M&A in the US government contractor sector
May 2012 | TALKINGPOINT | MERGERS & ACQUISITIONS
FW moderates an online discussion examining M&A in the US government contractor sector between Craig King at Arent Fox LLP, Jeremy C. Silverman at McKenna Long & Aldridge LLP, and Scott Thompson at PwC.
FW: Could you outline recent deal trends in the US government contractor sector? What level of activity have you seen over the last 12 months?
King: M&A activity in the US government contractor sector remains relatively robust with transactions requiring increased sophistication on both the seller and buyer side. While trends in some industry sectors merit attention, in particular, defence and aerospace, perhaps the more important trends involve key forces that are affecting deals differently today in the US government sector. First, many US contractors have seen substantial business growth in recent years due to sales related to the conflicts in Iraq and Afghanistan and owners now are seeking to sell these companies at values that reflect that strong performance. However, military draw-downs in Iraq and Afghanistan and, more generally, reductions in defence budgets, give rise to significant uncertainties and contingencies and call into question the valuation of these companies. Second, significant opportunities for strategic acquisitions are arising as a result of certain changes in government focus and spending. While some traditional business lines are in decline, changes in approaches and priorities of the Department of Defense are giving rise to potentially lucrative investments in companies involved in current priority areas such as special operations, unmanned vehicles, cyber defence and satellites. Changes in health care priorities also are giving rise to new opportunities in federal procurement. Similarly, recent government requirements that companies divest business units that involve potential organisational conflicts of interest (OCIs) are creating some wonderful opportunities to buy companies with established, key relationships supporting government agencies. Third, margins for many types of government work are being reduced significantly – due to funding cuts, increased competition and changes in government procurement approaches. Finally, the emergence of private equity funds as more significant players in the US government sector is changing the landscape for mergers and acquisitions.
Thompson: 2011 was a record year for Aerospace & Defence (A&D) M&A, with about $43bn in deals. A $16bn acquisition was the industry's largest deal in history, helping to drive the record, but deal volume was also a record. The past two years, there were also a lot of spin-offs and divestitures. These sales and spin-offs have been in response to new conflict of interest rules, as well as the desire to re-balance portfolios based on defence spending trends. In 2012, we expect deal volume to continue at high levels, while deal value returns to more typical levels, probably in the $15bn-$20bn range for the year. We also expect to see some consolidation in defence in response to the declining market.
Silverman: Our firm’s M&A practice is very middle-market focused and we have continued to see steady middle market deal flow over the last 12 months. In terms of trends, M&A seems to be serving an R&D function for many acquirers, with targets providing buyers with new technology or service capabilities, as opposed to just adding more contract backlog or personnel bench strength. With respect to specific technology, cybersecurity and other technology geared toward the federal intelligence community continue to be very hot and we expect that to continue based on government budget priorities and newly-imposed regulatory requirements.
FW: Have there been any recent regulatory and legislative proposals that would influence M&A in this space? What impact might an Administration change have in this regard?
Thompson: A few years ago, the government issued new organisational conflict of interest (OCI) rules that prevent companies from providing advice that results in a sister company providing services. Those rules resulted in several divestitures.
Silverman: There has been significant recent legislative and regulatory interest in small business-related issues, including rules related to preferences and set-aside contracts. Many companies have acquired small businesses in the past because of the perceived advantages. Congress appears to view this area as the next big fraud hot spot, which may mean that acquirers’ ability to take advantage of small business preferences will become more limited. Because of how far along legislative and regulatory developments are in this area, change at the White House is unlikely to have much impact. A more recent area of executive and legislative branch attention is in the area of sustainable acquisition, including the imposition of environmental-related requirements on federal agencies. On the one hand, for example, servicing the government’s needs around improved energy efficiency of federal buildings could drive interesting M&A opportunities, as traditional government contractors look to add environmental capabilities. On the other hand, given that the Republicans are less likely to view climate change as policy priority and, because the relevant regulatory effort is still in its infancy stages, a new administration could shut this down.
FW: To what extent might the recent federal budget crisis influence dealmaking? What is the outlook for federal contract spending against the backdrop of recent defence budget cuts?
