PErspective in Government Contracting - Summer 2016
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Prime contractors have come under increased pressure to spin off their non-core IT services divisions over the last few years. These businesses may be large and even profitable, but their margins are relatively slim. As such, they are especially vulnerable to government pricing pressures. Separating public sector and technology verticals into independent entities enables both businesses to compete better in the tight budgetary environment without having to tussle over internal resources.
In late 2014, defense contractor Exelis spun off its services unit into a new publicly traded company called Vectrus. Similarly, L-3 Communications spun off its software support, consulting and management services to create Engility in 2012, while Northrop Grumman sold its services unit TASC to private equity groups General Atlantic and Kohlberg Kravis Roberts for $1.7 billion in 2009.
Given this year’s stock market volatility and prolonged IPO drought, selling assets to financial or strategic buyers is currently more appealing than taking them public. The only cyber technology IPO this year to date was Dell’s SecureWorks division, which was spun off largely to help fill a $10 billion funding gap in Dell’s $67 billion acquisition of EMC. The firm’s lackluster debut did not help instill confidence in further tech services IPOs, Reuters reports.
In fact, several government services firms have explored IPOs over the last year, but ended up selling off in a private equity transaction instead, according to the Washington Business Journal. Alion Science & Technology and PAE both ditched IPO plans to be acquired by Veritas Capital (July 2015) and Platinum Equity (January 2016), respectively.
Low profit margins have also driven pure-play services players to seek scale and synergies through M&A, providing private equity firms with both investment and exit opportunities. Engility acquired TASC from its private equity owners for $1.1 billion in late 2014. Computer Sciences Corp (CSC) divested its government services division at the end of 2015, merging it with SRA International, to form a new public sector IT services provider, CSRA Inc. SRA’s private equity backer Providence Equity retains a minority share in the new firm, which became one of the largest providers of government IT services with a combined revenue of $5.5 billion, and 19,000 employees, according to the Washington Business Journal and Washington Technology.
As the divestiture and consolidation trends keep the M&A market active, the government technology services sector will provide interesting takeover targets as well as exit opportunities for private equity firms with an interest in the space.
The U.S. government’s pursuit of contracts on a LPTA basis has pushed margins down significantly in the post-financial crisis environment, driving divestitures of non-core businesses and consolidation between rivals in the government contracting space. With defense spending also down 20 percent from its 2010 peak, many government services firms have found they can no longer afford to position themselves as a one-stop shop.
With the government contracting space continuing to experience low revenue growth, the second half of 2016 will see sustained strong M&A activity. Many in the sector are looking to simultaneously create a competitive advantage and enhance value, leading them to more frequently turn to M&A to add scale, and to pursue tuck-in acquisitions to add portfolio-enhancing assets, according to forecasts published by Washington Technology.Additionally, government contractors are likely to continue to forego IPOs in favor of private equity deals, reports Washington Business Journal. Investors are expected to focus on niche subsectors with robust budgets and strong valuations, including cybersecurity, intelligence analysis, data analytics, special operations and healthcare IT, predict CNBC.com and Washington Technology. While deals will remain prevalent, the market isn’t likely to see any further mergers between big U.S.-based government contractors due to opposition from Pentagon acquisition chief Frank Kendall, who may put forth official legislation to prevent mergers of top defense firms later this year, notes Defense News. Furthermore, the presidential race presents the potential for a slowdown in government contracting M&A as we near Election Day, with investors grappling with uncertainty around candidates’ policies. However, Washington Technology anticipates that any slowdown would be minor and short-lived, as spending in many areas isn’t likely to be affected by a new president.
PErspective in Government Contracting is a feature examining the role of private equity in the government contracting industry.
Sources: CFO.com, CNBC.com, Defense News, Forbes, Reuters, TechCrunch, Wall Street Journal, Washington Business Journal, Washington Post, Washington Technology
Future PErspectives: Government Contracting in the Second Half