Government contractors (GovCons) are good investments for several reasons. However, there are a lot of due diligence considerations when it comes to GovCon M&A. These may include financial, tax, IT/cybersecurity, regulatory compliance, and post transaction integration, among others. 

In January 2024, CohnReznick connected with the Greater Washington GovCon community for a live panel discussion titled, “M&A in GovCon: What’s the Deal?” The conversation covered many aspects of GovCon mergers and acquisitions, and included insights from those who have previously gone through transactions from various vantage points including private equity, large public, private strategic, M&A advisors, and government contractors.

Long-time CohnReznick Government Contracting industry partner, Christine Williamson; CohnReznick’s Transaction Advisory Services Partner, Gen Oraa; and John Pribnow, VP of Government Contracting and Asset-Base Lending at LiveOak Bank, served as moderators. Panelists included Kathryn JohnBull, CFO of DLH Corporation; Rachael McClure, Director of Corporate Development at Leidos; and Jason Rigoli of private equity firm Enlightenment Capital.

Fueled by insights from our panelists and questions from the audience, the discussion revealed several real-world tips for a successful GovCon transaction. Key highlights include the following:

GovCons are good investments, as opposed to other industries, because of the following:

1. The largest qualified buyer/customer of technology: The U.S. government buys essentially everything. Additionally, the U.S government has high credit quality, pays in a timely manner, and awards long-term contracts; which allows for greater certainty of revenue from backlogs.
2. Greater lower/middle market opportunities: Congress has dictated that 25 cents of every dollar must be spent on small businesses, creating an ever-replenishing market for the lower/middle markets.
3. Market forces have limited impacts to the government buyer: GovCon stock holds its value through economic headwinds in the consumer market. Meaning, the government is not always impacted by volatility resulting from natural disasters and other external economic factors.

Ideal attributes of a GovCon target/acquisition:

1. Management team and intelligent resources: For any acquirer, the management team and its other intelligent resources are key to scale the business.
2. Technological capabilities or unique offerings: Not all companies look for contract vehicles as a primary driver for an acquisition. Many investors in today’s market are looking for innovation, tech-enabled services/products, and capabilities that are unique service offerings, as well as talent.
3. Concentrated and strong backlog acquisition strategy: This can help with access to additional customers/capabilities and fill market gaps that resonate with today’s market buyers.

Challenges to GovCon investments and related due diligence include:

1. Compliance: The GovCon industry is a highly regulated industry with extensive compliance requirements. Certain required contract clauses can impose additional layers of complexity to compliance for buyers.
2. Current anti-trust environment: This environment is aggressive, resulting in deals getting challenged at the contract level; Deals must go through extensive diligence in multiple aspects to close.
3. Bank cash flow considerations: Banks want to protect future cash flows and will scrutinize the contract vehicles a target is on. Therefore, it’s important to balance equity versus debt financing in a higher interest rate environment. Additionally, we are seeing a shift away from debt-to-equity deals, where smaller deals are financed by debt, as debt has become increasingly more expensive in the economic environment.
4. Mitigation of the challenge: As they say, “You don’t know what you don’t know.” Therefore, it pays to engage experienced outside consultants to assist with due diligence and financing/banking needs. This likely includes GovCon compliance-focused due diligence, not just financial, tax, cyber, human capital, etc. Companies need to either have deep industry expertise and/or use outside advisors that have extensive industry expertise to advise on potential pitfalls, risks, and opportunities. 

Key due diligence aspects of a GovCon:

Investors expect rigorous due diligence when investing meaningful capital, so it is helpful to have outside third-party providers validate the acquirer’s assumptions.

1. Accounting perspective: Financial due diligence focuses on EBITDA, net working capital, and indebtedness. In addition, contract waterfall and pipeline/backlog are key to understand concentration in customer/projects/segments, and historical and current backlog that support projections and strategic plans.
2. Other items that should be evaluated include tax, human resources, GovCon compliance risk assessment (e.g., indirect rates, contract clauses for exemption status, compliance with current regulatory environment, etc.), and information technology; including cyber security and legal. 
3. Qualitative assessment of the “cultural fit”: While ”cultural fit” is not quantitative and is difficult to assess and predict during due diligence, it is a crucial element to evaluate. This qualitative assessment does not just include personalities and expectations of employees, but also includes more tactical areas such as processes and approaches to business.  

Best practices for managing GovCon compliance considerations: 

1. Current regulatory environment: Assess the target’s current regulatory environment and understand what exemptions post-acquisition may “go-away” (e.g., small business status, commercial item designations on products or services that were not fully vetted with the government) 
2. Time charging methodology: Assess historical approach to time charging and whether or not time charging has been done correctly in the past. This could have impacts to future pricing strategies for pricing labor and cultural integration.
3. Anticorruption/antibribery: For international companies, evaluate compliance with the Foreign Corrupt Practices Act of 1977. Anticorruption, and antibribery, which can all become large issues if not properly assessed during diligence, can become an inherited liability risk the buyer needs to be able to quantify.
4. Contractor Performance Assessment Reporting (CPAR): Evaluate tangible performance documentation issued by the U.S. government to understand how a target is performing as a GovCon. In the commercial world, however, you may have a due diligence professional talk to a target’s customers.

Some unique provisions that buyers are seeing during the due diligence process: 

1. GovCon and human resource compliance: Both of these areas are heavily regulated, so the buyer needs to understand the risk and have protections against obligations prior to closing.
2. Representations and warranty: Insurance for representations and warranties have helped close deals since founders are not necessarily on the hook in the same way that a buyer is. However, proper due diligence and having a group of people with deep experience in this area supporting buyers’ thorough due diligence will become vital to mitigate significant risks.
3. Avoid earnouts: Defining the earnout metric is always messy because sellers and buyers have opposing interests; so, it’s vital to either define the metric upfront clearly or simply avoid earnouts, if at all possible.

GovCon key integration considerations:

1. Rip off the band aid and integrate quickly: Resoundingly, the panel concluded that it’s important to think about integration as soon as possible as delaying integration only makes it more difficult down the road for entities to come together not only from an accounting perspective, but in terms of people and operations as well. 
2. Priorities for integration: Quickly integrate accounting and other back-office functions. Financials, human capital, and securing target data under the acquirer’s data compliance umbrella is important. Information technology/data is of interest to adversaries and if an acquirer does not properly secure its acquiree’s data quickly, it can lead to possible data security issues.
3. Reason not to integrate: From an operational perspective, service-based business models that acquire a product-based business model may leave a commercial licensing model on its own to keep both sides of the business competitive. Earnout provisions in the purchase agreement should also be a consideration in integration.

What’s the outlook for GovCon M&A? In short, it’s bright! 

1. Major strategic buyers becoming “un-paused”: 2023 was a  slower year for M&A. The panel predicts that the “pause” button will come off for strategic buyers and reinvigorate the marketplace. 
2. Cost of capital: This is expected to decrease and accelerate the market, with forecasted lower interest rates in the U.S. 
3. Portfolio reshaping: A prediction was made on the panel that strategic and private equity (PE) firm portfolios may be reshaped; including possible consolidation of business for PE’s and carve outs or decompartmentalized businesses for strategic players. 
4. Volume will not slow down: Opportunities will not slow down as the GovCon market tends to be steadfast and consistent when it comes to managing through economic headwinds in the consumer market.
5. Strategic acquisitions: Large publicly traded primes will need to start looking for other avenues of growth, which will include more strategic acquisitions of unique, concentrated (i.e., single target customer), or unique technological capabilities or service offerings to add to its portfolio.

For more information on why GovCons are good investments and how GovCons can best navigate a transaction, please contact us.