With a downturn in federal spending, are private equity investments at risk in this “safe” sector?
By Charles C. Reardon and Douglas M. Schmidt
Published in the “Journal of Corporate Renewal” of the Turnaround Management Association, November 2012.
Occasionally there is an industry cycle that lasts so long investors cannot see when they have crested the hill, or, even worse, they think the good times will never end. In the 1990s, during the creation of the Tech Bubble, private equity disdained companies that conducted business with the federal government. These government contractors (or, pejoratively labeled ”Beltway Bandits”) often had alphabet soup names such as GRC, ACS, BTG and CACI. For high flying tech investors, the worst aspects of the government market companies were their low margins and low growth—clearly tortoises in a decade made for hares. A few brave private equity firms (then called LBO Funds) like the young Carlyle Group and Caxton-Iseman saw some opportunities in this plodding industry. But for the most part, these early pioneers were left to play alone in the sector.
In 2000, when the rest of corporate America began slipping into recession, the tortoise caught the hare and a new era of investing in Government Information Technology (IT) and Defense/Aerospace companies began. The U.S. government spent massively on outsourcing in 2002 and 2003 to help blunt the recession of 2001. The September 11th attacks had also occurred, and soon we were fighting the War on Terror as well as the new battle for Cyber Security. From 2000 to 2011, total federal spending grew at a compound annual growth rate (“CAGR”) of 6.6%, outstripped only by Defense Department spending which grew at an astounding CAGR of 8.5%. Meanwhile, our nation’s GDP grew at a CAGR of only 3.9%, less than half the defense spending rate.
With little to no growth in many industry sectors in the past decade, private equity firms were attracted to the market of companies serving the U.S. government like bees to honey. Stifel Nicolaus Weisel tracks over 35 major private equity firms invested in the government sector. Pitchbook.com indicates there are over 150 private equity firms with buyout or growth/expansion investments in the aerospace/defense/government services industry. High profile deals include Carlyle/Booz Allen Hamilton, Providence Equity Partners/SRA International, Veritas Capital/Lockheed Martin’s Enterprise Integration Group, KKR and General Atlantic Partners/Northrop Grumman’s TASC, and Cerberus Capital Management/DynCorp International. There are scores more transactions in the middle market range and half a dozen investment themes. One theme involves taking large minority owned companies which formerly received preferential contract awards and growing them into large “full and open” companies. Another popular theme is a pure Cyber Security roll-up strategy. Another involves spinning out divisions from the largest aerospace companies.
In hindsight, one could look back almost 20 years and see a pattern of steady top-line growth in the government industry—one that was seemingly immune to the downside of the business cycle. In such an environment, have investors lost sight of the horizon and become overconfident and over-invested? For those firms which already own companies in the space, are the management teams of portfolio companies willing and able to address the realities of a declining market for their services?
2012 may become a year that government market investors come to rue. Warning lights are going off all over the sector. The budget impasse and Sequestration (the automatic reduction of the budget to begin January 2, 2013 if Congress cannot pass a budget bill) are not just a political threat; they represent a new economic paradigm. Cyber Security may be here to stay, but the wars are winding down, the federal deficit is at maximum capacity, and government spending stimulus to combat a lackluster economy has run its course. Under any scenario and under any President, there will likely be little choice but to rein in spending and, in particular, the most lucrative outsourcing departments like Defense and Homeland Security. For the first time in decades, real outsourcing spending is experiencing a decline, a trend which is likely to be sustained.
There are plenty of horses to feed, but the supply of oats is diminishing. The evidence is everywhere. Public company valuations have shrunk to levels unseen in the industry since the recession of 1990-1991. Public stalwarts such as General Dynamics and Raytheon are trading at less than a 10 times trailing price/earnings ratio while the S&P 500 trades at 16. The numbers of industry M&A transactions as reported each year by Washington Technology have dropped from 99 in 2010 to 82 in 2011. 2012 will likely contain an even more precipitous drop in numbers. Whole legions of investment bankers and law firms who have built practices around this industry are feeling the pinch. Seminars on M&A and financing that once packed the room are now lightly attended. The industry itself complains every day as competition for fewer contract awards drives pricing and profitability to discouraging levels.
In light of a potentially sustained downward trend in the government industry that is destroying significant shareholder value, we have to ask the unthinkable question. Can a company serving the government industry fail and go bankrupt?
This was unthinkable for the past two decades because of the seductive characteristics of investing in the government industry – steady growth in demand and pricing and the certainty of getting paid. New customers, contracts and increased scope were the norm. In addition, this industry has had virtually no write-downs or write-offs. You may have a problem getting a timely payment, but the government always honors its payables. Consequently, over time, a service industry with no hard assets became a powerful magnet for commercial lending. This was followed by venture bank/ mezzanine lending to private equity buyers, which were eager to boost their base equity returns with leverage. The cash flows were predictable and almost always growing. Receivables were platinum plated and formed the basis for stretch financing. With so many deep pocket private equity firms in the industry, what lender could turn away from pushing the limits and helping a brand name private equity fund push the envelope of the capital structure of a newly acquired portfolio company?
