Conditions ripe for more deals in the federal market
- By Marc Marlin
- Aug 17, 2018
The government contracting market is “hot” and according to the inaugural KippsDeSanto & Co.Aerospace /Defense & Government Services 2018 M&A Survey, the excitement should continue.
A generally optimistic outlook from the strategic and financial buyer communities given the favorable funding and economic environments, coupled with an increasing population of potential acquisition targets that have themselves returned to or have accelerated growth, aligns the incentives for deal making.
The survey reflects feedback from over 160 deal makers in the space, including C-suite executives from corporate/strategic buyers and partners and senior professionals from private equity groups. Across the board, the feedback echoed optimism for 2018 -- economic growth, the same or more deals, and increased valuations. This temperature was frankly emblematic of what KippsDeSanto has been seeing in public company valuations and M&A deal activity through 2017 and into 2018.
Public valuations -- a leading indicator around corporate expectations -- have recently peaked at or above 10-year highs for both Government Technology Solutions (GTS) businesses and the defense primes. The median GTS enterprise value to EBITDA valuation multiple has trended near or above 11.0x for the past 24 months, approaching 13.0x most recently.
This valuation metric is compared to an 8.4x median over the past decade. The market is clearly strong, and over 75% of survey respondents anticipated M&A activity to increase in 2018 over 2017. With over 100 announced deals in 2017 per Washington Technology and a similar pace this year, KippsDeSanto anticipates significant deal making in the back half of the year and continued momentum into 2019.
M&A activity 2009-2018
Source: KippsDeSanto & Co.
Not only is industry expressing an excited anticipation around M&A, but it’s acting or planning to act on it. Nearly 85 percent of deal makers surveyed expect to close the same or more deals in 2018. Of the 15 public GTS and defense primes, four have already announced a deal in 2018, highlighted by General Dynamics’ near-$10 billion acquisition of CSRA. This marks an increase from the two GTS transactions announced by mid-year 2017, CSRA’s acquisition of NES Associates and KeyW Corp.’s acquisition of Sotera Defense Solutions, Inc. The influencers driving M&A appetite are strong and appear enduring for the near-to-medium term.
Over 80 percent of survey respondents identified defense spending and customer budget increases and nearly 50 percent of survey respondents identified economic confidence, public valuations, and favorable credit markets /interest rates as extremely or very influential to M&A activity and valuations.
With a positive operational and M&A environment, firms from the largest defense primes to private equity backed-growth platforms and smaller and mid-sized owner operators are thinking strategically and seeking ways to take advantage of the current climate to improve competitive posturing and accelerate growth.
Notwithstanding the uptick in deal activity and government contracting being back in vogue, the general thesis around deal making both year-to-date and looking forward has remained consistent -- adding scale, adding critical mass with new customers, or adding critical mass with new capabilities/technology. Especially given the favorable macro environment, there is a sense of urgency to make investments now and reap the strategic benefits before the cycle ends, or to capitalize on the market and valuation momentum to monetize and reposition.
This approach biases strategy toward M&A, both for buyers and sellers. From a pure scale perspective, the median revenue size of the public GTS and defense primes has steadily climbed over the past few years. These larger, public acquirers are trading at historic levels, and with stronger balance sheets and geographic and customer footprints affords longer-term strategic decision-making.
In GTS, the perception of cost advantages from scale and capturing a greater share of government spend via broader customer access and capabilities underpinned the aforementioned General Dynamics’ acquisition of CSRA.
This bias towards scale was also evident in the reported pursuit of CSRA by CACI International and Science Applications International Corp., both of which are perceived as subscale (notwithstanding fiscal 2017 revenues of $4.4 billion and $4.5 billion, respectively).
If this scale advantage holds, it also begs the strategic question for Booz Allen Hamilton, ManTech International and KeyW Corp. among others, whether to bulk up or potentially find themselves acquisition targets or merger partners.
