Investment bankers Bob Kipps and Marc Marlin outline what they see as the drivers behind the coming wave of M&A deals in the government market.
In our January 2014 article for Washington Technology, we made nine predictions for 2014:
- Deal announcements below historical average, but a 20 percent plus increase over 2013
- Prioritization of growth markets
- Set-asides and preference programs remain confusing and discounted.
- Alternative transactions
- Renewed focus on larger deals
- Contract vehicles the holy grail
- IP branded solutions
- Adapting to the new normal
While the official tallies from the bankers aren’t yet in, early indicators suggest a year-over-year increase in activity of approximately 11 percent. 2014 experienced a handful of large transactions such as Blackbird Technologies and Zeta Associates, following the CACI-Six3 transaction in late 2013 that started this recent round of larger middle-market consolidation.
We also saw a multitude of alternative transactions across all size deals, to include the TASC / Engility combination and the Triple Canopy employee-stock-ownership-plan and subsequent merger with ACADEMI.
Contract vehicles also continued to be prized possessions and motivate deal activity for public companies and smaller privates. ManTech made two contract vehicle motivated deals with ATG (EAGLE II and TABSS) and 7Delta (T4), while mid-sized firms such as Octo Consulting were similarly proactive (Alliant, CIO-SP3 business acquisitions).
The market also saw its share of portfolio shaping via divestitures as firms (especially the larger ones) continue to focus on their core. General Dynamics sold its Advanced Systems line of business to MDA and more recently Boeing exited the commercial cyber market with its Narus technology transfer to Symantec (announced in 2015, but in play during 2014).
In a market that has been covered with uncertainty over the past few years, we can take a deep breath and exhale having the trends play out generally to script.
But, where does that leave us having turned the page to 2015?
Commensurate Deal Volume; Valuations Remain Disparate
Buyers will likely continue to be extremely particular about which deals they chase and how hard they pursue. The larger, typically more aggressive acquirers (namely the defense and government publics) will stay focused on the larger ($100 million-plus in revenue), prime, full and open firms with critical mass in the priority areas of health, cyber, intel, C4ISR, big data and cloud. It will continue to be a Seller’s market at double digit multiples for the select few firms that meet these criteria.
That said, ample deal activity will remain amongst the remainder of the market as well, but at healthy, yet more modest valuations. However, those latter transactions will comprise sellers more motivated by three things:
A true desire to exit
To improve their competitive positioning
To diversify their personal investment.
They won’t be swayed by an “offer they can’t refuse”. We anticipate a greater number of potential sellers firing on all cylinders coming out of 2014, and as a result may be more apt to explore their alternatives in 2015.
Increased Proportion of Alternative Transactions
Piggybacking on the above, we expect an increase in alternative transactions to include mergers of equals, ESOPs, leveraged recaps, contracts sales/purchases, minority investments, and private equity control investments.
The traditional model of M&A being the end, for many will be replaced by a transaction that is a “means to an end,” affording partial liquidity but continued “skin in the game”.
The credit markets are still friendly and despite the macro market challenges, the government defense space remains an attractive, cash flow generating investment opportunity. Ample debt financing and equity capital will encourage deal making. Especially as it relates to control and minority private equity investments, entrepreneurs will prioritize smart money in an effort to partner with folks who have done it before.
Financial sponsors that can effectively promote their non-monetary value (relationships, experiences, sage advice etc.) should have many strong opportunities to put capital to work with proven management teams and well-positioned companies.
Perhaps a Changing Landscape of Existing Private Equity Platforms
The traditional private equity investment is three to five years, suggesting vintage 2008-2011 private equity investments are in the sweet spot to explore strategic alternatives. It wouldn’t surprise us to see equity swaps to facilitate private equity portfolio company combinations – essentially private-to-private replications of the TASC / Engility transaction.
While less likely, but possible, when will one of the larger privately held companies explore the public markets? In the wake of cost cutting and earnings growth amongst the public government and defense contractors, market multiples have crept north from ~6.0x at the trough in early 2012 to ~9.0x as of December 2014; recent market volatility notwithstanding.
Emergence of New Power Brokers in the Mid-market
2015 should be a notable year for the procurement and award of multiple high visibility contract vehicles such as DIA ESITE, VA T4NG and CMS ESD II. The demography of the awardees will position these companies in the pole position for what may be the next upswing in the contracting cycle. Firms left on the outside looking in may look to buy, and firms in the win column that gain traction and can accelerate their growth will create options.
Refinement of Hot Lane M&A Preferences
For some time there has been feverish M&A interest in the hot lanes – health, cyber, C4ISR and intell, cloud, and data analytics.
However, the acquisition strategies in these areas have been less defined; no longer the case. Health analytics around quality of care and driving outcomes, patient engagement and fraud waste and abuse will be top of mind. Following the headlines of the Sony breach, cyber remediation and forensics services will continue to be viewed as high value, differentiated, and mission critical in nature. Cybersecurity technology development and deployment at the end point and data loss prevention remain high growth cyber segments as well.
As for C4ISR, full motion video analytics and data transmission continue to receive buyer attention. Intell has a number of faces and angles. There will continue to be strong interest in national intell on both sides of the river.
However, we also anticipate similar interest in SOF customer access and capabilities. Companies with a Tampa, Fla., or Fort Bragg, N.C., zip code – headquarters or office – will see continued strong interest.
Of all the above, one of the hottest markets for M&A in 2015 may be the cloud, and specifically cloud migration consulting. The market demand for migrating applications to the cloud – commercial and federal – is red hot. The high growth potential of this market segment resembles the Health IT, cyber and “three-letter agency” M&A waves we experienced at points over the past five years or so.
In summary, we anticipate that 2015’s M&A market will resemble 2014 with a few tweaks here and there. Market leaders will continue to have attractive alternatives in both the sale and hold scenarios, and consolidators will continue to invest in growth areas and their core business. Happy New Year!
NEXT STORY: The time is right for bridging procurement gaps