Recent mergers and acquisitions activity among government contractors has been frothy, especially in the government services sector. What has been driving all the activity? Elevated stock prices and readily available credit has certainly accounted for some of it, at least until the recent decline of capital markets at the end of 2015 and thus far in 2016. However, even with the capital markets decline, there are macro trends specific to government services that at least partially counteract the decline of the broader market and cause many in the sector to remain relatively bullish on continued M&A activity.
The most important of these macro trends are contract vehicle consolidation and a shift toward low price-technically acceptable (LPTA) awards. During President Obama’s term, in the name of budgetary concerns, the administration has worked with agencies to reduce the number of federal contracts by consolidating contracts into fewer and larger vehicles. Mid-sized government services players need to grow larger to be able to continue to compete for these larger vehicles. They often seek growth by acquiring other contractors with sought-after, differentiated capabilities and deep customer relationships. Buyers are choosy when it comes to acquisitions, and contract consolidation has made it more difficult to accurately analyze whether a target’s contracts will be eliminated altogether or consolidated into a larger vehicle. This makes valuations a challenge, which helps explain why we see a fair number of earn-outs based on renewals of specific contracts. However, companies with coveted prime positions on full and open contract awards with a good backlog can find themselves highly desired targets.
Also, the shift during this administration towards LPTA awards is another macro driver, especially at the lower end of the market. For certain services, the government has announced a policy of getting the services at the lowest price possible as long as they are technically acceptable. By the government discounting the value of higher end services, contractor margins have been squeezed. Therefore, contractors continue to need to pursue economies of scale and spread overhead across more employees in order to maintain or grow margins.
Whether or not M&A activity will maintain its recent pace remains to be seen. But it seems safe to say that companies with coveted full and open contracts that provide differentiated capabilities and/or deep customer relationships will continue to command higher valuations.