M&A activity remains strong despite challenges

After an unprecedented level of merger and acquisition activity in 2021, there were expectations markets would be “cooling down” in 2022.  In reality, 2022 fell into a normalized level of deal flow, in-line with historical performance. 

As the calendar turned to 2023, a new host of dealmaking challenges arose – notably:

• Rapidly evolving credit market dynamics – punctuated by regional bank failures.
• Continued inflationary pressures and fears of recession.
• Impending debt ceiling uncertainty.
• An increasingly elongated procurement cycle, with contract award delays and recurring protests further impacting growth visibility for both buyers and sellers in the government technology services market.

While each of these respective dynamics were top of mind for much of the first half of 2023, government technology services M&A activity remained resilient – the first half of 2023 showed a 10%+ uptick in transactions (50) as compared to the second half of 2022 (45). 

This puts the industry on pace for annualized deal volume generally in-line with recent years (excluding the outsized post-COVID activity of 2021).  When looking at this volume in the context of the above-referenced market challenges, along with broader economic volatility, there is much to be optimistic about for well-positioned companies as we come down the homestretch of 2023.

Private Equity Undeterred by Credit Market Turbulence

After a prolonged period of historically inexpensive debt, a series of steady rate hikes from the Federal Reserve was seen as a potential blow to the impressive run private equity has been on.  Though the availability and pricing of debt has no doubt had an impact, the party is far from over for these serial investors.  In the first half of 2023, more than 65% of announced transactions involved private equity buyers (both new platforms and tuck-ins to existing portfolio companies).

Several familiar faces remain active on this front, including Enlightenment Capital, which made five tuck-in acquisitions for existing portfolio investments (Boecore acquisitions of Orbit Logic and La Jolla Logic; iNovex acquisitions of Innoplex and Secure Innovations; Agile Defense acquisition of XOR Security).

Other examples include Blue Delta’s investment in Core One Solutions and a subsequent tuck-in of Global Research Analytics; Godspeed Capital’s SilverEdge Government Solutions’ acquisition of Gardetto Engineering (marking the sixth deal of that roll-up), and; Arlington Capital’s announced formation of Eqlipse Technologies through several recent acquisitions. 

The considerable fundraising activity of the last several years has supported this aggressive posture from private equity buyers, irrespective of credit market influences.  With the Fed’s decision not to increase rates at its June meeting (spoiler alert: that pause was short-lived), it does appear rates are nearing a peak, and as such, we would expect continued involvement from sponsors and sponsor-backed businesses that outpaces both public and private buyers alike.

Rebuilding the Middle Market

One often overlooked offshoot of incredibly high M&A activity over the past several years is also making its presence felt in the first half of 2023 – the need to “rebuild” the middle market.

A steady string of sizable, high-profile deals in recent years has given way to a greater proportion of sub-$100 million acquisitions.  During the first half of 2023, less than 15% of deals exceeded $100 million in enterprise value, down from nearly 25% in 2022 and almost 30% in 2021.  This appears to be driven by several factors:

• An increasingly selective acquisition appetite from public strategics (generally speaking, the more aggressive buyers for larger targets).
• Heightened demand for truly differentiated, next-gen capabilities (for which the potential targets often skew smaller – e.g., AI / ML, cyber).
• Private equity remaining a “net buyer”, with more new platform acquisitions than exits as they focus on roll-up strategies designed to build scale and attract high exit multiples.

Notable recent examples include Altamira’s acquisition of Virginia Systems & Technology, Meadowgate Technologies merging with Engineering Solutions, and the ongoing portfolio strategy of Sagewind Capital with Axient, Sigma Defense, and Tria Federal.

As smaller acquisitions account for a larger share of overall deal volume, we would expect to see accelerated growth of currently sub-scale companies to replenish an increasingly sparse layer of the market – that of the ~$250 million acquisition target.

Creative Contracting Landscape

Large-scale, in-demand governmentwide acquisition contracts and indefinite delivery, indefinite quantity vehicles continue to reign supreme for driving growth.

However, as government procurement delays continue to extend the timeline for new awards (and by extension, impede growth), more and more companies are making smart use of less-traditional contracting mechanisms.  Phase III small business innovative research IDIQs, in particular, have seen an ascent to near-equal footing with blanket purchase agreements and Other Transaction Agreements.

The ability to utilize these less traditional procurement approaches to secure unrestricted task orders has seen increased adoption, and with that, an influx of acquisition targets that offer an “easy button” approach to winning work.  And while flagship vehicles, such as OASIS+, CIO-SP4, Alliant 3, and T4NG 2 will likely become a golden ticket for many awardees, successfully navigating these other task-order based contracting mechanisms continues to create differentiation, and thereby enterprise value, across the marketplace.

Increased Adoption of Commercial Technology Solutions

Digital transformation and IT modernization are by no means new concepts; however, their ubiquity is now on par with the run “cyber” had more than ten years ago (and which persists today).  As the government has turned its fiscal attention to better, more efficient technology solutions, contractors are lined up to secure these budget dollars. 

And while there are varying flavors of what truly constitutes a transformational solution, it is apparent that government customers have started to welcome commercially developed technology that has been tailored for the government market with open arms.  The Department of Defense has demonstrated its commitment to this in multiple ways – notably, utilizing software factories and SBIR solutions, as well as its nascent Immersive Commercial Acquisition Program.

Companies with demonstrated expertise in key technology platforms (e.g., ServiceNow, AWS, Oracle) and disciplines (e.g., automation, AI / ML, cloud, digital engineering) are well-positioned to drive above-market growth.  Recent examples following this blueprint include Arcfield (a portfolio company of industry heavyweight Veritas Capital) acquiring Strategic Technology Consulting and cBEYONData (Bluestone Investment Partners) acquiring Summit2Sea Consulting.

Notwithstanding macro-level challenges to government services M&A, the deal landscape remains active.  And with a flurry of deals anticipated for the second half of 2023, the full year outlook – as well as looking ahead to 2024 – gives plenty to be optimistic about from a transaction activity standpoint.

About the author: Brian Tunney is a Director with KippsDeSanto & Co. and has more than 15 years of M&A experience.  He is a graduate of the University of Virginia.  He may be reached at btunney@kippsdesanto.com.