The evolution of Booz Allen Hamilton is a successful example of this leveraging strategy. In 2008, The Carlyle Group sponsored a classic management buyout (MBO) of the government consulting business of Booz Allen Hamilton for $2.54 billion. Carlyle levered the transaction using senior and mezzanine debt. By the time that Carlyle took the company public in 2010, debt was 72 percent of total capitalization and proceeds were used to pay down debt. Today, Booz Allen Hamilton, as a public company, maintains a debt to total capitalization percentage of over 80%, while the remainder of the publicly traded industry is closer to 25%. In the years since the MBO, The Carlyle Group has taken advantage of this leverage to provide itself with a healthy cash return for its sponsorship.
Is there an Achilles heel to the investment strategy that has flourished in the government industry for the past decade? A prudent investor might model low-growth or even no-growth when determining a leveraged buyout capital structure, but in the face of 20 years of increased government spending on outsourcing, how many of these investments have been modeled with negative growth? Shrinking revenues and shrinking cash flows in the face of constant balance sheet leverage can be a sure recipe for disaster.
But wait, you say, no government industry company has ever gone belly up. At worst, the poor performers simply shrink and fade away. Not true. In February of 2009, the mighty BearingPoint Inc., a public company spun out of KPMG, filed for bankruptcy protection after two years of struggling with losses on its services contracts, including ones with state & local as well as federal entities. Let’s examine what happened to BearingPoint and see how it may be a model for current government companies (including and especially private equity backed ones) that may start struggling with their debt load.
BearingPoint “demergered” from KPMG in 2000 and was an IPO in 2001. Fueled by its success in the U.S. governmental services market and by access to inexpensive debt and public equity capital, the newly public BearingPoint went on an acquisition spree around the world, buying what were viewed as bolt-on businesses to its main U.S. platform. However, expected synergies proved hard to achieve and financial performance of its units in the non-U.S. federal markets began to nosedive. Unable to downsize appropriately or otherwise shed unprofitable contracts, BearingPoint was forced in 2009 to file for Chapter 11 bankruptcy protection with a self-described “prearranged” restructuring plan. It soon proved difficult for BearingPoint to obtain all of the required support, both from the company’s formal bankruptcy constituents as well as many of its foreign “partners,” to confirm the proposed plan quickly. At the same time, customary concerns about the effects the bankruptcy was having on BearingPoint’s customer base (and particularly on its primary customer – the U.S. government) and employee retention decreased the company’s negotiating position in bankruptcy. Various constituents began pressing the company to consider other options, including a 363 sale of some or all of its business units.
BearingPoint had previously run a sale process that had failed to produce any acceptable offers. There was considerable concern that a 363 sale process would prove ineffective, particularly given the practical and legal issues surrounding the transfer of federal contracts. However, one party – Deloitte – emerged that was willing (and able) to move quickly and negotiate a stalking horse agreement to buy a significant portion of BearingPoint’s North American Public Services practice for a headline price of $350 million in cash. That agreement, which blended elements of a typical stalking horse asset purchase agreement and more traditional government services M&A agreements, allowed Deloitte time to continue evaluating contracts and maintain the required personnel to staff those contracts until the final closing. At the transaction’s conclusion, Deloitte acquired a highly desirable unit from an otherwise highly flawed parent, bringing with it ongoing contracts with numerous U.S. government agencies, as well as the people who delivered the services under those contracts. Ultimately, many buyers carved up the remaining portions of BearingPoint, leaving no trace of a “prearranged” restructuring.
The BearingPoint case study teaches several lessons. First, while nothing beats good planning and free fall filings are always problematic, bankruptcy filings do not necessarily mean the death of businesses or the jobs that go with them, including those businesses operating in the government market. Further, although a government market company filing adds unique wrinkles with which to deal (e.g., contract termination and novation), bankruptcy tools can still be effective for both buyers and sellers in the reorganization or sale of a government contractor faced with capital structure challenges.
Charlie Reardon (email@example.com) is the Senior Managing Director of Asgaard Capital, a boutique investment banking and restructuring firm based in Vienna, Virginia. When formerly at Houlihan Lokey, Mr. Reardon advised Deloitte on the BearingPoint transaction. Doug Schmidt (firstname.lastname@example.org) is the founding partner of Chessiecap Securities, investment bankers to growth and technology companies in the Mid-Atlantic, based in Bethesda, Maryland. Mr. Schmidt has twenty years of experience in the government services market. Asgaard and Chessiecap collaborate on challenging and complex corporate finance situations.