Playing Defense

The US defense sector is bracing itself for what could be a trillion dollar shock. Unless Congress reaches a compromise soon, the US government will initiate automatic cuts at the start of 2013 that would slash almost $1 trillion from the defense budget over the course of the next decade, according to reports. Those cuts, along with the conclusion of the Iraq War, will probably contribute to smaller or fewer contracts for companies that provide goods and services to the Department of Defense (DoD), sources say.  

“If the cuts happen in January, you’ll start to see DoD award fewer contracts,” says Todd Harrison of the Center for Strategic and Budgetary Assessments. “The industry’s going to get smaller, because there’s going to be less money going around.”

The possibility of deep cuts likely had a negative effect on deal flow over the course of 2011, when defense sector M&A deal volume fell by 22 percent, according to a Deloitte Corporate Finance study.  

“The potential for reduced budgets and the looming threat of sequestration (the procedure by which an automatic spending cut is triggered) has raised uncertainty with regards to the future outlook for some defense companies, and that is causing a near term decrease in defense M&A. That applies for private equity buyers and sellers as well,” says Peter Frankfort of Deloitte Corporate Finance.    

Several years ago, many assumed that future cuts to government defense spending would target new programs, according to Argosy Capital founding partner Kirk Griswold. Contractors that provided research and development, or assisted with day-to-day operational services, were expected to be unaffected. 

However, under sequestration, cuts would likely be felt across the board, creating uncertainty as to how individual portfolio companies could be affected by reduced spending.  

That uncertainty prompted Argosy to expedite its plans to exit Ranger International, which provides maintenance, modification and overhaul services to Department of Defense and US Armed Forces’ aircraft and vehicles. Whereas Argosy typically holds its portfolio companies for four to seven years, the hold period for Ranger was less than three and a half years. 

“The board had been aware of the budget cuts, and made the decision a year ago to explore the option of combining Ranger with a larger, more capable company … The concern over budget cuts was certainly a part of that,” Griswold says.
However, the cuts may also present opportunities, sources say. Harrison thinks it may enable some contractors to renegotiate DoD contracts to their advantage, while Griswold says that cost-saving programs in areas such as cyber security and unmanned aerial vehicles are “just hot”. 

This thesis recently influenced The Jordan Company’s $98.75 million acquisition of VT Services, which provides logistics and engineering services support for the US Army and Navy, says managing principal Adam Max.    

“Why would we buy into the defense industry when the budgets are getting cut?” Max asks. “This business is about logistics and communications within the DoD and related entities. If these organisations don’t have information systems operating at full capacity, they can’t run the other programmes. If you materially cut these activities, the results are binary … the organisation can’t operate.”

So will lower spending equal lower returns? Possibly, but not necessarily.