By Robert N. Rubin, Partner, Stronghold Advisors
About two years ago I wrote, “Valuations for smaller companies (revenues under $50 million) in the government services sector, in general, have declined more than the levels experienced by publicly held companies. For companies with large amounts of restricted contracts or providing commodity type services the decline in valuations is even more pronounced.”
A lot has happened since that was written, including an economic downturn of unprecedented magnitude, yet M&A activity involving government services companies remains relatively robust.
Buyer demand for companies who possess the size to be an effective platform for further expansion, coveted contracting authority and/or unique expertise remains very strong and commands premium valuations. Companies uniquely positioned in intelligence, homeland security, cyber security, and other mission critical areas within the Department of Defense continue to attract strong interest from buyers and premium valuations.
While these same characteristics are true for M&A activity involving small and mid-sized companies, overall the number of transactions and valuations have declined.
More than ever, buyers are exhibiting a laser-like focus on specific acquisition criteria and appear more reluctant to pursue opportunities not closely aligned with these characteristics.
As predicted by many (including this writer), changes in Small Business Set Aside Regulations effective at the end of 2007 which potentially impact an acquirer’s ability to continue operating under a contract have become a major factor in the sluggish pace of transactions for smaller companies. This has made larger tier I and II companies reluctant to pursue transactions where a significant amount of restricted contracts are present. The result has been the elimination of a very active and qualified group of buyers from the pool of acquirers for these companies.
Instead, small strategic buyers have become aggressive acquirers of companies with restricted contracts. This is viewed as a way to accumulate the critical mass necessary to compete and win larger and prime contracting opportunities while enhancing their long term value. Private equity firms have also become active acquirers of government services companies, particularly in the intelligence and homeland security arenas, and are more likely to consider a target with restricted contracts. Also, more foreign buyers are entering the market through acquisitions, although these tend to be larger transactions involving larger companies.
Transactions are increasingly including larger components of owner financing in the form of subordinated debt and/or earn out, particularly when major contracts have restrictions. While bank financing is in greater supply, it is still not back to where it was before the economic downturn which has increased the need for higher levels of seller financing.
Long-term industry fundamentals point to continued consolidation in government services. For owners of small and mid-sized companies, particularly those with a large amount of restricted contracts, realizing shareholder value is all about fundamentals. A combination of a diverse contract and customer base, providing mission critical work which addresses issues of national importance and a highly skilled workforce with security clearances are currently the most sought-after elements by buyers.