To truly understand the gears that consummate a successful transaction, one has to start at the beginning — with the buyer.
“The Right Time…The Right Price”
In 2010, CGI was one of the biggest buyers on the government-contracting circuit. The Montreal-based business group made its mark on the industry, acquiring Stanley Associates for $1 billion, which boosted its federal practice.
“CGI’s strategy plan calls for a combination of organic growth and acquisitions to continue to profitably grow the company; so it is not an ‘either/or’ for us,” he said. ”As a company, we are always looking for strong, profitable companies in our target markets and geographies to acquire. For us, we look for the right company, at the right time, at the right price.”
In today’s merger-and-acquisition climate, opting for growth via transaction might be an easier proposition than internal development.
Jack Hughes, a leading government-contracting finance veteran with more than three decades’ experience, and a current “buy-side” M&A consultant for Altus Associates, points to several trends in the market making growth through acquisition a better option.
“[Factors including] in-sourcing of jobs by [the federal government], significant budget cuts, more stringent regulations and higher levels of government audit activity” are all making the proposition of organic growth for federal contractors difficult, he said.
Hughes said his firm anticipates the uptick in buy-side activity to continue for the foreseeable future.
Once the buyer has committed to growth through acquisition, it’s time to consider the target firm up for sale.
Tim Dowd, former CEO of INPUT, points to a variety of factors that can lead a perfectly healthy and successful firm to be put on the market. Dowd would know – in 2010, he oversaw his firm’s successful sale to Deltek for $60 million in cash.
The reasons to sell can range from owners looking to monetize a firm’s value, to investors seeking to reap target returns for an investment fund.
Market timing is also an important factor, Dowd added.
“A hot industry with strong growth prospects and an enterprise operating well with a clear plan can be a valuable asset,” he said. “For instance, the combination of INPUT’s business model, double-digit growth and record profits during the downturn of 2008 and 2009 made it an even more attractive asset.”
And, sometimes, an ownership group can simply realize it has taken the firm as far as they are willing or able to take it. At this point, the valuation factor plays a strong role — that is, what will the firm’s price tag read?
“These days valuation is being driven by a handful of critical factors,” he said. “What markets are the target [company] in, and what are the characteristics of those markets. Are they growth markets or are they declining?”
While Chao notes that premium valuations are being put on larger companies compared to small businesses, he also points to the issue of “critical mass.” In other words: Is the target large enough to be a viable stand-alone business, and can it support the necessary infrastructure required of a government contractor?
“There is also a look at contract vehicles and which customers sets can be addressed via those contract vehicles,” Chao said. “There should be an analysis of how much sub-contracting work versus prime contract work, and how much of the work is fixed-price versus cost plus.”
Once firms on the market have been valued, the M&A picture is still imprecise. There are many buyers and sellers on the market at one time — and only a few perfect fits.
For Schindler and CGI, there are a number of factors to ponder when looking for a growth opportunity. Beyond considerations such as target markets and geography, matching people is key.
“While intellectual property assets are important, the cultural fit between the potential acquisition and CGI is very critical to us — because ultimately, it will come down to the people — our people and their people working side by side to support our customers’ missions,” he said. “That fit has to be right for us.”
After a potential acquisition partnership has been identified, investment bankers enter the equation. As Bob Kipps of investment banking powerhouse KippsDeSanto puts it: “Investment bankers do whatever is necessary short of drafting the definitive documentation to complete the transaction between two parties.”
He notes that depending on the circumstances, including which side of the deal they are supporting, bankers will typically advise their clients as to what strategic and financial options exist within the markets to reach their goals—whether it is a financial exit for the seller, acquiring strategic penetration into a new market or other forms of growth.
While attention will inevitably focus on the closing of the deal itself, bankers provide advice and support long before the deal is finally executed.
“Middle-market banking in particular is like a good game of chess — really the combination of strategic consulting and deal execution — with every move, communication or discussion being deliberate and a means to achieving success,” Kipps said.
Specifically, he pointed out that the advice of investment bankers can include everything from understanding the positive and negative attributes of a firm’s business and helping owners to prepare their business for a transaction to determining the correct time to pursue a transaction and the proper approach to the market.
Without that strategic plan in place, a potential deal could be doomed to fail. Kipps said once the overall strategic approach has been determined, bankers create the market for the company by reaching the appropriate parties, coordinating the dissemination of materials and managing the deal schedule and associated meetings to allow their clients to understand their options and make informed decisions.
Bankers negotiate the business terms of the transaction, including the price and deal structure, as well as the other business and risk mitigation terms customary for transactions.