Along these lines, Engility Holdings at $1.9 billion in revenue is reportedly considering a sale. This was not surprising given that private equity firms KKR & Co. and General Atlantic still have substantial investment in the business formed from the 2012 spinout from L3 Technologies and the combination with TASC in 2015.
On the defense side, KippsDeSanto has seen similar, large-strategic activity, highlighted by Northrop Grumman’s acquisition of Orbital ATK and Boeing’s acquisition of KLX Inc. From a market fever and monetization perspective, KippsDeSanto has seen L3 Technologies announce the divestiture of its Vertex Aerospace segment to American Industrial Partners , and Veritas Capital’s acquisition of PriceWaterhouseCoopers’ U.S. public sector business (which recently rebranded as Guidehouse).
In the mid-market, KippsDeSanto has seen and expects continued strong activity around the customer or capability deal rationale. Over 75 percent of survey respondents identified priority interest areas of cybersecurity or IT modernization (cloud, big data), and nearly 70 percent and 60 percent identified systems engineering and technology platform consulting/integration (Salesforce, ServiceNow, Amazon), respectively.
Not surprisingly, these themes are evident in a number of recently announced transactions. Alion Science and Technology (a Veritas Capital portfolio company) announced the acquisition of MacAulay-Brown, a leading provider of complex engineering solutions and services for national security missions across the Department of Defense, intelligence community and special operations commands.
Parsons Corp. acquired Polaris Alpha (an Arlington Capital portfolio company) an advanced, technology-focused provider of mission solutions for defense, intelligence, and security customers, amongst other federal government customers. Earlier in the year, SAP National Security Services acquired command, control, communications, computers, intelligence, surveillance and reconnaissance (C4ISR) solutions provider Technology Management Associates to expand its position across the intelligence community. Scale, customer access and/or depth in differentiated capabilities are key value drivers for government contractors.
Beyond the customers and capabilities, financial performance and more importantly the composition of the contract portfolio are also impacting the M&A environment. Set-asides remain the most pervasive challenge of mid-market government contracting M&A. Increasingly complex contracting nuances around on-ramp and off-ramp provisions and larger businesses’ aversion to acquiring and challenge to retain set-aside awards long-term through a recompete continue to complicate and dampen the value proposition for many high-performers.
The ongoing buyer skepticism and impact on valuation has encouraged mid-sized businesses to pursue acquisitions (either full companies or contract vehicle-centric lines of business) to accelerate their transition from small to large versus being a target. Private equity continues to play a critical role in this market segment, evidenced by Arlington Capital’s current Integrity Applications Inc. roll-up, which includes Xebec Global Corp. and Dependable Global Solutions as well as Madison Dearborn’s recent acquisition of Linquest Corp.
Enlightenment Capital’s investments in Cadmus Group, CyberCore Technologies, and ByteCubed are other examples of the ample growth capital available to mid-market entrepreneurs looking for partners to help take their business to the next level. While not a specific survey category, KippsDeSanto sees continued private equity activity as both buyer and seller in the space. Of note, KippsDeSanto has also seen an increase in M&A activity and interest from Alaskan Native Corporations and Native American tribal organizations. However, demand significantly outnumbers supply for what is still a small universe and highly selective advantaged buyer segment.
Overall, executives remain very optimistic about the economy and expected M&A activity in the near and medium-term. The roadmap for value creation and opportunity to double down in the sector is front and center, from the publicly traded industry titans to the small engineering firm solving a niche mission challenge. An obvious inflection point surrounds the mid-term elections in November, with the longer viewpoint targeting the 2020 presidential election.
However, while political agendas have a definite impact, both the national security and global threat environment mission needs within the defense, intelligence and homeland security communities, coupled with the government-wide value proposition from IT transformation/modernization and application of artificial intelligence and big data, suggest substantial continued opportunity, excitement, and optimism for the rest of 2018 and momentum into 2019.
For more insights and trends in the Aerospace /Defense and Government Services acquisition market, click here for KippsDeSanto & Co.’s 2018 M&A Survey, or visit www.kippsdesanto.com .
Mark Marlin is a managing director with the investment banking firm KippsDeSanto.