The last twelve months have seen an increase in M&A activity within the government contracting sector. While many companies deleveraged their balance sheets during the economic downturn, owners are now feeling more confident in pursuing acquisitions – at the right price. According to Aronson Capital Partners, “The leadership teams of public contractors are finally seeing the uncertainty that dominated the government contracting community be replaced with a refreshing sense of stability and growth.”
ManTech International Corporation’s 2013 annual report noted that, “For the first time in years, customers are accelerating procurements instead of delaying them.” With this renewed confidence, many contractors are exploring acquisitions as a primary way to enhance shareholder value, supplement growth, and capitalize on the improved market environment.
Buying a federal or state government contractor involves unique risks and characteristics. For instance, many contracts are not easily novated to a potential buyer, so stock purchases are fairly common. This means that buyers are potentially purchasing unknown liabilities, especially if they have cost plus or fixed price contracts.
Over the last few years, government entities have sought low price, technically acceptable (LPTA) bids, leading many contractors to reduce their estimated profit margins when bidding potential work. Since some of this work is fixed price, buyers risk purchasing contracts that will ultimately result in a loss. To protect themselves, buyers should discuss these contracts with project managers, employees, and, in some cases, customers to determine whether the estimated costs to complete the project are reasonable.
LPTA also forced many contractors to reduce their overhead and G&A rates in order to offer more competitive bids. Many have provisional rates that are in excess of the actual rates incurred, which can result in unrecorded liabilities due back to customers. Since the Defense Contract Audit Agency and many state auditors are delinquent in reviewing incurred cost submissions or client developed rates, these liabilities may not be known for some time. Buyers should review historical provisional and actual rates, confirm that the actual rates are computed accurately, and review open cost plus contracts to determine if there are potential liabilities. If the client completes an incurred cost submission, buyers may request a copy of the most recent submission since one of the schedules contains much of the information required to determine whether a liability exists.
Buyers can also protect themselves by holding back a portion of the sales proceeds from the seller until the open contracts are formally closed out by the government. If there are unknown or unreported liabilities, the buyer will recoup the money from the holdback.
If you are planning to pursue an acquisition, it is a good idea to consult with attorneys, accountants, and other advisors who understand the unique risks involved in government contracting M&A deals.