Silverman: There is a general consensus that the pressure to reduce the federal deficit and get spending under control will lead to continued reductions in US defence spending. My partners who closely track the defence budget believe the areas that are likely to do relatively well – meaning they will be funded at relatively higher rates despite tight funding – include cybersecurity, IT generally, unmanned aerial vehicles, and intelligence. We are already seeing those anticipated budget priorities driving M&A activity – every government contractor deal I have done in the last two years falls in one of those areas. Our policy specialists believe that the areas within the defence sector that are not likely to do as well involve military construction, heavy armoured ground combat vehicles, and personnel and benefits.
King: Historically, draw-downs in US government budgets have spawned an increase in mergers and acquisitions as contractors seek new business arrangements that enable them to maintain at least some portion of shrinking government programs and funds. Sometimes, government customers affirmatively encourage such business combinations – with government program managers seeking to engineer ways to maintain specific capabilities of competing contractors where there no longer is sufficient funding to maintain multiple sources. In this latter situation, government antitrust authorities and other regulators may be readily persuaded by the procuring agencies that proceeding with the transaction is in the public interest. Limits on cash or credit for acquisitions, however, are a significant complicating factor in today’s environment. Potential buyers in the US and abroad are analysing a significant number of potential acquisitions but holding back, and not pulling the trigger, pending stabilisation of the cash/credit situation and broader economic uncertainties.
Thompson: The expectation of declining defence spending will cause consolidation that will be in proportion to the drop in defence spending. The ultimate drop in defence spending is still uncertain. While the president’s budget calls for $500bn in defence cuts over the next decade – about 10 percent – the full year 2013 budget is essentially flat. In addition there is the prospect of sequestration hanging over the industry. If sequestration is not averted, it could result in about $1 trillion in defence in the next decade, or about 20 percent.
FW: Has there been an increase in appetite from private equity and trade buyers, given that this industry is stable with proven long-term returns? Are struggling small and medium-sized contractors typical targets?
King: Private equity firms were slow to come to the US government markets – due in large part to their lack of understanding of, and resulting discomfort with, the many rules, specialised practices, and risks that are unique to these markets. However, a number of private equity funds now have tested the waters with initial, and seemingly successful, purchases of US government contractors and these funds are becoming comfortable with the unique aspects of doing business with the US government, and the uncertainties and contingencies associated with this business. Private equity funds that are in the US government markets now are looking to do additional deals that build upon and enhance their investment. Other private equity firms are considering entry. Again, right now there is a lot of shopping going on – with a potential for significant transactions in 2012.
Thompson: Private equity has been very active in defence for a long time. Several of the divestures previously mentioned were acquired by private equity. Small and medium-size contractors are attractive targets for private equity, which focuses on cost cutting or roll-ups to improve absorption of fixed costs.
Silverman: There been an increase in appetite from buyers. In particular, a much broader group of private equity buyers are looking at federal sector deals today as opposed to five or even three years ago. Although reduced federal spending may temper enthusiasm somewhat, there are and will continue to be attractive sub-niches within the federal sector, as discussed above. And although there was a time when many private equity funds were not interested in dealing with the regulatory hurdles of government contracting, that barrier to entry is viewed as less intimidating than it once was. It has not been my experience that struggling small and medium-sized contractors are typical targets. With few exceptions, the targets we see are successful companies and not struggling. In our experience, the more common target profile is a company that has grown quickly based on size or other status preferences, but for whom the future may be uncertain as it must compete for full and open contracts.
FW: What specific due diligence issues need to be taken into account when executing a transaction in the government contractor sector? What additional considerations need to be made on both the buy and sell-side?
Thompson: There are many issues that need to be considered, including standard issues around understanding the quality of earnings and the business forecast. Specifically for defence contractors, the nature of contracts poses special considerations relating to long term contracting estimates and changing defence priorities and funding. One of the most important things to focus on is due diligence of an A&D company that relates to the estimates to complete contracts, as the contracts may involve advanced technologies and/or execution over many years, both of which make it challenging to evaluate estimates of future performance.
