M&A in the government contract sector
February 2016 | TALKINGPOINT | MERGERS & ACQUISITIONS
FW moderates a discussion M&A in the government contract sector between Holly Roth, a partner at Kelley Drye & Warren LLP, Marc Marlin, managing director at KippsDeSanto & Co, and David Ayres, founder and president at TATE, Incorporated.
FW: How would you describe M&A activity in the government contract sector over the last 12-18 months? What factors, in your opinion, are driving deals?
Roth: M&A activity in 2015 was vibrant and varied. It included large government contractor mergers, divestitures, splits and strategic acquisitions. Small and mid-size government contractors actively participated as well – frequently with the goal of growing and diversifying their businesses to compete for larger, and potentially bundled, government contracts. Many government contractors, large, mid-size and small, are focusing on strengthening existing capabilities, expanding relationships with agencies that are current customers or broadening their reach into new, synergistic opportunities. Concern over the Federal Reserve increasing the interest rate, the 2016 presidential election, the continued tightening on federal funds available to contractors, the consolidation of existing contracts to save costs, the drawdown of troops, and avoidance of the negative impact certain government regulations such as the conflict of interest regulations may have on future government contract opportunities, are factors that contributed to the types of M&A activity that took place in 2015.
Marlin: The defence and government services sector has seen a noticeable increase in M&A activity over the past 12 to 18 months, both in the number of closed transactions and also in total deal volume. This uptick was fuelled by increased market optimism, and valuations, stemming in part from an improving budgetary environment, including passage of a two-year budget deal, as well as a greater appreciation of homeland and national security risks. These altered dynamics have also helped the publicly traded defence and government services companies to forecast positive revenue growth. Additionally, many public and private companies are evaluating their portfolios and refocusing growth strategies on ‘core’ capabilities, which has led to both highly strategic acquisitions, as well as divestitures. For instance, companies such as Raytheon, Lockheed, and CACI have recently acquired companies that enhance capabilities, add scale, afford access to key contracts, customers or intellectual property, while at the same time Lockheed, BAE, L-3, and others have explored divestitures of non-core assets, and, in some cases, even a complete split between commercial and government operations as we saw with CSC.
Ayres: With the current uncertainty in long-range projections for the government contract sector, a number of mid-size firms are seeking buyers. With an increase in small business set aside contracts and the aggressive pricing exhibited by the larger firms, mid-size firms, for example, have few options other than searching for suitable buyers.
FW: How would you characterise the impact of tighter government spending on M&A activity within the sector? In which segments are deals most prevalent?
Marlin: Although the 2011 sequester legislation continues to support a tightened budgetary environment, the recently passed two-year budget has provided increased visibility into near-term federal spending and therefore improved overall confidence across the contracting community. This optimism has resulted in increased public valuations and an increase in M&A activity as buyers look to better position themselves within this improved marketplace. In addition, there has been an increase in larger, scale-driven transactions, which enable consolidators to take advantage of both revenue and cost synergies. On the supply-side, business owners who had previously delayed exit events given lacklustre financial performance are seeing brighter prospects following years of budget cuts and uncertainty, which is elevating their interest in selling. Budget challenges over the last half decade have also influenced federal procurement strategies by refocusing agencies on more effective uses of limited funds. Prioritisation of mission-critical requirements, such as cyber, national security, unmanned systems and ISR, continue to drive M&A and premium valuations for companies that are well positioned in these consensus growth areas.
Ayres: The reductions in government spending appear to be focused on those manpower support contracts that ballooned following 9/11. Many firms expanded to immediately fill the governmental gaps that were prevalent in the 2002-2006 timeframe. These firms that do not focus on a particular area or niche market are most at risk. Firms with advanced technology appear to be in the best position for acquisition.
Roth: Tighter government spending in 2015 resulted in the government’s continued, and increased, use of ‘lowest price technically acceptable’, or LPTA, evaluations in its procurements versus procurement evaluations that emphasise technical superiority over price. The result of the government’s continued focus on lowering costs and the consolidation of existing contracts in follow-on procurements has resulted in a number of contractors re-evaluating lines of business that provide fungible professional services and commodities to the government regardless of whether the government customer is one of the branches of the department of defence or the civilian agencies. Lockheed Martin’s divestiture and CSC’s spin off are just two examples of the results of the government’s tighter spending.
FW: To what extent has the current landscape proved to be a magnet for private equity firm interest in this space?
