How will GovCon M&A play out in 2019?

In retrospect, 2018 can certainly be characterized as a “Year of the Megadeal” for the government contracting market with one large transaction either announced or closed after another to further consolidate the market.

Just see General Dynamics-CSRA, the creation of Perspecta and Northrop Grumman-Orbital ATK as examples. This year will see Science Applications International Corp. buy Engility and the L3 Technologies-Harris Corp. merger advance through its process.

But the large publicly-traded companies that made those megadeals were not the only active players on the merger-and-acquisition scene last year. Private equity-backed contractors also continued to make their mark, while other large and mid-tier companies not on the public markets added scale through deals of their own. A government services company also might undertake an initial public offering this year.

And scale will continue to be a premium for dealmakers this year just like it was in 2018, GovCon M&A investment bankers told Washington Technology, given the perceived benefits of added size in the current market environment.

Marc Marlin, managing director at KippsDeSanto & Co., said to expect continued consolidation “as firms of all sizes appreciate and invest behind the benefits of scale in terms of both customer reach, capability depth and cost advantage.”

Government services companies that have pursued large deals see that added size as a way to spread out their costs over a wider base of business, which can help position them for larger, longer-term and more complex contracts. This was part of the rationale put forth by General Dynamics in its CSRA purchase, plus Leidos through its merger with the former Lockheed Martin IS&GS services business two years ago.

That thirst for scale among prospective buyers should carry forward last year’s robust M&A activity into 2019 for both large and middle market transactions as potential sellers look to exit, according to The McLean Group Senior Managing Director Greg Woodford.

“We are experiencing a window of opportunity for sellers right now based on strong market fundamentals due to budgetary stability, readily available capital, and an overall optimism from a stable (for now) economy,” said Woodford.

“With greater potential risk beyond 2019 due to a more challenging political climate and economic concerns growing worldwide, we predict that many business owners will test the market in 2019 before market dynamics change again.”

Those economic concerns certainly have been brought to the forefront in recent weeks even with just a cursory glance at the turmoil in global financial markets on concerns about trade, growth and other macro factors.

Within the government market, contractors currently have their eyes on the current partial government shutdown but then attention turns to the next round of budget negotiations between a divided Congress and the current administration. Much of the M&A activity last year focused on perceived areas of long-term opportunity that are seen as less susceptible to political headwinds.

“Given budget outlook and perception of above average growth, M&A interest will continue to be heavily focused on defense, intelligence and national security markets, as well as next-generation capabilities -- cloud and IT modernization,” Marlin said.

Private equity should also continue to be an active participant as a buyer and especially for businesses that may not interest PE investors with experience in the market, he said.

“Given the selectivity of the strategics, private equity funds are being more competitive for a number of the mid-sized, very attractive growth businesses that may not resonate with the larger strategics for whatever reason or more simply as that growth engine for executives looking to take their business to the next level independently.”

Woodford has one word of caution that a panel of bankers also spoke of at an October event hosted by law firm Morrison and Foerster: the M&A market also may have a supply-demand imbalance to work through.

“We are getting consistent feedback from buyers in the government contracting market that while they are seeing a lot of deal opportunities, many of the companies trying to sell are either coming to market too early, or valuation expectations are too high,” Woodford said. “Quality companies that are going to market are generating significant interest, but there is a concern from buyers about how much ‘supply’ is left out there.

“It seems like buyers are fighting over a shrinking universe of high quality companies which is forcing them to either pay higher multiples for deals or take more risk on deals that have some challenges.”