2016 Recap: Focus on Higher Margin Business Segments
- Tuesday, 07 February 2017 21:12
- Michael Potolicchio
A total of 92 M&A transactions were announced in the defense technology and government services market in 2016, which was slightly below the 107 transactions completed in 2015, but in-line with 2013 and 2014 levels. M&A in 2016 witnessed a “normalization effect” after the flurry of activity that occurred in 2015. Contractors have started to notice the effects the 2013 and 2015 Bipartisan Budget Acts’ sequester relief has had on the overall procurement environment. This relief has allowed the Department of Defense to significantly reduce the amount of anticipated cuts in technology operations and maintenance, translating into strong performance across the defense technology and government services market. As a result, there was active participation across the entire buyer landscape in 2016, driven primarily by (i) private equity sponsors acquiring scalable platform targets and/or “doubling down” with add-on acquisitions that provide complementary capabilities to their existing platform companies, (ii) larger Tier-1 and Mid-Tier’s divesting noncore, low margin assets and focusing more on higher margin business segments aligned with the mission, and (iii) Non-Traditional buyers focusing on targets in high priority end markets in order to strengthen their capabilities, expand market share and add new customers.
The strengthening of the budgetary environment and positive sentiment in the government services public equity markets has enabled private equity firms to remain active in the space. Private equity buyers led 33% of the transactions, including new market participants Chart Capital (acquisition of Fed Data Systems), and Platinum Equity (acquisition of PAE from Lindsay Goldberg). Meanwhile, seasoned investors in the sector, DC Capital and Arlington Capital, both secured new government services platforms earlier in 2016 with the acquisitions of QRC Technologies and EOIR Technologies, respectively. Existing private equity backed platforms drove 21% of the private equity activity, as Arlington Capital continued its buying spree by acquiring ISS and PROTEUS Technologies and merging it with EOIR Technologies to form Polaris Alpha. In addition, Belcan, LLC (acquisition of Intercom Consulting and Federal Systems Corp), Preferred System Solutions (acquisition of Synaptic Solutions, Inc. and Tetra Concepts), Sirius Computer Solutions (acquisition of Force 3, Inc.) and Altamira Technologies Corporation (acquisitions of APG Technologies and Prime Solutions) all strengthened their portfolios with bolt on acquisitions. Lastly, private equity firms continue to utilize the favorable budget environment to exit their existing investments. Examples include the sale of Aquilent (backed by Warwick Capital since 2002) to Booz Allen Hamilton, Camber Corporation (backed by New Mountain Capital since 2008) to Huntington Ingalls Industries, Vistronix (backed by Enlightenment Capital since 2013) to ASRC Federal and PAE (backed by Lindsay Goldberg since 2011) to Platinum Equity.
Mid-Tier and Tier-1 contractors continued to reshape the federal government contracting industry with notable M&A deals in 2016. Leidos’ $5.0 billion acquisition of Lockheed Martin IS&GS earlier in 2016 has catapulted the SAIC mission focused spin-out into the largest mid-tier publicly traded Government Services focused contractor ($10.7 billion in enterprise value as of December 31st, 2016) and allowed them to effectively compete for even larger contracts sought after by Tier-1 defense contractors. In addition, ManTech Corporation acquired the Cyber Network Operations Practice of Oceans Edge in June 2016, to expand upon its vulnerability research, development and analysis capabilities and Edaptive Systems, LLC in December 2016 to strengthen its federal healthcare presence. Booz Allen Hamilton acquired digital and cloud services provider Aquilent for $250 million to strengthen its capabilities and enhance its presence within HHS. Finally, Tier-1 contractors, Boeing and L-3 have made the strategic decision to focus on their autonomous systems and collaborative robotic capabilities with the acquisitions of Liquid Robotics and MacDonald Humfrey, respectively. In addition, L-3 officially changed its name from L-3 Communications to L-3 Technologies in order to capitalize on its strong brand equity, while better reflecting the Company’s evolution into a leading global provider of technology solutions.
As shown in the table, the 2016 buyer mix continued similar trends when compared to 2015, with public strategic buyers representing the largest buyer group (35.0% of all M&A activity). However, this year it was mainly driven by non-traditional buyers making transformative acquisitions to strengthen capabilities in areas of funding priority, gain customer access, and expand their contract portfolios. These buyers in 2016 included KBR (Wyle and Honeywell Technology Solutions, Inc.) Huntington Ingalls Industries (Camber Corporation), Magellan Health, Inc. (Armed Forces Services Corp.) DLH Holdings Corp (Danya International, Inc.) Jacobs Engineering Group, Inc. (The Van Dyke Technology Group) and Ball Aerospace and Technologies (Wavefront Technologies). The non-traditional buyer activity over the past twelve months bodes well for the industry as it signals renewed confidence in the overall growth prospects of the federal market.
2017 Outlook: The Trump Effect
- Tuesday, 07 February 2017 20:52
- Michael Potolicchio
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.