Tax policy drives increase in M&A activity

If the last couple of months of merger and acquisition activity are any indication, the market for M&A transactions in the government contracting market is poised for a very strong finish in 2010. The factors contributing to the strength in the numbers of deals completed and the valuations attained in those deals are multi-faceted. Thus, despite the fact that our index of publicly held government services companies is down more than 20 percent compared with this time a year ago, M&A market valuations for companies with the right characteristics are well in excess of the valuation multiples provided by investors in publicly held government contracting companies.

Tax policy ranks as one of the primary factors driving significant activity and the supply of deals in the second half of this year. The Obama administration and Congress have yet to deal with the critical question of tax policy for 2011 and beyond. The issue is whether the Bush tax cuts will be extended and, if so, if such an extension will apply to people who make more than $250,000. If not, capital gains taxes will increase by at least 5 percent in 2011. Also, private equity firms are concerned that their carried interest, now taxed at capital gains tax rates, may be taxed at much higher ordinary income tax rates in the future. Consequently, portfolio companies in a position to sell in 2010 are now in the market.

The supply of deals in the market is also affected by the current interpretation by the government of organizational conflicts of interest (OCI). Many contractors are feeling the pressure to divest certain divisions that could create OCI issues in the eyes of their customers, the most notable example being the divestiture of TASC by Northrop Grumman Corp. and more recently the sale of QinetiQ North America’s security business unit to ManTech International Corp.

The availability of capital and return on capital are significant drivers of demand for deals in the market. Many strategic buyers in the government contracting industry are flush with cash that is earning a very low interest rate. Thus, company executives are eager to deploy their capital in a manner that they believe will deliver the highest return on investment for shareholders. Acquisitions are typically one of the best ways to deliver such returns.

For example, in the largest prime defense contractor community, the combined level of cash is approximately $23 billion. Furthermore, both strategic and financial buyers are enjoying access to credit at very attractive rates of interest and at levels that are much more aggressive than was available in 2008 and 2009. A perfect example is the recently announced sale of Lockheed Martin Corp.’s EIG business unit to Veritas Inc.’s capital where Veritas was able to offer a very compelling double digit multiple of EIG’s earnings before interest, taxes, depreciation and amortization, due in large part to the level of debt available to finance the acquisition.

In addition to capital and return on capital, demand for deals is also being driven by newer buyers entering the federal services market to supplement their traditional commercial customer base where growth has been more challenging. Examples include AECOM’s acquisition of McNeil Technologies Inc. and CGI Group Inc.’s acquisition of Stanley Inc.

The majority of activity continues to center around companies that focus in key growth segments of the market, including cyber security (Raytheon Co.’s acquisition of Technology Associates International Corp.); the intelligence community (Global Defense Technology and Systems Inc.'s acquisition of Zytel); intelligence, surveillance and reconnaissance (Boeing Co.’s acquisition of Argon ST); health care; and other mission-critical offerings in growing segments of the federal budget. Buyer demand in such areas is extremely high as buyers seek to reposition their capabilities and customers to match up to the highest potential growth areas of the federal budget.