Investors were not kind to publicly traded government services companies in Q3 2010. In fact, you could say these companies took a beating from their investors. The federal services space took the brunt of it, with pricing down 19%, while defense prime contractors declined 5%. Even worse, valuation multiples are at the lowest levels in the past decade.

While this sounds like a lot of ‘glass half empty’ perspective, it isn’t all bad news. Recently ACG National Capital member Jean Stack of Houlihan Lokey wrote an article in Washington Technology regarding mergers and acquisitions in the government services sector. She, like so many others, predicted the M&A pace will remain strong into 2011 even though the industry has experienced downward momentum in pricing. Why? Companies and investors are cautious about organic growth prospects and are looking at M&A opportunities in order to support growth.

Between the Obama Administration increasing federal insourcing, the Department of Defense scaling back its spending, and the winding down of military efforts in Iraq, an increase in M&A activity among government contractors seems imminent. Especially since 2010 is already shaping up to be one of the strongest years for industry consolidation. This will definitely continue well into 2011 as more public companies are targeted for acquisitions by larger prime contractors and private equity sponsors are emboldened by relatively inexpensive public pricing.

However, for these deals to truly support long-term growth, companies must reconsider the “buying for size” mentality and focus on acquiring new capabilities, contract vehicles, and customer relationships in areas that are perceived budgetary priorities.

The current economic outlook for defense contractors may not be all positive, but the market is primed for aggressive M&A activity and consolidation. For small and medium-sized companies with competencies in growth markets like cybersecurity, this negative turn can end up having very positive consequences.

Despite the market cooling off, there’s a hot front of M&A activity on the horizon. What do you think the market will look like when things cool back down?