Ayres: Private equity firms appear to be searching for acquisitions that represent the next wave of government contracting. Rather than focusing on training and operational support, they are seeking Big Data and cyber security companies – sectors that are emerging in the defence space.
Roth: Sector savvy private equity firms continue to have interest and invest in this space because they know how government contracts work and understand the attendant risks. As a result, and instead of investing in contractors who have good procurement ‘win’ ratios, private equity trended towards specific, highly specialised support services, such as cyber security and information technology in the healthcare and human resources arenas. As the October 2015 Budget agreement rolled back part of sequestration for financial years 2016 and 2018, and government budgets became final, the government could move forward with additional procurements. The avoidance of a government shutdown provided, generally, more potential stability in this space. Similar to the corporations that participated in M&A in 2015, private equity sought to obtain benefits of corporate consolidation to increase the size of individual holdings and attendant capabilities to bid on larger contracts or to broaden its holdings base.
Marlin: Private equity has been active on both the sell side and the buy side. On the sell side, in response to increased strategic M&A interest, certain private equity firms are taking advantage of rebounding valuations and exploring platform exit events. For example, Leonard Green, Snow Phipps, Providence Equity and Arlington Capital Partners recently consummated portfolio sale transactions at premium valuations, with reported or rumoured enterprise values in excess of 10 times trailing 12-month EBITDA. On the buy side, many private equity firms are leveraging an abundance of ‘dry powder’ and attractive financing to aggressively pursue platform companies that are well positioned to capitalise on the improving industry fundamentals. Clearly, it is interesting to see seasoned industry investors like Carlyle and Veritas making significant new industry platform acquisitions, as both did in 2015. In light of the current contracting environment, which has often favoured lowest priced technically acceptable and cost-plus contracts for more commoditised services, and given an expectation of continued consolidation across the industry, certain private equity buyers are attracted to roll-up strategies that take advantage of operational efficiencies and cost-synergies created by M&A.
FW: What specific considerations do buyers and sellers need to make when structuring and executing M&A transactions in the government contract space? How important is thorough due diligence and effective risk management?
Roth: Given the risks attendant with being a government contractor, and the chimeric value of some multiple award, indefinite delivery, indefinite quantity contracts, thorough due diligence and effective risk management is extremely important to determine a correct valuation for the seller, or whether the perceived benefits of the seller are significantly overshadowed by the seller’s possible noncompliance with one or more material laws or regulations. We have participated in due diligence efforts where a hard look at the seller’s existing government contracts and compliance resulted in a substantial reduction in the seller’s value or where the acquisition ultimately did not occur because the risk of uncovered noncompliance overcame the seller’s perceived benefit. As US law prohibits the ‘sale’ or assignment of US government contracts, the first important consideration is whether the transaction should be a stock acquisition, where generally no novation of the contracts is required, or an asset acquisition, where novation of the contracts is required. Where buyers are non-US entities, important considerations are whether the structure would result in the seller being deemed an inverted domestic corporation – and no longer able to be awarded any future government contracts – or whether the structure should include a US board of directors as part of a mitigation plan to permit the continuation of the seller’s facility clearance, if any.
Marlin: Contracting with the federal government adds a number of intricacies to structuring and executing transactions for both sellers and acquirers. For example, more often than not, an acquiring company does not qualify for any special designations under which the target may have been awarded certain federal contracts – commonly referred to as set-aside, such as minority-owned, small business, service disabled veteran owned, and so on. This can adversely impact a buyer’s ability, or at least perceived ability, to recompete a target’s existing contracts. A company with classified programmes can also create unique challenges for buyers if they are unable to perform due diligence on the actual contracts without appropriately cleared employees, and in select cases, explicit customer permission. An additional layer of complexity is involved if an acquirer is a foreign entity or a domestic company with outside foreign ownership interests. Finally, all federal contracts include certain Federal Acquisition Regulations that require appropriate due diligence to ensure compliant past practices and controls. For buyers, it is critical to engage with diligence consultants that have considerable qualifications in the federal contracting space. Equally, if not more critical, federal contracting sellers should engage legal counsel and an investment bank with a strong reputation in the space, transaction experience in their specific customer or capability areas, and strong relationships within the likely buyer community.
Ayres: Although it is obvious that the buyer will perform due diligence for potential acquisitions, the seller should be equally focused on ensuring that the acquisition either advances their long-term goals or fills a current gap that cannot be solved with organic growth. Equally important is an understanding of the integration of fundamental systems such as accounting software, human resources practices and audit compliance.
