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Structuring Deals In The Government Contractor Sector « Back
Matt Atkins, August 2012
Due to their sensitive nature M&A transactions in the US government contractor sector raise a number of risks and regulatory hurdles, which new entrants to the sector may find particularly daunting. Acquirers need to manage risk by carefully assessing the target’s finances, operations and compliance processes, bearing in mind specific regulatory issues which also require attention during the due diligence process. While navigating the pitfalls can be a challenge, the sector presents attractive opportunities for buyers and investors alike.

Unique risks

In the past 10 years M&A activity in the contractor sector has grown markedly, with deals increasing in sophistication and complexity. While, in essence, acquisitions in the commercial arena and those of government businesses share a great deal in common, contractor acquisitions require acquirers to address a number of key differences, which could unravel the deal, or undermine its value, if overlooked.

“Structurally, government contractor acquisitions are almost always acquisitions of stock or other equity interests, which minimises the need to obtain formal government consent to the novation – assignment – of contracts from the seller to the buyer,” says Jeremy Silverman, a partner at McKenna, Long & Aldridge LLP. “The equity acquisition structure means that buyers are at greater risk from liabilities relating to the pre-transaction operation of the target business. Beyond structural considerations, another key distinguishing feature in government contractor acquisitions is that the customer has a level of power and control that is different in kind from that of the typical commercial customer,” he adds. Indeed, the ability of the government to terminate a contract at any time is unique, and factors such as changing budgetary priorities, heightened security threats, or the ending of war can result in money being reallocated from certain projects to others.

Those doing business with government agencies must expect unique risks to arise, especially given the complex regulations associated with these transactions and the procedural and political backdrop against which such deals take place. Buyers must bear these areas in mind, ensuring that their target is compliant with relevant regulations and in a position to secure ongoing contract awards. Indeed, the twin risks of customer and contract concentration are under particular scrutiny in today’s market. “Contract funding, of course, is going to be of particular concern,” points out Erik Choy, vice president of Investment Banking at D.A. Davidson & Co. “Given the sequestration threat, all government contracts are being scrutinised, delayed or are under threat of cancellation. In order to mitigate these types of risks, the general consensus has been to invest in the more stable parts of the budget – health IT, cyber security, intelligence or energy. Additionally, buyers will have a preference for targets that have a more diversified customer base.” Assessing a contractor’s active contracts and potential future contracts is of great importance. Acquirers should ask if the target’s area of expertise is likely to be required by the government in the future, whether demand is on the increase or decrease, and whether the target is in a position to re-secure its current contracts when they expire.

Regarding regulatory compliance, due diligence for companies that contract with the US government should involve an assessment of the contractor’s compliance with Federal Acquisition Regulations (FAR), Cost Accounting Standards (CAS), and Defense Contract Audit Agency (DCAA) requirements. Other regulatory matters may arise dependent on the type of work that the contractor carries out.

No matter how complex such regulation appears to be, it is fundamental to government contracting and must be followed to the letter. If not, a company may jeopardise its ability to do business in the sector. Firms should remain particularly wary when acquiring smaller targets. Given the complexity of regulations, the burden of compliance, and the frequency with which rules change, smaller business can often fall short of full compliance. Larger contractors acquiring these companies must therefore remain vigilant for such infractions, or else leave themselves open to government penalties which can include significant fines, personal criminal liability or a total prohibition from further contracting work.

Acquirers approaching deals in the sector cannot afford to underestimate the complexity of structuring deals in the contractor sector, and in general need a healthy knowledge. Those with little or no experience in the sector can be naïve to the risks. “Some may not fully understand the risks, the ways to manage those risks, or the role of the various interested government agencies in approving aspects of the deal,” explains Craig S. King, a partner at Arent Fox LLP. “However, acquirers learn quickly. The vast bulk of our work is with acquirers who now have done at least one deal in the government contracts sector – and desire to do more. Today, buyers and sellers in the government contractor arena are much more sophisticated than they were just a few years ago.”

Fortunately, those who have only recently entered the market will find an army of advisers, emergent in recent years and willing to offer their in-depth experience for a price. “As the government contracting M&A market has evolved, a community of specialty advisers – accountants, lawyers, and other consultants – with deep knowledge of the regulatory complexities and risks has grown,” says Stephen M. Saunders, managing director at Fennebresque & Co. “Most experienced acquirers are cognisant of the unique risks in the sector and are quick to bring together a team of experienced advisers to help them thoroughly assess any acquisition target they actively pursue. In my experience, most are cautious, thorough and well prepared when it comes to structuring acquisitions and managing their risks.”
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