When will M&A be great again?

Despite all the advisor hype and other "fake news", the GovCon M&A market has been tough for all but the best-positioned firms for most of the past four to five years. 

Deal activity is down about 20 percent over that period vs the 1998-2011 levels.  But like seemingly almost everything else in the world, that appears to be changing.

The Trump administration--as untraditional and controversial as it is--appears to be a meaningful positive catalyst for both government contractor valuations and industry M&A activity. 

There are plenty of reasons to understand why the industry is “bullish:”

  • Valuations of government services and defense public companies near recent highs
  • Low interest rates
  • A concerning number of national security and homeland security risks
  • The promise of increasing DoD budgets
  • Talk of a pro-business contracting climate

However, with a polarizing new administration agenda taking form 140 characters at a time, it remains a bit unclear what will actually occur and perhaps, most importantly, when will the rubber hit road on new spending and favorable policy changes.

Strong Capital Markets- All Systems Go!

While public pricing has slightly come-off post-election highs, today’s sector valuations (11x forward EBITDA) remain well above the longer-term averages (of ~8x EBITDA).

Those valuations combined with super robust debt markets (despite ongoing rate increases) provide the necessary confidence and capital for aggressive deal making.  In addition to the active large and mid-tier buyers from 2016, some of the larger strategic buyers (e.g. CSRA, CACI and Leidos) have now integrated their 2015/2016 mega-deals as well as paid down some debt and expect to be active this year.

Follow the (Smart) Money!

In several high profile deals, Carlyle, Veritas and Arlington Capital have bought new platforms in the government services marketplace over the past 18 months with Novetta, Alion (and Harris IT) and Polaris Alpha, respectively.  In each of those cases, further “add-on” acquisitions are likely.

Even more importantly, other private equity groups have seen those investments and are noticing the renewed attractiveness of the federal vertical.

Buyer Priority Areas

As always, strategic buyers generally buy to garner new or critical mass in new customer areas or new technologies and capabilities. NextGen IT including cyber, cloud migration consulting and digital will continue to be coveted capabilities as budgets continue to be allocated in that direction.

Whether in those areas or not, differentiated technologies or offerings continue to be in higher demand given ongoing market cost-competitiveness.

Customer-wise, intel (national and military) as well as Special Operations Command customer-oriented businesses will continue to be in demand given continued terrorists threats and activities outside the U.S.

Not surprisingly, Trump’s emphasis on the shipbuilding and border security are creating increased demand for Navy and DHS focused firms (whether they build walls or not).  Also, health related customers with two big exceptions---Affordable Care Act and (currently) Veteran’s Administration (VA) —continue to be sought after. 

While there is endless chatter about other alternatives, until VA establishes a contracting solution for the Rule of Two ruling last year VA will be less coveted than in the past.

When Will the M&A Market Be Made Great Again

As important as the market is, the actual contract and financial profile of each potential seller is often much more influential to their valuation, saleability and the optimal deal timing.

Taxes are an important factor into sellers’ timing equation.  Trump has deferred emphasis on taxes until spring.  While often times tax actions are retroactive, some clarity on what reform/reductions will occur will also be a catalyst.  As such, and given that most companies will not start seeing greater financial performance from the new administration’s initiatives until later this year or (more likely) in 2018, we expect the bigger uplift in deal activity to be in 2018.

As always, deal timing, saleability and valuation are seller specific.  An honest strategic assessment is invaluable to charting out the best value maximization strategy for your GovCon business.

About the Authors

Bob Kipps is managing director of KippsDeSanto & Co.

Mark Marlin is a managing director with the investment banking firm KippsDeSanto.

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