Davis wants M&A hearings

Industry consolidation squeezes out midsize IT services companies

"We have a problem where these companies get eaten up and acquired. It helps the government to keep these companies [that are being bought] in play. We're going to do hearings." ? Rep. Tom Davis (R-Va.)

Henrik G. de Gyor

The chairman of the House Government Reform Committee is calling for hearings to examine whether the current pace of consolidation among federal IT services contractors undermines the long-term health of the industry.

"We have a problem where these companies get eaten up and acquired," said Rep. Tom Davis (R-Va.). "It helps the government to keep these companies [that are being bought] in play. We're going to do hearings."

Davis said that because of all the mergers and acquisitions, only large companies -- those with more than $150 million in annual revenue -- usually can compete for prime contracting.

Speaking March 23 at FOSE, the government information technology trade show produced by PostNewsweek Tech Media, Davis said his committee plans to hold hearings about the effects of mergers and acquisitions among federal IT contractors. PostNewsweek Tech Media also is the publisher of Washington Technology.

The number of mergers and acquisitions among federal IT contractors has increased steadily in recent years, from 47 in 2001 to 64 in 2002 to 73 in 2003, according to investment bank Houlihan, Lokey, Howard & Zukin. The aggregate value of the deals grew from $3.8 billion in 2002 to $5.9 billion in 2003, according to the Los Angeles firm.

IT industry observers welcomed Davis' interest in the rapidly consolidating market, saying the government is best served by a broad and diverse industry base.

"Often, the best service provider is a provider for which the project is an important part of that company," said Jerry Grossman, managing director of Houlihan, Lokey, Howard & Zukin in McLean, Va.

"For example, a $10 million project being performed by a $100 million IT services company would be a very important project to that company, and one that it could plausibly perform very well," Grossman said.

"On the other hand, if [the project] is being performed by a $4 billion or $5 billion company, that is obviously a less-significant project," Grossman said. "There should be a reasonably good market in the middle for companies that are not so small they need government help, but are not as large as the [largest] primes."

But that middle market is being swept clean by mergers and acquisitions, said Lou Ray, who was president and chief executive officer of Matcom International Corp. until the midsize company was sold to SI International Inc. early this year. Matcom had about 500 employees and about $70 million in annual revenue.

"If [Davis] thinks it beneficial to have companies in that space, the government is going to have to do something to help small businesses grow without being driven back into the small-business arena," Ray said.

IT executives said the problem is that in government contracting, businesses are recognized as either small or not small. Companies that have graduated from federal small-business development programs are left to compete with the not-small companies, including billion-dollar behemoths.

"Right now, one of the worst things that can happen to a small business is to become slightly large," Ray said, because it will be too large for small-business set-aside contracts, but too small to compete effectively in open competitions.

"When you cross the threshold, it's important you do it in a big way. We did it with an acquisition that took us close to $50 million" in annual revenue, Ray said.

Grossman and other market-watchers suggested that Davis should look beyond market conditions that are driving acquisitions, such as capital market support and high stock valuations for defense contractors, and examine how government policies and practices, such as contract bundling and small-business contracting goals, may be driving industry consolidation.

"The companies in the middle have felt some pressure from large companies taking some of their work away as contracts are consolidated or bundled into pieces that may be too large for that middle-size company to manage," Grossman said.

"On the other hand," he said, "some of their work is being awarded at contract expiration to small companies under set-aside programs. If you start taking business away right when they start competing, that doesn't seem to be consistent with the goal of helping small business in the first place."

The more IT requirements are made very large or very small, the more acquisitions will increase, said Stan Soloway, president of the Professional Services Council, an Arlington, Va., trade group.

"Then what happens to that industrial base? We need to be thinking about all policies in this area, so we don't end up in a situation where the industrial base is dominated by a handful of very large integrators," Soloway said. "Small businesses will be unable to grow, and you won't have the diversity to determine what [contractor] options best meet your requirements."

Creating a set-aside category for midsize IT firms may not be the way to keep those companies in the government contracting mix, industry observers said.

In fact, midsize companies probably would not recommend a set-aside category for themselves, Grossman said.

"I'm sure most of them don't feel like they need special attention. They just need more of a level playing field," he said.

Davis told FOSE attendees that he doesn't favor creating new set-aside categories.

"I'm not a great fan of set asides," he said. "When you limit competition, which is what set asides do, you increase costs" to the government.

Industry consolidation "is a long-term problem," he said. "I don't know the answer."

Staff Writer Gail Repsher Emery can be reached at gemery@postnewsweektech.com.

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