FW: In your experience, what are the main challenges facing those interested in acquiring assets linked to government security, defence and intelligence services? Do these hurdles increase significantly for foreign entities?
Marlin: Buyers looking to make acquisitions of companies operating within the intelligence and defence market must ensure that they have the requisite clearance levels, which are often customer specific, to perform effective due diligence. This requirement can be a particular challenge for buyers without an existing presence at a particular agency. For instance, a buyer with an established presence at the NSA looking to acquire a CIA-focused contractor may lack the appropriate credentials and may therefore need to turn to outside advisers or consultants to perform various diligence activities. In addition, foreign ownership can make the process even more difficult given the onerous legal requirements associated with the Committee on Foreign Investment in US (CFIUS) review process. As a result, the risks associated with a foreign buyer successfully consummating a transaction with any intelligence or defence contractor can be particularly high, potentially making foreign buyers less attractive to US sellers. From a foreign buyer’s perspective, the requirements associated with managing US subsidiaries are arduous and can make US intelligence acquisitions less desirable.
Ayres: There is an evolving concern with regards to foreign entities, specifically for those agencies with restrictive foreign disclosure and foreign contact reporting requirements. The clearance process is arduous and foreign contacts or foreign holdings make the approval process even more daunting.
Roth: Ensuring the buyer and seller understand the government’s requirements for an ‘assumption’ of a government contract is an important challenge. In an asset acquisition, the government has to determine whether the transfer of government contracts is in the government’s interest, and also whether to approve the transfer of government contracts, through a novation, from the seller to the buyer. To obtain governmental approval, the buyer and seller must demonstrate either the buyer is acquiring either all of the assets of the seller, or all of the assets of the seller that are necessary to the performance of the contracts being acquired. As part of a three party novation agreement, both the seller and the buyer must understand that both parties will be liable to the government for performance of the contracts, both prior and post-acquisition. US government involvement, and the associated hurdles, increases significantly in any asset or stock acquisition by a foreign entity of a seller in the government security, defence and intelligence services sectors. A seller with a US security clearance is required to notify the Defense Security Service (DSS) at the start of any negotiations for a proposed acquisition resulting in a foreign interest within the cleared seller’s chain of ownership. The notification must include the identity of the foreign buyer and a plan to mitigate or negate the foreign ownership, control or influence the foreign entity gains as a result of the acquisition. Facility clearance agreements with the DSS do not convey with an asset acquisition. Furthermore, given the sensitivity of these sectors, a foreign entity buyer and US seller will likely have to file a notice with CFIUS describing the seller, the buyer and the transaction, and obtain CFIUS’s approval of the transaction before the transaction can be closed.
FW: Have any recent legal or regulatory developments had an effect on the government contract sector? If so, have they helped or hindered transactions?
Roth: Laws, regulations and executive orders issued from December 2014 through 2015 will have a significant impact on the government contract sector. President Obama signed a number of executive orders that impose new requirements on service contractors. These executive orders mandate a minimum wage, paid vacation and certification of compliance with all labour laws. For contractors who source services, or obtain supplies from overseas, the final version of the regulation – Combatting Trafficking in Persons – imposed new burdens for those contractors who are responsible for ensuring the compliance of their subcontractors. Likewise, the Cybersecurity Act and other cyber security regulations proposed by various agencies placed increased compliance burdens on contractors. Finally, the US Department of Justice is increasing its efforts to hold individuals civilly and criminally liable for a contractor’s noncompliance. Going forward, a buyer’s due diligence will be expanded to include additional areas of compliance review and how well the seller monitored its subcontractors’ compliance.
Marlin: Probably the most impactful regulatory changes over the past few years have been related to the landmark Affordable Care Act, which has materially injected significant funding into the federal healthcare market. Despite a challenging overall budgetary environment, the Department of Health and Human Services’ budget continues to rise, growing 9 percent from $74bn in 2014 to an estimated $87bn in 2017. In addition, the Department of Veterans Affairs’ budget is projected to increase 18 percent to $75bn over the same timeframe. This has made government services companies focused on the healthcare market considerably more attractive from an M&A standpoint.
FW: Looking ahead, what trends and developments do you expect to see in government contract sector M&A? Will cyber security and intelligence services drive a significant portion of activity in the future?
Ayres: Cyber security, intelligence services, Big Data analytics and social media analysis comprise an ever-expanding government sector component. These areas are just maturing so acquisitions in this field have the potential for greater returns and higher margins during the next few years. These areas represent technologically sophisticated functional areas so the investment in personnel and data charges is not trivial, leading to more expensive contracts and competition in the hiring ranks due to the wide number of opportunities.
