The federal market is a prime example of an industry where companies have turned to inorganic strategies to drive growth. This is especially true in the lower middle-market contracting community ($50.0 million – $1.0 billion in revenue) where the need to scale to compete in an evolving industry has become more prevalent. KEYW’s recently announced acquisition of Ares Management, L.P. Portfolio Company, Sotera Defense Solutions (Sotera) serves as an excellent case study for owner-operators who are striving to build value in their business.
The publicly disclosed total cash purchase price of $235 million (~9.8x 2017E adjusted EBITDA, net of expected present value of tax benefits*) represents an attractive valuation driven primarily by a number of value drivers inherent in the business combination, which include:
- Customer Access to Intelligence Community (IC) Agencies: The acquisition of Sotera adds high-priority, new customer agencies to KEYW’s existing IC portfolio (~$176 million in 2017 revenue), including highly sought-after FBI and DHS customers, and creates additional avenues for growth in the DoD market (e.g., Army Intelligence).
- New and Complementary Capabilities: KEYW’s acquisition of Sotera augments the strengths of each company to create a leading pure-play products and solutions provider, adding new and complementary capabilities in agile software and solution development, cyber security, data analytics, machine learning, and big data. This well-rounded capability will expand KEYW’s reach across the value chain and unlock cross-selling opportunities with existing customers that would have otherwise contracted with the competition for the same product and/or service.
- Access to a Large Portfolio of Prime Contracts and IDIQ Vehicles: KEYW will gain immediate access to past performance qualifications, customer relationships, and revenue streams of more than 12 prime IDIQ and GWAC contract vehicles. Moreover, the combined company will offer a complete set of enhanced capabilities to new and existing customers utilizing a more powerful and robust business development function.
- A Unique, IC-focused Provider of Significant Sale: The transaction will create a pure-play IC-focused services provider with an estimated $535 million of pro forma 2017 revenue and $62 million in adjusted EBITDA (~10.0+% adjusted EBITDA margins). The combined company will have over 2,000 skilled employees with ~80.0% maintaining Top Secret clearances and above. The combined scale of both companies will provide a more competitive cost model to drive additional growth.
- Cost Synergies: A transaction of this size typically generates significant cost synergies associated with the removal of duplicative indirect functions. This transaction is expected to yield approximately $3.5 million of cost synergies within the fiscal year 2017 and a total of $7 to $10 million in expected synergies over the long term.
- Enhanced Cash Flow Metrics/Realizable Tax Attributes: The combined company is projected to generate roughly $43 million in pro forma 2017 operating cash flow. Expected net present value tax attributes of $46 million will increase net cash flow through a reduction of cash tax expense.
M&A comes with a number of challenges for companies of all sizes. Therefore, it is important for both buyers and sellers to develop a thorough strategy prior to embarking on an M&A event to mitigate uncertainties that emerge during a deal process. Companies should perform financial (e.g. pro forma P&L forecasting, balance sheet management) and organizational (e.g., operations, systems, employees) due diligence to assess potential challenges relating to:
- Cultural fit (e.g., employee retention);
- Financial wherewithal (e.g., transaction financing);
- Contract mix (e.g. small business set-aside/F&O, prime/sub);
- Revenue synergies (e.g. realizing identifiable synergies pre- and post-closing); and,
- Effective integration (e.g. operations, systems, employees).
Implementing a clear and well-defined roadmap and assigning accountability for tracking and executing on your M&A strategy will increase the likelihood of a successful transaction in the future.
For questions and more information, please contact Michael D. Potolicchio at firstname.lastname@example.org.
*Ignoring the tax attributes, the 2017E EV/EBITDA multiple is ~12.2x
This past Wednesday, February 15, ACG National Capital sponsored a roundtable discussion entitled, “Inorganic Growth Strategies to Drive Increases in Enterprise Value.”
This roundtable was a peer discussion for C-level executives to share insights on inorganic growth strategies, and was facilitated by the following participants:
- Mike Beach, CFO WeddingWire, Inc.
- Larry Davis, Managing Director, Aronson Capital Partners
- Dan Ilisevich, Chief Financial & Administrative Officer, Compusearch Software Systems, Inc.
- Tim Meyers, Managing Director, Baker Tilly Virchow Krause, LLP
- Jonathan Wallace, Managing Director, Outcome Capital
During the discussion, these individuals discussed common reasons and strategies for pursuing acquisitions to increase the value of a firm, such as: entering new vertical or geographic markets, expanding service offerings, acquiring new contract vehicles, rolling-up competitors to gain economies of scale and valuation arbitrage. They also shared the pitfalls to avoid when pursuing inorganic growth initiatives.
Here are some of my key takeaways from this discussion:
Identifying revenue synergies:
- If you have a strong technology platform, it’s easy to expand, including internationally.
- Be honest with yourself as an acquirer about the motivations of the seller, and identify revenue generators in advance.
- When buying a company, think about how to meld the cultures.
- Do no harm because people can and will vote with their feet.
- Integration early is important in order to capture the synergy.
- Melding cultures becomes more difficult as time passes.
- Service M&As are harder than technology M&As because you’ll need to keep most of the team if it’s a service company.
- Doing the deal is important. But, it’s the integration that’s really important.
- It gets more difficult to navigate change down the road after the acquisition.
The role of the CFO and CEO in an acquisition:
- CFO builds model to convince board that going through integration challenges is worth it.
- CEOs can generate some great deals and some terrible deals.
Integrating disparate organizations:
- With international M&As, integration is tricky.
- For domestic M&As, starting up joint projects early on is key.
