November 20, 2024 - Government contractors should consider private equity (PE) funds as a valuable option for succession planning, exit strategies, or financing growth initiatives. PE funds have increasingly shown interest in acquiring lower middle market government contractors. This interest is driven by the potential for attractive returns, unique market opportunities, and strategic advantages. In addition, PE M&A volumes are expected to increase in 2025.

1. Reliable revenue streams

   Government contractors are awarded long-term contracts with federal, state, or local governments. These contracts provide a predictable and stable source of revenue, which is appealing to PE funds looking for profitable businesses with stable and recurring income. That is one of the primary factors in the PE interest in the government contracting sector.
   
   In addition, government contracts are generally less susceptible to economic downturns compared to commercial businesses, offering another degree of financial stability. This resilience can make mid-size government contractors attractive investments, particularly in uncertain economic environments. Most government contractors fared well during the COVID-19 pandemic, primarily due to the contractual nature of their revenue sources.

2. Strategic synergies

   PE funds often look for strategic acquisitions that complement their existing portfolio. Small and mid-size government contractors with specialized capabilities or technologies or a broader customer base can enhance a PE fund’s existing investments, offering synergies and additional value.
   
   Acquiring smaller players can provide PE funds with insights into the government procurement process, access to valuable government contracts, or the ability to reduce the reliance on a single agency, which is often the case for start-up government contractors.

3. Operational improvements

   PE funds are known for their ability to drive operational improvements in their portfolio companies. Small and mid-size government contractors, often with less mature management and operational structures, present opportunities for PE funds to implement best practices, optimize operations, and enhance profitability.
   
   Many mid-size government contractors have the potential to scale significantly with the right resources and strategic guidance. PE funds can provide the capital needed for growth, expand operational capacity, and invest in technology and infrastructure.

Due Diligence Challenges

Conducting financial and tax due diligence of lower middle market government contractors involves several unique challenges. These can complicate the evaluation process and impact the accuracy of assessments. Here are some key challenges:

1. Unreliable financial reporting

   It is common to find that smaller government contractors use less sophisticated accounting systems (like QuickBooks), rely on a single individual for all accounting and bookkeeping duties, or even report their financial results inconsistently during the year. Many contractors also lack sophisticated internal controls, increasing the risk of errors. Government contracts often involve indirect cost rates, which need to be properly calculated and applied. All these factors might complicate or lengthen the financial due diligence review.
   
   In addition, many small and mid-size government contractors are owner-operated, which can blur the lines between personal and business finances. Prospective PE acquirers need to carefully separate and assess these to understand the true financial state of the business.

2. Review of contracts and financial projections

   It is critical for the prospective purchaser to engage a law firm with government contracting expertise to review the target’s contracts. Ensuring that the contractor has complied with all terms and conditions of their government contracts requires detailed review of contract documents, which can be extensive and complex.
   
   In addition, evaluating a contractor’s performance on existing contracts is crucial but can be challenging. Assessing past performance involves understanding both quantitative and qualitative aspects of contract fulfillment.

3. Contract transferability

   The Anti-Assignment Act prohibits the assignment of federal government prime contracts to a third party. As a result, the transfer can be executed through a novation process, whereby the contractor requests that the government permit the transfer of its prime contracts to its contracting officer. The novation process can be burdensome on both parties and delay the closing of a transaction. Novation agreements are required for asset purchases, consolidations, and mergers, but not stock purchases. As a result, it is most common to find that the acquisitions of government contractors are structured as stock purchases.

4. State and local tax compliance

   When the acquirer is buying the stock of a government contractor, it is also taking over all liabilities, whether reflected on the balance sheet or disclosed by the seller. One particular area of complexity relates to state and local tax compliance, which has become challenging for small businesses, especially since the U.S. Supreme Court’s Wayfair decision in 2018. Several states require tax filing based on economic nexus, instead of physical presence. State and local tax due diligence is a critical step for prospective PE buyers when evaluating a target.

Conclusion

In conclusion, the growing interest of PE funds in the government contracting sector presents unique opportunities and challenges for both contractors and investors. The reliable revenue streams, strategic synergies, and potential for operational improvements make lower middle market government contractors particularly attractive targets for PE investment. However, prudent due diligence remains a crucial element in these transactions.

For government contractors, partnering with a PE fund can be a transformative step, offering not only capital for growth but also strategic guidance to enhance operational efficiency and expand market reach.

As the landscape of government contracting continues to evolve, those who strategically align themselves with PE funds may find themselves well-positioned to thrive in an increasingly competitive environment. By recognizing the complexities and leveraging the advantages of private equity, government contractors can create a robust framework for sustainable success and navigate the future with confidence.