2012 M&As? Uncertainty ahead.

Government services mergers and acquisitions in 2011 started off with a bang but ended with a whimper. Uncertainty in the growth outlook was furthered by the failure of the supercommittee to reach consensus. In addition, corporate financial performance generally didn’t hold up to expectations. This confluence of factors forced a number of M&A transactions to be put on hold pending an improvement in financial momentum and greater confidence in the market.

M&A activities in 2011 were particularly memorable for go-private transactions and a wealth of spin-offs and corporate divestitures. These transactions helped mitigate the overall modest decline in deal activity. While transaction multiples at the median were unchanged, the bifurcation in M&A pricing intensified. Aggressively priced deals occurred in high growth sectors of the market while the rest of the industry has faced erosion in M&A pricing.

The current market environment favors flat, or perhaps, modestly increasing M&A activity in 2012 with balancing views of supply and demand. Sellers that once considered a near-term IPO as a path to growth and liquidity will need to look at other options. Business owners may once again consider transactions in anticipation of a change in tax policy. At the same time, buyers have a tremendous amount of capital sitting on the sidelines. Hungry for deals, strategic buyers are selectively but aggressively pursuing companies outside an auction process. Similarly, private equity sponsors with vintage funds are feeling the pressure to deploy or give back capital that’s not been put to use.

As we move further into 2012, with the recent passage of the defense budget, federal contractors are cautiously optimistic about their own organic growth prospects. Although industry pricing and activity aren’t likely to oscillate substantially, there are a number of trends emerging that will characterize the market going forward:

• Reminiscent of the late 1990s, federal contractors are pursuing a diversification strategy into adjacent commercial markets. To counter the federal budget headwinds, large defense primes and government services companies are looking to buy into commercial markets to accelerate growth and reduce volatility. Notable examples include Science Applications International Corp.'s recent acquisition of Vitalize (which provides systems integration services for health care providers) and Lockheed Martin’s acquisition of Sim-Industries (which manufactures flight simulators for commercial aircraft).
• With leaner infrastructure and a more agile culture, small and mid-tier companies are seeing new opportunities to capture market share from the “Big Guys.” As the government becomes ever increasingly cost conscious, winning is often driven by the most price competitive, technically acceptable solution.
• Business owners are pursuing growth and liquidity alternatives outside traditional M&A activity to achieve their financial and business objectives. With depressed multiples in some sectors of the market, now may not be the optimal time for business owners to exit.
• Rather, alternative strategies, including leveraged recapitalizations or minority deals, are becoming more appealing to owners who are optimistic about the longer term outlook for their businesses. These approaches to obtaining capital can be a great way to buy out minority or absentee shareholders or help achieve liquidity or fund an acquisition strategy. At the same time, management can retain operating control as well as the unique corporate identity and culture. Entrepreneurial owners are looking to take some chips off the table while retaining their upside potential.
• During 2012, we’ll see an increasing number of technology deals, often very small, as buyers look to acquire growth and market differentiation. Notable recent examples include Lockheed Martin’s acquisition of Procerus (autopilots for UAVs ) and Raytheon’s acquisition of Pikewerks (anti-tampering software).

Many companies in the industry have only known the market buoyancy of last decade. Looking to the challenges ahead, companies will need to take an aggressive approach to corporate strategy to achieve their business and financial objectives.