Know yourself: How corporate identity should dictate strategy

The government contracting industry is in for yet another shift in direction over the next four years.  It seems like that is a recurring theme, doesn’t it?

There is plenty of opportunity to build and grow businesses in the government market:

• A $660 billion annual addressable market for government contractors in fiscal 2016 according to Deltek.
• More visibility as a result of the congressional budget process.
• Programs structured to provide competitive opportunities to up-and-coming companies.
• Specific, publicly-disclosed mechanisms for accessing customers and the funding that drives government contractors.

But the challenges seem to get the most attention. Too much regulation. Too many restricted competitions. Not enough mid-tier company support. Not enough visibility. A heated competitive environment that has been focused on price vs. best value. 

The list goes on, different for each company depending on the point of view and different year-to-year depending on the political and fiscal drivers of this market.

And, to top things off, the competition is substantial.  According to Bloomberg Government, there were 117,090 Federal contractors in fiscal 2015, of which 1,479 are mid-tier companies with between $25 million and $500 million in annual revenue and 115,502 are small companies below $25 million in annual revenue. 

The opportunities and challenges of this industry make mergers and acquisitions a dominant theme of every conversation we have with government contractor owners and management teams. 

According to Washington Technology, there have been between 65 and 79 merger and acquisition transactions in the government contracting space for each of the last 3 years (2013-2015).  Based on KippsDeSanto & Co. research, we estimate that the industry will likely meet or slightly exceed that number of M&A transactions in 2016 and that the number of transactions will likely increase annually over the duration of the Trump administration. 

Set-aside, or restricted, competitions provide an opportunity for many government contractors to develop substantial business on an annual basis in relatively short order. According to KippsDeSanto & Co. research, seven companies were acquired since the beginning of 2013 that have been between $50-milion and 250 million in annual revenue and have generated over 50 percent of their revenue on a set-aside basis.  That is 2.5 percent of the of the 283 transactions closed in this industry over the past four years. 

As you can see from the market perspective and numbers above, selling your business is statistically not the most likely outcome for your company, especially if it has significant restricted revenue exposure.

It is extremely important for companies in the government contracting industry to be honest about the identity of their business, establish a strategy that is consistent with that identity and be aware of the commensurate liquidity goals and options.  This industry offers many means to create shareholder value.

We see three typical ownership strategies in the industry, including (i) building to sell in the short-term (<5 years), (ii) building to sell in the long-term (>5 years), and (iii) building to own “forever.”

Each ownership strategy has a set of unique options available to pursue and unique timing considerations.  There is no blanket or general right answer; but there is an answer for each company.

This determination is important to recognize early so that the operational strategy can be tailored to the ownership strategy, aligning ownership and management objectives with the profile of the company.  Some useful questions to consider as part of this planning process include:

Is your company growing, prospering in the full and open competitive environment?

This is a unique and valuable profile in the government contracting industry.  Time to look at the potential buyers for the business in the short-term given current demand.  If now is not the time to sell the business for specific reasons, then the logical answer is likely to invest more resources into a growth engine that is already valuable and differentiated.

Is your company growing, prospering in the restricted competitive environment? 

It is time to think hard about your future and plan for the longer-term.  Buyers in this market have a difficult time acquiring these types of businesses because of the growth limitations that exist after the change of control transaction. 

Do you have a unique differentiator that will attract buyer interest based on the current profile? 

The deals completed for companies with meaningful restricted revenue exposure typically have one or two key differentiating attributes, such as a substantial long-term contract, a position on a specific contract vehicle, truly unique capability or highly-differentiated and concentrated access to a customer. 

Do you believe you will be one of the few that will make the transition to a larger, full and open competitor?    

That mindset may lead you to invest heavily in the organization, from business development, to recruiting, to culture and long-term management incentives based on value. 

Will the transition to full and open competitor take many years and a complete shift in the profile of the business? 

This would suggest that it is time to put the pedal down and win as much restricted competitive work as possible before “graduation,” limit internal investments to harvest as much cash flow as possible for the shareholders, and install shorter-term management incentives based on cash flow.  Alternatively, but not always the most logical way of thinking, becoming a smaller, differentiated and full and open business in the future may be more valuable.

Is your ownership interested in selling in the near-term irrespective of the limited pool of potential buyers resulting from having won work in the restricted competitive environment? 

Looking at alternatives to a sale may be a means to maximizing the value to the shareholders and management team.  Utilizing the cash flow and balance sheet of the company to recapitalize by borrowing from your bank at historically low interest rates can provide meaningful liquidity (and is the model embraced by many of the sophisticated private equity groups that operate in the government contracting industry).  Exploring an employee stock ownership plan to provide for gradual liquidity for the existing shareholders.  Or acquiring assets that might meaningfully impact the near-term value of the business, such as a full and open contract vehicle position.

For those interested in building the “forever” strategy, this involves focusing on a progression that puts the business in a long-term position to compete for contracts that are prime, full and open, and in areas that are squarely long-term budget priorities (be it technology, customer or both).  Add to that strong cash flow on those contracts and you have the fundamental building blocks for value.  And any option will be available at almost any time.  Not too complicated.  But you don’t get there by turning on a dime.

The continuous shifts in this market, year-to-year and administration-to-administration, can make long-term planning a challenging exercise.

As owners and leaders of government contracting businesses it is important to understand the current identity of your business and take advantage of the substantial opportunities offered in the government contracting industry.  And focus on an ownership strategy that is consistent with the identity of your business.