Opinion: How to trust your instincts in a troubled economy

In finance and investment theory, risk is defined as the volatility or uncertainty of future outcomes and investment returns. The magnitude of economic distress, coupled with the unprecedented influence, spending tempo and private-market reach of the federal government, has prompted industry executives and investors to reassess their positioning and rethink their strategies. Also in the mix are traumatized capital markets, huge federal deficits and falling gross domestic product levels.

Contractors today face more issues and more uncertainty around those factors that influence their companies and the economy. Thus, it is critical for them to stay abreast of capital markets' behavior, risk tolerance and valuation.

Company executives and board members want to know the current and prospective pace of mergers and acquisitions activity, the level of buyer interest, and the values at which companies are trading. While the desire for insight and precision about valuation is more intense, the most accurate feedback often is “it depends.”

It’s true that the selling prices of government contractors always vary based on specific company attributes and market conditions. The difference today is that individual company salability and valuation are more variable and somewhat less certain than they were during the 2002 to 2007 period. Strategic buyers are more skeptical and more inclined to walk away from companies with contract transition barriers and undistinguished capabilities. Buyers are much more likely to restrict themselves to companies that meet their very specific acquisition criteria. Buying revenue to bulk up has become a historical artifact.

Pure-play public federal services companies are trading at cash flow multiples 30 percent to 40 percent below the 2005 to 2007 period. Other active acquirers have experienced even greater declines in their pricing multiples. These lower equity values, combined with tighter, more expensive debt financing, have combined to increase the cost of capital. Increased risk and more expensive capital have consequences for transaction value and structure. Excepting those sellers in the hottest segments – cybersecurity, health care information technology and logistics – lower prices or shared risk solutions are prevalent.

Increasingly, transaction considerations include many elements in addition to cash at closing and working capital adjustments. Examples include contingent payments, promissory notes issued by the buyer payable to the seller, buyer stock, consulting agreements and renegotiated lease terms. The value of those deal components at close – that is, the present value – is greatly dependent on assigned probabilities of future events and other assumptions. Accordingly, the total transaction value is less subject to black and white calculations of enterprise value. EV to earnings before interest, taxes, depreciation and amortization multiples, a common reference point for transaction analysis, is more subject to interpretation and factoring for probability and less concrete.

M&A activity in 2008 and 2009, compared to the 2005 to 2007 period, reflects the economic trends, market conditions and federal initiatives under way. Many interested buyers and investors remain in the space. However, the pace of announced and closed transactions in 2009 is roughly one half that of the same period in 2008. On average, valuations are somewhat lower, down between 10 percent and 20 percent.

Sellers have partially filled the gap created by difficult debt markets, accepting seller notes and buyer stock in lieu of cash at closing to prevent greater declines in transaction value. Frequently, the interest rate on these seller notes, usually subordinated to senior bank debt, is below market for similar paper acceptable to institutional capital sources. During the earlier period, less than 5 percent of deals contained contingent or non-cash components. Over the past two years, 15 percent to 20 percent or more of industry transactions contain these contingent or non-cash elements.

An understanding of these meaningful changes in federal services M&A markets is essential to ensure that corporate development planning and shareholder liquidity strategy formulation is done in the context of current and prospective market realities.

Jerry Grossman (jgrossman@hlhz.com) is managing director at Houlihan Lokey Howard and Zukin.