Marlin: The market dynamics that fuelled a strong increase in M&A activity in 2015 should persist into 2016. Public companies that are still burdened with near-term organic growth challenges are likely to leverage strong balance sheets to pursue strategic acquisitions that supplement organic growth and create shareholder value. In addition, the remaining budgetary challenges and competitive advantage of scale, encourages an atmosphere for continued consolidation as companies seek more efficient cost structures and synergies associated with M&A. As a result of these trends, three major themes have emerged over the past 12 to 18 months that have and are expected to continue to drive robust M&A activity and premium valuations. The first is an increase in portfolio-enhancing acquisitions that augment core capabilities, contracts or customers. These strategies are typically focused around cyber, data analytics, SOF, intelligence, and more broadly C4ISR, as well as health IT. Given that budgets for these areas are expected to continue to increase, they will likely remain core drivers for both acquisitions and premium valuations. In addition, certain buyers are increasingly placing a premium on target companies with unique capabilities or intellectual property, which provides both market differentiation and typically more stable and higher-margin revenue streams. This theme especially favours continued M&A interest for smaller and mid-sized companies, which tend to be more operationally nimble and therefore focused at the forefront of new commercially-accepted technologies and associated federal adoptions. The third theme highlights an increased interest by certain buyers to make large-scale, transformational acquisitions that add considerable scale and provide opportunities for both revenue and cost synergies. Examples of these types of transactions include the mergers of TASC and Engility, CSC Government Services and SRA, and Orbital and ATK.
Roth: The foreign and domestic terrorist attacks, cyber attacks and data breaches over the last few years, as well as the laws and regulations implemented to protect against such events, have ensured that specialisations in cyber security or intelligence services will continue to drive a significant portion of M&A activity in the future. In December 2014, President Obama signed five new cyber security laws: the Federal Information Security Modernisation Act of 2014, the Homeland Security Workforce Assessment Act and DHS Cyber Security Workforce Recruitment and Retention Act of 2014, the National Cybersecurity Protection Act of 2014, and the Cybersecurity Enhancement Act of 2014. On 10 June 2015, the Defense Information Systems Agency (DISA) released a five year strategy that called on defence personnel to treat cyberspace as a new war-fighting domain. In late 2015, Congress passed the Cybersecurity Act. These laws, the regulations promulgated under these laws, and government strategies, such as DISA’s, impact agency and government contractor compliance and response requirements. On the one hand, agencies will be looking to the government contractor community to comply with these laws and agency-specific strategy. On the other hand, the contractor community will be looking to obtain the necessary expertise both for in-house compliance and to compete successfully for these specialised government service contracts.
Holly Roth is a partner in the firm’s Washington, DC office and chair of the Government Contracts practice group. Ms Roth has more than 20 years of government contracts experience, including 10 years with a Fortune 50 systems integrator as subcontracts manager, where her experience included bid and proposal efforts as well as drafting, negotiating and administering a broad range of federal government subcontracts. She focuses her practice on a wide range of counselling and litigation relating to federal, state and local government procurement matters as well as federal assistance agreements and grants. Due to her superior client focus and forward thinking solutions, Ms Roth has been recognised as a 2014 Client Service All-Star by BTI Consulting. She can be contacted on +1 (202) 342 8478 or by email: firstname.lastname@example.org.
Marc Marlin is a managing director at KippsDeSanto & Co., and has a broad base of experience in providing transaction advisory services. Mr Marling leads KippsDeSanto’s Technology Solutions practice, focused on growth oriented professional services, IT and software companies. Prior to co-founding KippsDeSanto & Co., Mr Marlin was a member of Houlihan Lokey’s Aerospace Defence Government industry investment banking group. Previous experience includes work with Harris Williams, JPMorganChase and the International Finance Corporation, a member of the World Bank Group. Mr Marlin can be contacted on +1 (703) 442 1403 or by email: email@example.com.
David Ayres is the founder and President of TATE, Incorporated, the leading provider of high-risk of capture training for the Department of Defense and other US government agencies. TATE, Incorporated has offices around the world and supports all sectors of the personnel recovery (PR) mission area – developing training and technological support programmes to support those who are working or travelling overseas. Mr Ayres can be contacted on +1 (703) 504 9630 or by email: firstname.lastname@example.org.
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