Even in good times, M&A takes a steady hand

The stars are aligned for many government contractors interested in pursuing mergers and acquisitions. This was the consensus of executives who took part in the Industry C-Suite Panel at last year’s annual Aerospace, Defense and Government Services M&A Conference. The event was hosted by the law firm Pillsbury Winthrop Shaw Pittman, the accounting firm RSM, and Capital One Bank.

Greater Visibility Spurs Greater Activity

Much of this bullishness has to do with the current outlook for federal spending. The panelists pointed out that fiscal year 2019 marks the first time in a decade that the Department of Defense has a two-year budget, not a continuing resolution. As a result, contractors have greater visibility into the growth prospects and pipelines that is unprecedented in recent years.

Even better, it is a budget notable for its size, with growth distributed not just in defense and intelligence but in civilian departments as well. The Navy, Air Force, National Security Agency, Central Intelligence Agency, Department of Justice, and the Department of Health and Human Services are among the organizations slated for above-average spending growth. Areas such as intelligence, IT modernization, and opioid abuse are seeing major increases in investment.

Another key driver for M&A, the government is consolidating procurement, in large part for contracting efficiency. Given the size of the budget, there are relatively fewer RFPs, but the typical RFP is larger, more ambitious, and has more moving parts than in previous years.

Government Services Make an Attractive Target

The overall performance of government services companies is another reason that companies are looking at M&A. As Tobey Sommer, managing director of equity research at SunTrust Robinson Humphrey, pointed out during the kick off of the conference, government services stocks have outperformed the S&P 500 since the beginning of 2017, fueled by the resumption of strong organic revenue growth.

With additional federal spending, organic growth should increase further, making government services companies even more attractive targets for private equity investors as well as strategic acquirers.

Certainly, M&A activity has been strong. Sommer noted that “small-scale deal-making has picked up in recent years, with transformational deals intermixed as companies seek to increase customer access.” In 2017, there were 72 acquisitions of government services companies, the highest level since 2012. The vast majority of these were for transactions of less than $300 million. SunTrust Robinson Humphrey believes investors are looking for more M&A to come, driven by budget increases and the resulting increases in cash flows.

M&A Essential: A Compelling Thesis

In this environment, there are many solid reasons to pursue M&A. Scale is an obvious motive, though most government services management teams interviewed by SunTrust Robinson Humphrey maintained that scale was a beneficial by-product but not a primary goal. Firms also pursue M&A to gain access to contract vehicles, acquire a new customer set, or secure new capabilities.

As a lender, we are agnostic about these different strategies, but we ask that acquiring companies articulate their rationale for the immediate transaction, support their reasoning persuasively, and place the deal in the context of their larger goals and vision. Is the transaction the product of a top-line strategy, for instance, trying to achieve scale or gain access to new clients? Or is it driven more by bottom-line considerations — enhancing efficiencies or acquiring a higher-margin business? And how does it fit into their end-game? Are they ultimately positioning themselves to be acquired? Are they contemplating an IPO? All these issues are part of the discussion we will have with them.

We find it particularly compelling when companies link their strategy to the anticipated needs of their government client. In other words, a company that embarks on an acquisition to acquire a capability that will make it more attractive to a critical client makes a much more cogent case than one looking simply to diversify its skillset. This also tells us that management is attentive to the needs of its customers, increasing the likelihood that their strategy will be successful.

The ability to articulate immediate strategy in the context of long-term goals benefits borrowers.  It means that we as lenders can shape the credit structure and the covenant package to help them complete the acquisition to realize their vision. To the extent that leadership can support as well as verbalize that strategy, we can finance more appropriately.

M&A Essential: Quality Management

The emphasis we place on management’s ability to develop and describe a coherent vision of their company’s future underscores the critical importance for Capital One of an experienced management team. For us, the cornerstone of our lending decision is not the acquirer’s financial projections — though you can be assured that we will test its assumptions thoroughly. Rather, it is the management’s track record. In assessing management, we ask ourselves a number of questions. Has the succession of positions they have held during their careers prepared them to take on their company’s current challenges? Are they regarded favorably, both as individuals and as a team, by knowledgeable industry observers? Have they been successful in realizing the potential of previous M&A transactions? If we are not comfortable with management, we will never be comfortable with their forecasts, no matter how plausible they seem.

M&A Essential: An Experienced Lender

While lending criteria tend to remain stable over time, the challenges that acquirers face in securing financing tend to be shaped by the market. At the moment there is no shortage of liquidity. Indeed, one of the issues that borrowers face can be called managing abundance. For firms turning to the pro-rata market, a legitimate cause for concern is managing relationships with the various participants. Because of the surplus of available capital, individual lenders are now being given much smaller allocations to borrowers than their original commitments.

There is also an abundance of competing buyers, a situation the means that all-cash deals are increasingly common. In this situation, acquirers have little or no ability to protect themselves from such significant issues as recompete risk. At the same time, those turning to debt financing face a bewildering array of choices, both new and those that had been reserved for larger companies. They include unitranche, term loan b, mezzanine financing, and pro-rata bank financing.

In these circumstances, it only makes sense for companies considering an acquisition to start talking to experienced lenders before they identify a target. It is critical that you find a lender whose experience and capabilities match your needs. This should be a lender with a dedicated government services group composed of veteran bankers. They can sort through the financial instruments available to you and help you zero in on the ones that are most appropriate for your circumstances and specific transaction.

Equally important, the bankers in this group should have gone through at least one cycle, giving them an understanding, for instance, of what sequestration means for companies in government services. Right now, it may be appropriate for acquirers to pursue a fairly aggressive financing package, but they will want to work with a lender who won’t panic if the market softens. In other words, you want a lender who can stick with you through the bad times as well as the good.

Finally, it is essential that you find bankers that you both respect and trust. You’ll be spending a fair amount of time with them over the term of your loan. Make sure that the professional chemistry clicks and that you feel comfortable having them as part of your team.