COMMENTARY

Is your banker part of the family? They should be.

There is no shortage of acquisition targets in the current merger and acquisition environment for government contracting. However, finding companies that meet an acquirer’s strategic goals – such as diversifying into new markets, adding competencies that anticipate the needs of existing customers, or simply building volume and capacity – can be a challenge.

This was the consensus reached by a panel of senior government contracting executives who spoke at the annual Defense, Aerospace, and Government Services M&A Conference, hosted by the law firm Pillsbury Winthrop Shaw Pittman, the accounting firm RSM, and Capital One Bank.

Commercial banks have their own criteria to evaluate these transactions—and my role on the panel was to provide the perspectives that our team brings when we consider working with a company to finance a merger or acquisition.

MANAGEMENT QUALITY IS CRITICAL

As potential lenders, commercial bankers carefully examine the acquiring company as closely as the company being acquired. However, the critical differentiator for Capital One is not the acquirer’s financial projections—though you can be sure we will test these assumptions thoroughly—but the quality of its management.

Our assessment of a management team is both broad and deep. What reputations have the C-suite executives earned over the course of their careers? Are they known for their strong client relationships and their ability to anticipate client needs? Have they been carefully following shifts in the federal budget and proactively responded to them? Have they completed acquisitions in the past, and what is their experience with integration?

Most importantly, we stress management’s ability to place the acquisition in the context of their underlying strategy. We truly serve our corporate customers by viewing the transaction through their eyes, judging it on their terms, and structuring the loan accordingly. For instance, if a company is working to reduce its concentration in a specific sector, we will look at the target in terms of the diversification it brings and whether competitors are attempting to enter the same market. When management can’t communicate its strategy in a clear and compelling way, we consider it a red flag.

Of course, we also look at management’s financial strategy. If the leverage a company requires is not in our sweet spot, we will pass. For these companies, the current environment offers other options – for example, they can turn to institutional financial markets for funding.

EVALUATING THE TARGET

We also take a careful look at the target, its contracts and capabilities when assessing a transaction. For example, current delays in awarding contracts are a challenge, making it more difficult to value a company’s earnings stream, but we anticipate that these delays will decrease.

We also scrutinize contract exposure and re-compete risk, as well as visibility into the pipeline. We survey the target’s backlog, noting concentrations of contracts that will reach their term during specific time periods. Visibility into the pipeline becomes particularly important when 20 percent or more of the backlog is up for re-compete in the next 12 to 18 months. When a high percentage of the future year’s projected revenue consists of rebids, we take a deeper dive, considering the target’s past success rate to determine their likelihood of winning the upcoming rebids and new contracts in their pipeline.

One of the most intransigent obstacles is a high percentage of small business contracts. There is no guarantee that the customer won’t instantly re-compete the contract after the acquisition, or that the acquirer will ultimately be successful in converting it to a full and open contract. Conditions vary from deal to deal, but if we are considering a five-year term, we would be concerned if the target has two or three years left in their small business designation.

POST ACQUISITON PLAN

Most service providers—attorneys, CPAs, investment bankers—step back from an M&A transaction once it is complete. By contrast, commercial banks are just starting a relationship with the acquirer that will last at least until the loan matures. Expectations established during the pre-acquisition stage and embedded in the loan’s structure will play out over its term. That is why companies must provide financial projections and integration milestones that are conservative and realistic. For example, in our experience companies tend to overstate the speed at which cost savings will be realized.

We also pay attention to the depth of thought that goes into a company’s post-acquisition planning. If there is a certainty in our business, it is that nothing ever goes completely as expected, so detailed contingency plans are crucial. We need to know that a company has thought through its options if a contract in the pipeline goes to a competitor or if government funding priorities shift.

Given the emphasis we place on management, it is understandable that we are particularly interested in steps taken to identify retain the target company’s key personnel and any planned incentives to motivate them.

FIND THE RIGHT BANK

Just as we approach each deal as a potential relationship, borrowers should do the same. As we like to say, your banker is going to be part of your family for the next few years. Make sure they are reliable, responsive and supportive.

Start by casting your net widely. Any company considering an acquisition, even if it already has a primary bank, should cultivate relationships with a variety of bankers. Each bank has its own view of the market, and it only makes sense to learn about them. The more perspectives you are exposed to, the more confident you’ll feel in your decision-making. Secondary banking relationships can be critical if your primary bank doesn’t have the capacity to deliver the funding you need.

You should also focus on banks that specialize in government contracting and who understand the vicissitudes of the business. For example, a veteran industry lender will have a deeper understanding of volatile market conditions and is less likely to overreact to them.

And finally, you should identify bankers who have a great reputation for following through and providing responsive, informed service for their customers. Ask your advisors, your attorneys, and your peers for recommendations. A good commercial bank should possess the expertise to help you achieve your financial goals while having the experience to steer you away from ventures you might regret later.

About the Author

Diane Zanetti is the market manager leading the government contractor banking team at Capital One Bank. She has over 28 years of commercial banking experience with the last 14 focused on the government market. She manages a team of bankers who provide capital and banking services to middle market and larger government contractors including closely held, private equity backed, and public companies.

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