M&A opportunities abound in a changed market

The seismic shifts in the government contracting market over the last several years have given rise to much debate among participants and advisors over the health of and near-term prospects for mergers and acquisitions.

The M&A market is healthy and strong, albeit in a much different manner than a decade ago. GovCon services transactions are up 20 percent for the two year period ending 2016.  To gain footing in this new landscape and clarify new drivers of M&A supply and demand, it is critical to employ an analytical perspective free from reliance on the now dated dynamics of the late 2000s.

Understanding and accepting these fundamental changes will lead to better executed strategic plans from buyers and much improved outcomes for sellers.

Supply-Side Challenges

The dominant factor impacting the current M&A market is an ever-decreasing supply of middle market businesses in the sector with an unrestricted contract base. The massive amount of transaction activity over the past decade has decimated the ranks of $50 million to $300 million full and open businesses.

Consider that prior to 2003, there were fewer than 50 GovCon services transactions per year. Federal contract spending nearly doubled by 2007, resulting in a surge of transaction activity. 2007 had 175 services M&A transactions alone.

Although transaction volume decreased during the Obama administration, with an average of roughly 100 services transactions per year, that is still more than double the pre-2003 period. In fact, since 2007, the McLean Group has tracked over 900 transactions in the sector.

Most of these transactions involved companies with less than $300 million of revenue.

One of the many positive attributes of the GovCon market is that there typically has been a very strong crop of next-generation companies that grow into the mid-market category, replacing those that had been recently acquired.

Unfortunately, recent federal procurement changes have made it significantly more difficult for small businesses to win larger, unrestricted contracts. On one hand, the government is utilizing more set-aside contracts, which benefits smaller firms at the expense of mid-market players. On the other hand, contract bundling and greater utilization of GSA vehicles and other non-GSA GWACs benefit larger companies that have the resources and requisite past performance to successfully compete for unrestricted slots.

This has resulted in what many describe as the “mid-market squeeze.”

Add this on top of the budget uncertainty of the sequestration era, LPTA procurements, and the slowdown (in some cases cessation) of new technology starts that plagues all market participants. These ongoing shifts have transformed growth strategies for emerging businesses, but also altered buyer behavior.

Demand-Side Adaptations

The market has adapted to this new reality in remarkably creative ways.

First, companies that do successfully grow in the mid-tier ranks with unrestricted contracts are garnering premium valuations. However, the old paradigm of valuation expectations has changed. While it used to be common wisdom that only cyber, intelligence, C4ISR, or health care IT companies generate robust valuations, recent and current M&A activity is yielding strong valuations for a wide range of companies beyond those “buzzword” areas.

Generalizations about higher value segments, capabilities, and customer bases as a rule are no longer applicable. Buyers instead are employing a targeted, highly rational approach toward evaluating opportunities that fill critical gaps, open new market opportunities, and bring innovation.

Second, buyers are also becoming increasingly creative in how they adapt to the new reality of a smaller base of full and open acquisition candidates. Many are pursuing businesses that until recently may have been of less interest, employing transaction structures that share risk of contract transition with sellers.

In 2016 there was a meaningful rise in transactions that involved businesses with a large amount or a majority of revenue from set-aside contracts, including small businesses and 8(a) contracts. These businesses tend to have strategic contracts, unique technology, or other differentiators that provide buyers with a high level of confidence that set-aside work will continue upon change of control.

Lastly, in addition to a growing universe of buyers willing to consider set-aside contracts in the right circumstances, the current market shows an expanding array of viable liquidity alternatives for a broader set of businesses. These include minority equity recapitalizations, senior and subordinated debt recapitalizations, and ESOPs. And, even within these categories, there is an emerging class of knowledgeable and dedicated capital sources for each of these transaction alternatives. 

While some may long for the heady days of peak valuation and transaction activity from a decade ago, a vibrant and creative M&A market exists.  The market has emerged from a tumultuous period of unheralded uncertainty, regrouped, and adapted to a different set of realities, creating significant opportunities for well-positioned buyers and sellers.