Silverman: Although many aspects of due diligence for acquiring a commercial business apply when acquiring a government contractor, there are a host of special issues to consider for federal sector deals. A broad set of regulations apply to all government contracting businesses and should be examined in connection with every target. In evaluating contract performance and compliance, acquirers need to go beyond the four corners of the target’s contracts and examine contract performance assessment reports (CPARs) and other correspondence between a target and applicable contract officers. One relatively recent area of regulatory attention is business systems, specifically the adequacy of a government contractor’s systems for accounting and billing, purchasing, estimating, material management and accounting, government property, and earned value. Since this is an area of enhanced government scrutiny, it should likewise be an area of due diligence focus in an M&A context. Beyond compliance, the strategic analysis of a target needs to take into account unique government contracting considerations. For example, if a target will lose its small size status or other disadvantaged business status by virtue of an acquisition, a buyer must evaluate to what extent the post-deal value of the acquired business may be different than the target’s pre-deal value.
King: Newcomers to US government markets are often surprised at the number and nature of unique issues that need to be addressed in acquisitions of companies that contract with the US government. Once a buyer is familiar with these issues, however, and learns how to take into account and address the risks and contingencies associated with government work, those buyers seem to develop a healthy appetite for additional acquisitions in the US government sector. As an example of the government-unique issues: under government contracts, the contractor has an obligation to perform any changes requested by the government, so long as the change is generally related to scope of the contract, and must continue performance even throughout resolution of any dispute as to the compensation due from the government. As another example, the government has the discretion to terminate any contract at any time for the government’s own convenience – a feature of government contracting that often needs to be explained carefully to lending institutions not familiar with US government work.
FW: Specifically, are there unique cybersecurity issues affecting government contractors that should be considered as part of M&A due diligence?
Silverman: New and evolving cybersecurity requirements affect all contractors who possess, use or have access to federal information of information systems on behalf of an agency. Failure to comply with these requirements exposes contractors to contractual, civil and even criminal liability. Accordingly, acquirers need to understand and take into account legislative and regulatory requirements that will affect their own business and the business of M&A targets and consider these requirements in their due diligence efforts. This is particularly challenging given the changing landscape, with the Cybersecurity Act of 2012 and other legislation currently pending in Congress and new rules potentially on the horizon.
King: Today, cybersecurity is receiving priority attention throughout the US government. Underlying this attention are actual or perceived cyber-attacks on US computer systems that are attributed to hackers, terrorist groups or other foreign entities. Legislation is currently pending that will strengthen laws providing for computer security – and will criminalise a wide range of acts that damage computers, breach data security, or constitute computer fraud. The government’s increased focus on cybersecurity is likely to have effects on mergers and acquisitions in US government markets. First, companies offering cybersecurity technologies or services are among the most sought after acquisition targets. Even in these austere times, government money is flowing liberally into cybersecurity – and contracts for cybersecurity technologies and services remain higher value-added, higher margin businesses. Second, the government is viewing a wider range of computers and computer systems as “critical technologies” that merit special protection from foreign control and influence. Congress and the president have charged the Committee on Foreign Investment in the United States (CFIUS) with interceding to limit acquisitions by foreign buyers that might imperil national security.
Thompson: Cybersecurity should be part of M&A due diligence. Government contractors are subject to some unique regulations pertaining to information on national security. Export regulations – international traffic in arms, or ITAR – is an area of complex, but mature regulation. Regulations surrounding the unintentional breach of national security, as a result of cyber attacks, are less mature. Nonetheless, companies must always consider the regulatory and reputational risks they may inherit as part of an acquisition, including the risk of cybersecurity breaches. Of course, cybersecurity services are a growing area of opportunity as well. Companies with specialised cybersecurity services are very attractive acquisition targets. The CFIUS staff may express a desire for changes in the transaction to minimise risks to national security. In those instances, the parties sometimes feel aggrieved. However, most of the time parties look back on the CFIUS review as not having any practical effect on the transaction except for the effort and possible delay of the review itself.
FW: Given the rise in interest from potential foreign owners for US government contractors, what obstacles arise from regulatory clearances such as CFIUS and antitrust reviews?
