2013 had its challenges, but the investment banking duo of Bop Kipps and Mark Marlin of KippsDeSanto expect a more active 2014 with some distinct trends to watch for buyers and sellers.
Before looking at the emering merger and acquisitions trends of 2014, it is critical to reexamine where we have been.
The past year proved challenging for the government services M&A market, defined by a significant decline in total announced transactions (approximately 50 announced transactions, half the number closed in 2012).
The 16-day government shutdown in October, alongside continued budget/sequester uncertainty throughout the year, led to reductions in obligated funding and delays in recompete and new contract award decisions during 2013.
The growing use of lowest price technically acceptable – explicit or implied – challenged incumbent win rates and continued to pressure forward-looking margins. An emboldened Small Business Administration also elevated uncertainty about future contract opportunities via its herculean push for more small business set-aside opportunities.
Finally, bid protest activity seemed to become the norm rather than the exception, which in turn further delayed contract awards. These dynamics all contributed to a weaker financial profile for prospective sellers.
On the buyers’ side, the lack of completed deals in 2013 was also heavily influenced by preoccupied strategic buyers whose attention was turned to corporate reorganizations and rethinking near and longer term strategies.
By refocusing on core services and in turn, reshaping portfolios, strategic buyers widened the valuation gap between transaction parties, often citing the lack of visibility and the perceived risk of target companies.
Financial buyers continued to target the federal space in increasing numbers; however, there was a similar valuation gap between value expectations tied to perceived headline risk by buyer, and optimism to buck the headwinds by seller.
In most cases, reality was somewhere in between. The value or deep discount plays sought after by another segment of buyers did not occur in any high numbers. Consequentially given the market conditions, in many cases, the “hold” alternative bested the sale alternative, especially for businesses with meaningful set-asides, above-average historical margins, or low/no growth. In those deals that did close, buyers increasingly shifted the balance of risk-sharing to sellers via terms and conditions, valuation multiples, and/or earn-outs.
However, the markets remain active, a federal budget deal is now in place, and trends are more positive going into the New Year.
Looking forward, below are our predictions for the 2014 M&A market:
Deal announcements below historical average, but a 20 percent plus increase over 2013.
We expect a significant pickup in 2014 and into 2015. Valuation imbalance remains for many when comparing deal value to the cash generation potential of the status quo; however, we anticipate this gap to close over time. Sellers are increasingly recognizing the challenges of the current market and opportunities that exist with the right partner (strategic or financial). Similarly, buyers’ anxiety has subsided for the time being, and they are showing a renewed interest in getting deals done and quenching their pent up acquisition demand. While this market may have its challenges, it remains ripe with opportunity.
Prioritization of Growth Markets.
Cloud, mobility, health care, data analytics, cyber, and C4ISR are all high on the shopping list for buyers. These segments sit at the nexus of bi-partisan support, mission importance, and opportunities to differentiate through branded solutions or technology (further discussed below). Within these areas, it’s also important that smaller and mid-sized company carve out focus niches in which they can scale and remain successful for the long term. For example, with the migration to cloud, much of the O&M work may be consolidated for hardware and infrastructure to be managed and monitored by a large Tier I contractors; however, value creation opportunities exist via market leadership in application development and application driven solutions for the smaller and mid-sized growth companies.
Continued divestitures from the primes and non-pure play industry players. Firms of all sizes have recommitted to their core strategy and are looking to invest primarily in areas that they have some form of competitive differentiation. The ability to divest, and redeploy capital into these focus areas is consistent with many firms longer term growth strategies.
Renewed Focus on Larger Deals.
Bigger companies – those above the “move the needle” threshold – are perceived as less risky and offer instant scale advantages, such as increased cost competitiveness. In the extreme case, the desire for scale may motivate potential mergers of private equity owned portfolio companies to achieve scale/harvest cost synergies.
Set-asides and Preference Programs Remain Confusing and Discounted.
In a higher risk environment, buyers often remain deaf to the practical treatment of set-asides and track record of performance post-deal. Large businesses remain less likely to take the transition risk, resulting in valuation discounts and/or earn-outs. Firms with a heavy concentration of restricted contracts may continue to find liquidity options challenging; however, this dynamic may also encourage the exploration of alternative transactions.
Business owners will continue to look for interim liquidity events to include minority sales/strategic investment, ESOPs or mergers between liked-sized firms. Given the competitive market dynamics, there is little room for companies too big to compete as small businesses, but too small to be competitive. These mergers are increasingly becoming rate and cost-driven as well. Especially for firms having a higher concentration of small business or subcontracts, creativity may become king. The market for minority transactions in terms of reputable investors and deal norms is maturing quickly, and increasing in its attractiveness to provide partial liquidity and outside expertise to hone and help execute growth strategies.
Contract Vehicles the Holy Grail.
The government is increasingly looking towards large, multiple award contract vehicles as the path of least resistance in an otherwise challenged procurement environment. Vehicle “poor” firms will increasingly look to acquire companies that hold coveted vehicles with broad government customer appeal (e.g., Alliant, CIOSP3) or the contracts itself. We would also expect a continued trend of strategics looking to acquire agency specific vehicles (T4, EAGLE etc.) in order to round out specific end market strategies for which they current sit on the sidelines.
IP as Branded Solutions.
Buyers will increasingly look for sustainable competitive advantages within professional services companies beyond “having the best people”. In response, firms will look to brand their services offering – templates, business approaches, management models, and increase investment in proprietary technology that can be sold or given alongside services. The perception by the government of buying a solution to a problem rather than labor hours may help diffuse the commoditization of services contracts. The ability to sell these branded solutions on a best value basis, may better position firms to sustain margins and stand out from the crowd.
Adapting to the New Normal.
From an M&A perspective, buyers are looking for a new playbook. For example, given the ever-changing COTS tools being introduced in the market to improve efficiency / productivity and savings, the contractors need to stay sharp and become more proactive seeking out these new COTS solutions. The old way of just being Microsoft or Oracle partners is less likely to serve as the differentiate that drives value.
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