3 market realities you can't ignore

Heraclitus of Ephesus, the pre-Socratic Greek philosopher, offered that the only thing that is constant is change. Anyone who has lived through the roller coaster ride of the past three years will stand shoulder-to-shoulder with Mr. H. on this one.

Much is written about the risks and opportunities regarding large, publicly traded corporations in the defense, aerospace and government services sector. Analyst reports and broadsheet coverage send constant reminders to shareholders and investors about the merits and perils of the sector’s equity characteristics.

But below these titans of the industrial base sits the foundation on which this great nation’s power is projected. When it comes to innovation supremacy, technology and engineering superiority, and logistical efficiency, it is the small business and middle-market constituents who drive such national competitive advantages.

So what are some of the realities for these businesses as the tectonic plates of government contracting once again shift in tandem with the swing of the infamous pendulum?

First, the glory days of merger and acquisitions valuations are, generally speaking, over. From 2003 to 2007, average companies garnered above average attention from buyers. Purchase prices were considerably more generous than they might be today. Consolidators were focused on market share and scale. Private equity, for the most part, simply couldn’t compete on the financial merits despite the abundance of cheap money.

Today, public company valuation multiples are 40 percent to 60 percent below post 9-11 peaks and there is scant reward from shareholders and financial markets for adding commoditized services and undifferentiated products. Certain companies that possess attractive and defensible characteristics are still able to command multiples above 10 times, but these tend to be exceptions.

Second, buyer dynamics have changed. Some of the most notable deals of the last two years that include Lockheed Martin’s sale of EIG to Veritas Capital and PAE to Lindsay Goldberg; SRA International’s sale to Providence Equity; Northrop Grumman Corp.’s sale of TASC to General Atlantic; Relativity Capital’s acquisition of Evergreen’s MRO business; and Ares Capital’s purchase of GTEC have gone to private equity buyers able to either out muscle or out maneuver strategic competitors involved.

The emergence of private equity as serious contenders presents an interesting option for sellers of privately held companies. The ability to remain involved, preserve organizational culture, continue to grow and monetize the years of sacrifice, commitment and effort is a compelling option.

That’s not to say this is unachievable in a sale to a strategic buyer, but precedent suggests it is a less likely outcome. Another development within the buyer universe is the prominence of engineering and construction companies entering adjacent markets in the government services sector. Examples of this trend can be seen in: Parsons’ recent announcement to acquire Sparta Inc. from Cobham; URS’s purchase of Apptis Inc.; and AECOM’s acquisition of McNeil Technologies.

Third, leadership matters. The recent changes at the National Security Council, which include: the new chairman of the Joint Chiefs of Staff (Gen. Martin Dempsey), a new secretary of Defense (Leon Panetta), and a new Director of the CIA (Gen. David Petraeus) will have direct and indirect implications on middle market companies.

Couple this with the recent appointment of budget hawk Ashton Carter to deputy secretary of defense, the pace of change should not be expected to yield any time soon. Certainly in the cases of Petraeus and Carter, these are grand thinkers and bold movers.

With that comes opportunity for the private sector. Carter’s track record of ‘efficiencies’ and Petraeus’s cerebral and unconventional approach to problem solving, support the creation of new and evolving fast currents of growth.

For example, the emergence of offensive cyber and strategic communications/information operations will become key tools in the budget constrained box of the federal government.

The shift towards an expeditionary military force structure suggests weight and size become magnified issues for ground forces and special operations units. Intuitively, market leaders with core competencies in miniaturization and weight reduction technologies will serve as attractive M&A targets.

Understanding the thinking and track record of key decision makers and visionaries will be crucial if you want to stay ahead and capitalize on the impending change.

In today’s environment, the ability of companies to adapt to the rapid and fluid environment of change will dictate their continued success and possible survival. In the context of M&A, the true winners will be those who have implemented, or will execute, strategies which position their organizations in the cross hairs of customer and buyer interest. Sheep are out, shepherds are in.