2017 M&A Outlook
As we enter Fiscal Year 2017, expect to see similar trends emerge with public strategic buyers (Tier-1, Mid-Tier, Non-traditional) continuing to focus on their core capabilities, expanding their market share and/or adding new customers. We expect private equity to continue to invest capital in the federal sector after two years of strong participation, fueled primarily by better visibility in the budget and continued emphasis of future federal funding priorities brought on by the new Trump Administration. President Trump’s initiatives to strengthen cybersecurity and increase infrastructure investment and defense spending could fuel more acquisitions and add new acquisitive participants into the mix. In addition, Trump’s desire to repeal the sequester spending caps that come back into effect for GFY 2018 – 2021 could add up to an addition $107 billion to the overall budget. If Senator McCain’s recently published, “Restoring American Power” recommendation gains traction, expect a more significant uptick in M&A. His report calls for an increase in defense spending to $700 billion (including OCO) and future growth of 4.0%.
Trump Administration’s Effect on Government Contractors
There has been significant headline attention in 2016 as it relates to President Donald Trump’s pledge to fully eliminate the defense sequester and submit a new budget to rebuild the U.S. military, strengthen national security and improve critical infrastructure. President Trump believes it starts with a better defense strategy focused on the U.S. military. More specifically, by modernizing the joint force and regaining capacity of the armed forces that has been “depleted” as a result of budget constraints and force drawdowns. In addition, Trump is focused on making cybersecurity a major priority for the public and private sector. It begins with efficiently prioritizing funding and investing sufficiently in cyber weapon systems that are necessary to conduct military operations and the development of critical training and the necessary tools to equip an expanding 6,200+ person cyber force. Finally, despite Trump’s view on increasing spend on critical infrastructure receiving mixed reviews, successful execution could lead to thousands of additional jobs and strengthen overall employment numbers.
In addition, Senator John McCain released a 28-page white paper echoing President Trump’s priorities, recommending a $700 billion base defense budget in fiscal year 2018, which would represent a $54 billion increase over the budget proposal put forth by President Barack Obama. If adopted, the result will not be cheap, or easy: a complete repeal of the Budget Control Act, a $700 billion base defense budget in fiscal year 2018 and an overhaul of the U.S. military ($430 billion above current defense plans over the next five years).
Trump Administration’s initiatives are summarized in the below table:
The Trump Administration’s budget reform plan will surely alter how agencies are organized and measured, as well as how budgets are prioritized. Over the past several years, the federal government has become accustomed to a structured procurement methodology (e.g. LPTA). However, with new priorities potentially reshaping the future of the federal contracting market, Trump plans to bring private sector “best practices” to bear on federal management, including practices designed to hold contractors to higher performance standards. This could mean a stronger emphasis on combating fraud, waste and abuse by implementing performance based contracting, where under-performing, redundant or disfavored programs could be closed or replaced with new programs aligned with administration priorities. Plans to strengthen contractor performance management could result in eliminating automatic renewal of option periods, withholding payments for poor performance and/or using performance based contracting. In addition, there may be a reemergence of more commercial-like buying practices and a greater use of GSA schedules or other efficient contract vehicles (e.g. T&M, FFP) to facilitate the procurement of goods and services. Trump’s budget reform also calls for a hiring freeze of civilian “non-essential” federal personnel. To put this into perspective, in 2013 roughly 900K employees, or 43.0% of the federal workforce was subject to furloughs. A decision to go through with this action would result in a potential 100K reduction annually in the federal workforce, ultimately driving agencies to increase the use of government contractors to perform work.
With all of this potential change brought on by Trump’s Administration comes uncertainty for government contractors, especially those furthest away from the mission (e.g. acquisition support, SETA). However, management teams with heavy concentration in these areas can utilize their free cash flow from current contracts and invest in mission-enabling capabilities more insulated from budgetary pressures, ultimately positioning them for future sustained growth.