King: At the outset, it is important to note that it is the policy of the US government to allow, even encourage, foreign investment in the US – consistent with national security interests. The government has long acknowledged that foreign investment can play an important role in maintaining the vitality of the US industrial base. That being said, CFIUS review is designed to ensure that foreign investment is consistent with national security interests. Foreign owners should not fear CFIUS review. Notwithstanding a few highly-publicised cases where transactions ran afoul of CFIUS, the CFIUS process generally involves an orderly, disciplined government review of relevant potential effects on national security – and the process most commonly results in CFIUS not taking a position adverse to the transaction. The CFIUS staff may express a desire for changes in the transaction to minimise risks to national security. In those instances, the parties sometimes feel aggrieved. However, most of the time parties look back on the CFIUS review as not having any practical effect on the transaction except for the effort and possible delay of the review itself.
Thompson: The principal challenge relates to restrictions on access of foreign nationals to information of national security. As a result, foreign investors often have to establish proxy boards and are restricted from access to national security information.
FW: Broadly speaking, what advice would you give to players in this market on how to conduct successful deals during 2012?
Thompson: Perform thorough market analysis and due diligence covering finance, operations and compliance. The industry poses special challenges in all areas. The nature of contracts can be complex, involving leading edge technologies and/or long periods, presenting special operational and financial challenges. For example, one of the operational challenges we see pertains to the supply chain. Combined commercial and military aircraft production is forecast to grow at 10 percent CAGR over the next five years. A PwC study suggests that 20 percent of the supply chain may be at high risk of not being able to respond to the demands. In addition, the unique regulations in the industry require special skills and attention.
King: History teaches that the realignments that occur in the US government market during periods of government austerity can give rise to new business combinations that are potent and profitable into the future. In this environment, potential buyers should focus on identifying value-added technologies and services that will be valued by the government as part of its future direction; key businesses supporting government programs where OCIs are leading to divestiture; and businesses selling services to the government where the margins may no longer fit in the higher-return portfolio of the owner. Buyers should feel confident that if the deal makes sense from a business perspective, the transaction generally can be accomplished. Government reviews generally will not impede a sound business deal – unless it involves foreign investment in an area deemed to be critical to national security. Foreign buyers also should be assured that the accommodations necessary to mitigate FOCI generally have proved to be workable and the return on such businesses almost always has proved to be well worth the limitations on foreign control and influence that are a part of such transactions.
Silverman: Those who are not experienced dealmakers in the federal sector need to make sure they know what they are buying. For example, will any of the target’s contractors – or options or task orders – be affected or potentially lost as a result of a change of control? This could occur as a result of change in size or other preferential status or just customer sensitivity to a change. If these acquirers don’t have in-house capabilities to analyse and evaluate special government contracts issues, then they should engage appropriate legal and other resources to assist them. Experienced federal sectors M&A players don’t need to be reminded or educated on the items noted above. However, anyone looking to expand their presence in the government contracting sector should be paying close attention to Congressional and executive branch priorities, both from a budgetary standpoint so they can try to best position themselves for the available dollars, and from a compliance standpoint to ensure they get to keep the dollars that flow from their federal business.
Craig King is a partner at Arent Fox LLP and head of the firm’s government contractor services group. Mr King provides legal advice and representation pertaining to all aspects of doing business with the US government and state governments. He has served as a director and/or outside general counsel for a number of government contractors in the security, aerospace, financial and securities services, missile, and electronics industries, representing many government contractors, large and small. Mr King can be contacted on +1 (202) 857 8938 or by email: email@example.com.
Jeremy C. Silverman is a partner at McKenna Long & Aldridge LLP and co-head of the firm’s Mergers & Acquisitions group. He has extensive M&A experience, especially in connection with the acquisition or sale of privately-held targets. Complementing MLA’s long-standing top-tier government contracts practice, he has particular skill leading transactions involving federal government contractors and advising clients in the federal sector on corporate matters. In addition, Mr Silverman frequently assists clients in the health care industry with M&A and other strategic transactions. He can be contacted on +1 (404) 527 4901 or by email: firstname.lastname@example.org.
Scott Thompson is the US Aerospace and Defense practice and Assurance leader at PwC. He leads a cross-functional team of professionals dedicated to the A&D sector in disciplines of audit, tax and advisory and has responsibility for assurance quality and service to A&D clients. Mr Thompson’s A&D experience covers financial reporting and disclosure requirements, internal control and implementation of SOX 404, coordination of large multinational audit engagements, business combinations and merger integration, corporate governance and employee benefits including pensions and OPEBs. He can be contacted on +1 (860) 240 2153 or by email: email@example.com.
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