A Question of Compliance
But, once the money discussion is underway, attention turns to a complexity faced by all government contractors: compliance.
“Government compliance in government-contractor M&A transactions is handled through a combination of up front legal due diligence, comprehensive contractual representations and warranties and indemnity provisions,” said Craig Chason, co-leader of the Corporate & Securities — Technology practice for law firm Pillsbury Winthrop Shaw Pittman.
Navigating the regulatory landscape is a tough task with always-shifting rules on the books for government contractors making legal due diligence
“Last year’s hot topic was Organizational Conflicts of Interests,” he said. “You saw, and continue to see, a lot of spinoffs, where larger government contractors are spinning off subsidiaries that have OCI issues. It is important to spot and fully evaluate these OCI issues during diligence.”
There are various differences, from a legal perspective, when discussing transactions between private firms and publicly traded ones — or some combination of both.
“A major difference between the two is that following a public company acquisition, there is no seller or continuing entity that an acquirer can seek indemnification against for breaches of representations and warranties,” Chason said.
Another notable difference is that a deal is subject to shareholder approval postsigning, whereas private firms are “locked in” until close.
“This is an important difference as it leads to the use of ‘fiduciary outs’ and ‘break-up fees’ in public transactions tied to the fiduciary duties of the boards of directors to evaluate higher offers post-signing,” Chason said.
Coming Together and Letting Go
Once the financial and legal experts have put the complex language to bed and the news releases are issued, there are still steps to ensure a successful merger or acquisition. For the firms involved in a transaction, the task of integrating two businesses comes to the front.
In the case of CGI, this is where the careful consideration of company culture pays off.
“Ultimately, it will come down to the people — our people and their people working side by side to support our customers’ missions,” CGI’s Schindler said. “Looking closely at cultural fit during the due diligence phase then puts us many steps ahead as we begin transition planning and move into integration.”
He pointed to meetings, email, portal and social media as a way “to get as much information in the hands of as many people as quickly as possible.”
“The more information people have about what is happening, the more your employees can focus on doing their jobs and supporting their clients,” Schindler said. “You just cannot overcommunicate during integration.”
For the seller, much like the parent sending a child off to college, it’s time to step back and let go.
“The hardest part for the seller is the realization that they really don’t have a lot of influence on the decisions at the end of the day,” Dowd said. “If the seller completely cashes out, then interest in the integration may be more emotional than impactful. Basically, if the seller is a founder, then how will their ‘baby’ be taken care of,” and the company’s brand be represented moving forward.
Retaining the Talent
Successfully integrating two companies goes far beyond merging two sets of corporate cultures. There is also the important consideration of benefits and compensation, an area of great personal concern for those employees involved.
Compensation expert Susan Marcille, a partner at Ernst & Young, said this area has the greatest impact on the individual employees involved.
“In order to retain key talent, there may be significant replacement costs to compensate such employees for the value of nonvested accrued benefits,” she said.
These include items such as pensions, nonqualified plans, stock options and share schemes and the like.
Marcille pointed to a handful of areas the acquiring firm must focus on, including the ability to replicate or replace benefits, design successor or replacement retirement and executive compensation plans, and establish new vendor contracts/trusts/insurance contracts.
The firm must also transfer knowledge of the new designs and vendors to human resources, as well as communicate this information to all employees while managing interdependencies and creating legal entities and regulatory filings.
Marcille said these issues can be easily overlooked by the acquiring firm – a flaw that could cost it the talent that drew it to the transaction in the first place.
“We continue to see organizations underestimate the importance of the ‘people’ aspects of a transaction,” she said. “Resistance to change can derail or delay realizing financial, operational and other transaction synergies. Early and sustained communication, identifying the right leadership team and implementing the right employee incentives are critical factors in maintaining the value of the organization.”
The Future of Government Contracting M&A
While the M&A pace has remained brisk for government contracting, it’s no secret the value of government-contracting firms — particularly those with high exposure to the supplemental budgets tied to the wars in Iraq and Afghanistan — is slipping.
But, the current atmosphere is far from the end of days, Chao is quick to note.
“If you’re on the acquiring side, and you’re buying a company that has a high exposure to the supplemental budget but you can buy it at a reasonable multiple, can get a good solid business that has a future, and has a future at a smaller size, then that can still be a win,” he said.
Firms with strong cyber and C4ISR portfolios are also in a good position in terms of valuation.
“The winners on the M&A landscape will be those companies that have formed a solid view of the future, developed a good view of their strategy that adapts to that future and can maintain a discipline in their acquisitions in terms of valuation,” Chao said. ♦