Handling M&A inquiries:
- If you receive calls about acquisitions, do your due diligence and research the company who is calling you.
- Ask a lot of questions before revealing proprietary information (e.g., are you doing an analysis of the market, and if so, can I get that report).
Is it a good time to buy or sell? Factors to consider include:
- Hiring freezes
- Contracting standards
- Is the program in the crosshairs of political change
- Also, watch where the companies who have access to the new administration are putting their money.
- Watch stock valuations and the bigger funds.
How do you finance a deal? Factors to consider include:
- Debt (many types of debt out there)
- Equity (last resort)
- Be creative.
- If there’s a way to have financing lined up ahead of time, this is more attractive to the seller.
Risks to consider:
- Management Team (need a champion for buying the company, preferably one level below the CEO)
- The company must perform during the sale. If not, value of the company will go down.
- When companies are close in size, acquisition can be risky.
Assemble your A-TEAM:
- Board (use your Board as “Dr. No”)
- Internal Champion
- Management Team
- Due Diligence Team – A big risk area is in customer and market due diligence.
- Experienced management teams are usually better with scaling as a result of acquisition.
- If adding bulk is the only reason you’re buying, might not be a great idea.
- But, sometimes this is done in government contractor and software companies.
- $100 Million is a good number to go public.
- Communication is critical when buying a competitor.
- Acquisition is not a strategy. It’s a tactic driven by the vision for growth
M&A activity and public company valuations across the Defense and Government Services industry have rebounded from 2013 lows. Trump-related spending tailwinds in the DOD and IC sectors, in particular, should drive similar if not increased buyer interest in the sector in 2017 and 2018 once a more definitive spending plan is established. In many cases, however, the prevalence of small business set aside or other preferential contract awards for a government contractor negatively impacts their valuation or even eliminates the available buyer universe in a sell side process. This is especially true for companies that operate in historically small business friendly markets (e.g., Department of Education, Department of Energy) or lack differentiated capabilities and provide more commoditized service offerings with minimal barriers to entry. These firms typically have two options: (i) invest in business development resources, make strategic hires and attempt to transition the businesses into a full and open competitor over a 3 – 5 year time horizon, or (ii) evaluate alternative liquidity options, including a leveraged ESOP transaction.
Leveraged ESOP Overview
A leveraged ESOP enables the existing shareholders to sell all or a portion of their ownership to a trust and receive partial liquidity. The available cash at closing is driven by the amount of senior debt the Company can borrow to finance the ESOP. Certain tax attributes of ESOPs, as outlined below, can enable the Company to borrow more at closing from a senior lender than under normal circumstances. In a 100% ESOP transaction, the selling shareholders typically hold interest-bearing seller notes for the difference between the total Enterprise Value of the Company and the amount of senior debt available at closing. The Company acts as a plan sponsor, repays the senior debt and shares are allocated to employee accounts each year. Over time, as the senior debt is repaid (typically over 3 – 5 years), the Company can then repay the seller notes, often by refinancing the senior debt. After the ESOP transaction, the Company will retain its small business status (if it still applies in the relevant NAICS code) and will have the opportunity to pursue set aside awards in the future.
An example of the closing consideration for the shareholders of a $5M EBITDA company in a 100% leveraged ESOP scenario is summarized below:
Pros & Cons of a Leveraged ESOP
A carefully designed and executed leveraged ESOP provides partial liquidity for selling shareholders while increasing the ownership participation of management and employees. In a highly competitive government services recruiting environment, the opportunity to entice new hires with an ESOP retirement plan can often times be a distinguishing factor. There are extensive tax savings opportunities with ESOPs that are more thoroughly described below. The ESOP also allows for preserved operational autonomy, a greater certainty to close, and the opportunity to continue to bid on small business set aside procurements. The challenges with an ESOP transaction include partial liquidity at closing, a leveraged balance sheet, and the incremental costs and compliance requirements associated with an ERISA plan.
Tax Savings Opportunities
There are three primary tax attributes associated with ESOPs. The availability of these attributes depends on the entity’s tax status as summarized below.
- Shareholders of C Corporations that sell at least 30% of their equity to an ESOP have the opportunity to defer capital gains taxes if they invest in qualified replacement property (“QRP”) 3 months prior to or 12 months after a transaction.
- Corporations that have elected “S Corporation” status are flow through entities and there are no corporate level income taxes. All income and related tax liabilities reside at the shareholder level. Since an ESOP trust is a tax-exempt entity, there is no tax liability for the ESOP’s pro rata share of the income. Therefore, 100% S Corporation ESOP companies do not have any income tax liability, and can therefore typically service the debt borrowed in connection with the transaction in a more rapid manner.
- Contributions to ESOPs are tax deductible for the Company making the contribution, up to certain limitation. This tax shield is particularly beneficial to C Corporation ESOPs and S Corporations partially owned by the ESOP trust.
An ESOP may be a good alternative if an outright sale is not achievable for a government contractor with a heavy reliance on preferential contract awards without a transition strategy to F&O status. Businesses with steady cash flows, strong management teams, large contract backlog and healthy borrowing capacities are ideal candidates, as outside financing is usually required to facilitate a shareholder liquidity event. Certain tax attributes of an ESOP-owned company can expedite the debt repayment and accelerate a selling shareholders full liquidity. The Company should have a sizable workforce and utilize direct labor (as opposed to subcontractors or 1099s) for a meaningful piece of the overall level of effort. Lastly, the opportunity for employees to be shareholders in their company can create a competitive edge in the highly competitive recruiting environment in the government services marketplace.
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 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.