.
• Capital tied up in a potential ‘low-growth’ investment could be more attractively re-deployed in higher growth segments.

Prospective sellers include small entrepreneurially owned companies, larger publicly traded companies seeking to divest underperforming subsidiaries and private equity firms seeking to lock in gains.

Consequently, we believe 2012 will be a very active year for M&A activities. Early movers in this consolidation will reap the rewards of this re-deployment of capital, garnering above average valuations. Conversely, diversified businesses with exposure across a number of ‘at-risk’ segments of the budget will be more challenged to maintain positive growth.

For independent private companies, the risk is valuation; for public companies, the risk is independence; for highly levered companies, the risk is solvency. While these risks are sobering, perhaps the more important risks are those to our national security industrial base and the future security of the United States.