Market Watch: Replacing confusion with clarity in the M&A arena

Jerry Grossman

Frequently, shareholders of government information technology and defense services companies take on sales and divestitures without solid guidance about the mergers and acquisitions market. Many sellers and transaction advisers believe we're in a seller's market. Some bankers, advisers and brokers have set forth sale valuation ranges and transaction multiples that give unrealistic expectations for all but a select few companies.

The fact is that the mergers and acquisitions market is highly stratified on both the sell and buy sides. While for certain companies in sought-after markets pricing is very rich, the sale price range overall is growing wider.

At any point in market and industry cycles, shareholder choices about liquifying investment, how to prepare and what advisory support is needed are among the most significant decisions they will face. In the current market, wide variation in pricing, based upon seller and buyer attributes, confirm that shareholders should exercise extreme care in making these decisions.

The government services and defense sector has been an active mergers and acquisitions arena since the mid-1990s. Over the past five years alone, nearly 500 mergers and acquisitions were announced. Deals in 2002 -- about 140 announced transactions -- are nearly 50 percent above the five-year average.

While the number of closed transactions was higher by around 50 percent in 2002, the number of companies offered for sale in 2002 increased about 100 percent to 200 percent over the five-year average.

Proportionally, these numbers suggest there were many disappointed prospective sellers. Some didn't close a transaction and withdrew. Some got into the middle of the process, received offers well short of high expectations and closed the transactions rather than turn back. For these reasons, and many others, it is important for shareholders to deepen their perspective and properly frame their expectations before beginning the sale process.

Back to the stratified M&A market. Transaction values are often viewed in terms of their relationship to revenue and earnings of the selling company. These pricing relationships are the result of the buyer's valuation of the seller and the negotiation process, in the context of capital market factors. The buyer's valuation of the selling company will differ, sometimes materially, based upon the services mix, customer mix, business focus, size, contract mix and management team of the selling company.

Other important factors, including the magnitude of small-business set asides, 8(a) contracts, prime vs. sub contracts and proportion of reselling and product pass-through, will determine valuation levels. Naturally, cost, marketing and operational synergies can create added value for the right buyer.

Relative to these factors, the values of selling companies can be stratified. In today's market, the most attractive companies are serving priority markets: intelligence agencies, homeland security and selected defense elements.

On the buyer side, there's a limited number with both the capacity and mandate to be aggressive. Those industry buyers with highly priced, publicly traded stock -- the major first tier aerospace and defense primes and a few, large, well-capitalized non-public buyers -- can and will selectively buy at prices that make selling shareholders smile. These valuations above the longer-term norms usually are aimed at adding key capabilities or entering and expanding priority markets. Even at high-end transaction multiples, these rich deals can be accretive to the buyer.

The rest of the buyers have different pricing parameters and noticeably lower valuation limits on the upside. Sellers will find these buyers have a different psychology about what constitutes a good deal, different capacity to pay and a different cost of capital. *

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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