Defense Spending Slowdown Might Slow M&A Activity and Supress Values

I recently returned from a meeting on the west coast attended by CEO’s, corporate development officers, and industry advisors to the defense and aerospace industry. The managing director of a large international investment bank best summed up the sentiment of the participants when he said, “I wish I were here to say we are entering a big M&A cycle. Rather, we think we are entering a period that will be filled with soul searching and analysis.”

Faced with anticipated cutbacks in federal government defense spending, industry leaders seem to share the same concern, that the robust pace of merger and acquisition activity seen over the past two years may slow. If a slowdown occurs many question whether valuations will be suppressed and if ultimately the availability of growth capital will be restricted.

While the prospect of federal defense spending cutbacks will adversely affect parts of the industry, many remain optimistic about growth and believe M&A activity will persist. This optimism is fueled by the governments’ developing focus on homeland security, shifting in the DOD’s priorities expected as a result of the Quadrennial Defense Review, and further government outsourcing expected as 30% of the federal workforce become eligible for retirement in 2006.

The PEG solution to fund growth

Given the shifts in the industry it is anticipated that defense and aerospace companies will require additional capital to fund their growth. Private Equity Groups (PEGs) are a source of equity capital that is currently readily available to growth-stage companies. PEGs have invested in the defense & aerospace sector for some time, having applied their clairvoyant ability refined in other sectors to buy at lower prices and sell or take the company public at higher ones. Even with the anticipated cutbacks in federal spending, there appears to be no sign of letup in PEG interest in the sector.

Serial entrepreneurs common in federal contracting and an industry with a history of successful IPOs are two factors that will continue to “fuel” sector interest by PEGs. Serial entrepreneurs who have sold their companies turn to PEG funding to leverage their own funds when they look to ride high again in another platform. Additionally, several PEG funds have started as a result of founders who sold their firms and want to reinvest in an industry where they enjoyed success.

PEGs need a receptive public offering market as one option to monetize their investment in portfolio companies. The IPO market for government contractors stood tall in 2002, with several PEG-backed firms going public. Even though the general IPO market has softened since that time, PEG confidence in the sector still seems strong, and investment has continued apace with other investments in this sector.

Another factor in the capital markets that look to influence M & A activity in the defense industry is the creation of  Special Purpose Acquisition Corporations (SPAC), such as Fortress America. Armed with over $40 million from the IPO, the company is now searching for its lead acquisition with an operation in the homeland security market. With only 18 months to spend 80% of funds raised the industry will watch its effect on the M&A marketplace.

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David Jasmund

Investment Banking
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