Market watch: The beat goes on for govt M&As
This year's pace of mergers and acquisitions has 2006 shaping up to be a continuation of the activity witnessed by government services companies in 2005.
Notable deals closed or announced in the first quarter include: Lockheed Martin's acquisition of Aspen Systems Inc.; General Dynamics acquisition of FC Business Systems Inc. and pending acquisition of Anteon International Corp.; Raytheon Co.'s acquisition of Houston Associates Inc.; CACI International Inc.'s acquisitions of Information Systems Support Inc. and AlphaInsight Corp.; SI International Inc.'s acquisition of Zen Technology Inc.; Apogen Technologies Inc.'s acquisition of Ocean Systems Engineering; and Federal Services Acquisition Corp.'s announced acquisition of Advanced Technology Systems Inc.
Together, the size of the government market and the growth of outsourcing opportunities are fueling the strong transaction volume and valuations in 2006. In addition, the contracted-out portion of federal IT spending is forecasted to grow at a 5 percent compound annual growth rate.
The limited supply of platform-sized companies has fed a frenzied market and pushed up valuations of smaller companies. There are only 25 companies with more than $500 million of federal prime contract revenue, and only 61 with revenue between $100 million and $500 million.
Interest in the sector remains strong, with multiple categories of acquirers creating a competitive environment and cultural and strategic alternatives for owners and sellers: Midtier defense and government services companies looking to build scale and expand customer base, foreign buyers and commercial firms looking for platforms to capture defense and outsourcing budgets, private equity groups seeking to duplicate the success of other equity backed ventures, and now special purpose acquisition companies. Never before have there been more options for owners to either experience a liquidity event or partner to take their companies to another level.
Capital is plentiful and relatively inexpensive. Lenders to government contractors have become very aggressive in recent months, and we have seen senior debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratios up to six times in larger transactions. The universe of public midtier government services companies has more than $1 billion in cash and $3 billion in debt capacity to complete acquisitions.
Recent and pending initial public offerings and secondary offerings will further increase investment capital. There is tremendous pressure on publicly traded contractors to deploy capital and supplement organic growth with acquisitions.
With our sell-side clients that have $50 million or more in revenue and potential to be a platform company, we are seeing a diverse set of buyers and usually at least one "outlier." In a recent transaction, the final suitors included a large defense company, a private equity group, a technical services company and a commercial construction company.
Valuations vary widely for these platformlike companies. Owners of these companies have a variety of options today: Recapitalize with a private equity group, become a platform for a foreign or commercial company, a back door IPO with a special acquisition corporation, be a big fish in a small pond by being acquired by a $250 million to $500 million-size company or sell to a large prime.
Even though there are many buyers and sellers today, due diligence has become much more onerous, a result largely of the Sarbanes-Oxley Act. Acquirers are more intensively investigating potential acquisitions to make sure there are no hidden issues. Preparation and professional representation has never been more important.
The rest of 2006 likely will continue to be strong for transactions and valuations. I expect a flurry of deals over the next 30 to 60 days.
Rick Knop is senior managing director and head of international banking investment at BB&T Capital Markets, of Reston, Va.