What's ahead for M&A in 2016?
In our January 2015 article for Washington Technology, we made five predictions for 2015:
- Commensurate Deal Volume; Valuations Remain Disparate
- Increased Proportion of Alternative Transactions
- Perhaps a Changing Landscape of Existing Private Equity Platforms
- Emergence of New Power Brokers in the Mid-market
- Refinement of Hot Lane M&A Preferences
As we predicted, the number of transactions that closed in 2015 across the defense and government services industry was commensurate with 2014. Despite flat volume, the average deal size increased significantly year-over-year and buyers of all sizes seem to have become increasingly focused on mergers and acquisitions as part of broader growth strategies.
A major driver of this increased focus was an improving budgetary environment and the passing of a two-year budget deal, which gave sellers and buyers enhanced visibility into future financial performance. As a result, publicly-traded companies forecasted positive average revenue growth for the first time in several years, which helped to support elevated public-company valuations and rebounded M&A multiples, as illustrated in the chart below.
These positive macro and micro trends gave companies of all sizes a renewed confidence to pursue strategic acquisitions, fueling continued deal activity.
Last year also marked a period of extensive internal portfolio evaluation and a refocus on “core” capabilities, which led to a series of large divestitures. Lockheed, BAE, L-3, Dell, and others explored divestitures of non-core assets and in some cases a complete split between commercial and government operations as we saw with Computer Sciences Corp.
These activities led to corresponding alternative transactions, and/or mega-mergers, as we saw with Leidos/LMT IT (Reverse Morris Trust), CACI/L-3 NSS (mega-merger), and CSRA (public spin-off and mega-merger).
This too was in-line with our predictions for 2015. As was the trend for companies to focus acquisition strategies around what we called Hot Lane preferences. Companies like Raytheon (Foreground Security, WebSense), Lockheed (Sikorsky), L-3 (ForceX), Cubic (GATR, TeraLogics), Vistronix (ACG, ExaTech, Objective Solutions), and Calibre (iMC’s health and defense business) made selective acquisitions that enhanced capabilities and/or provided access to key contracts, customers, and/or intellectual property.
Additionally, and also in-line with our 2015 predictions, private equity firms pursued opportunities to monetize older investments (Snow Phipps/Acentia, Arlington Capital Partners/Novetta, Providence/SRA, Lindsay Goldberg/PAE) and explored transformational transactions (CRGT/Salient merger, Iron Data/MicroPact merger).
Concurrently, many private equity firms leveraged an abundance of “dry-powder” and attractive financing dynamics to aggressively pursue platform companies that are well positioned to capitalize on the improving fundamentals (RLJ/Phase One, Carlyle/Novetta, Veritas/Alion, Platinum/PAE).
In summary, strategic positioning and a renewed near and medium-term optimism in 2015 re-energized M&A activity across the sector. But will this continue into 2016?
We believe so. We remain bullish and believe that 2016 will look similar to 2015, but with a modest increase in deal volume given an increasing desire by buyers to add scale and/or make portfolio-enhancing acquisitions. This increased focus on M&A will be driven in part by the following themes.
Transformational/Serial Scale-Driven Deal Activity
Largely in response to the remaining budgetary challenges and associated contracting environment, which has shifted toward lowest priced technically acceptable awards and cost-plus contracts, companies are seeking more efficient cost structures. This has led to a series of headline-grabbing mega-mergers, where buyers were able to add considerable scale and realize M&A-related cost synergies.
In addition, many smaller and medium sized companies are also looking to bulk up, either via a mergers of equals as seen with Salient and CRGT, or via serial tuck-in acquisition strategies (PSS, Vistronix, Braxton, SOSI). In either case, companies are looking to be more competitive in the marketplace while creating value. This will likely be particularly prevalent in 2016 for companies contemplating near to medium-term exit events and looking for opportunities to improve internal valuation prospects.
Niche Capabilities, Customers, Contracts, and IP Remain Focus Areas for Buyers
Buyers remain focused on, and willing to pay premium valuations for, cyber, data analytics, special operations, intelligence, and health. Given that budgets for these areas are expected to continue to increase, they will likely remain M&A focus areas.
Buyers are also likely to seek acquisitions that add key contract vehicles (Alliant, T4, OASIS, Eagle II, CIO-SP3, SPARC, ENCORE III) that offer considerable remaining ceiling and growth opportunities. In addition, buyers are increasingly attracted to unique capabilities and/or intellectual property that provide market differentiation and higher-margin revenue.
We believe this will continue in 2016 as companies look to improve margins in today’s cost-competitive environment. This theme especially favors M&A interest for smaller companies, which tend to be more operationally nimble and focused at the forefront of new commercially-accepted technologies and associated federal adoptions.
Increased Volume but Mainly Focused on Smaller Transactions
While the headlines have been dominated by large-scale activity among public companies, middle-market companies still make up the vast majority of deal volume, as about 80 percent of 2015 transactions had enterprise values below $100 million.
Given a fragmented marketplace and a rush to scale, this trend is likely to continue. Smaller companies will look to M&A to add scale to be more competitive and better positioned to pursue new awards while larger buyers will rely on tuck-in acquisitions to add portfolio-enhancing assets as detailed above.
Continuation of Portfolio-Shaping Divestiture Activities
While a number of companies executed on various divestiture-related strategies in 2015, this theme will likely continue, driven largely by the following:
- Several companies, including Airbus, Dell, and Xerox, are still pursuing divestitures and others are likely to follow suit;
- Elevated public and M&A valuations make divestitures more attractive from a shareholder perspective;
- 2015 mega-mergers may result in divestitures of non-core or non-productive assets;
- The strengthening dollar against the Euro and Pound may tempt European-based firms to shed U.S. operations.
Defense Assets Will Attract Increased Interest
In response to the passing of a two-year budget deal, a 4% growth in the GFY16 DoD budget along with the expectation of subsequent near-term increases, and the stabilization of OCO spending, we see buyers that spent the past few years expanding civilian footprints expressing a renewed interest in defense programs and acquisitions, particularly within the IC. No longer does a heavy defense portfolio result in a depressed valuation. As a result, we may see an increase in defense-heavy sellers pursuing an exit in 2016 now that valuations seem to be returning to more normalized levels.
Private Equity will Remain Active with Exits and New Investments
From 2011 to 2014, the industry experienced the dichotomy of depressed M&A valuations and attractive lending dynamics – a combination that led to numerous private equity investments that are now encroaching upon the three to five year hold durations. While some of these investments were wildly successful, some experienced internal struggles commensurate with the industry.
In both cases, we believe private equity firms may contemplate exit strategies to capitalize on increasing strategic buying and rebounded valuations. Conversely, we believe that private equity firms will remain focused on investing in well-positioned companies and strong management teams to pursue buy-and-build strategies that take advantage of improving market fundamentals. Similarly, given a number of new platform investments made in 2015, we expect PE-backed platforms to be highly acquisitive in 2016.
2016 Election to Have Minimal Impact on M&A Activity
While the sector may experience a brief slowdown in M&A activity as the election approaches, any slowdown is likely to be short-lived. In addition, there are a handful of key spending areas that should not be materially impacted by a new president, irrespective of political party.
For instance, cyber, C4ISR, and intelligence will likely remain priority spending areas and continue to see budget increases. Similarly, immigration is likely to be an area of increased focus regardless of which candidate takes office.
In summary, we believe that the market dynamics that re-energized M&A activity across the sector in 2015 are likely to persist in 2016, which provides a solid window of opportunity for shareholders considering an exit event to take advantage of the increase in M&A activity and improved valuations.
Bob Kipps is managing director of KippsDeSanto & Co.