How to know if the price is right

Government contracting is one of the largest and broadest ecosystems in the U.S. economy. It encompasses businesses of all sizes in an array of industries, including aerospace and defense, technology, business and professional services, life sciences, and health care. The ecosystem is defined by its customer, the U.S. federal government, which is the largest buyer of goods and services in the world.

The government contractor middle market is home to many growing, highly technical innovators and niche players. These companies are attractive to bigger players hunting for growth, added capabilities and access to specific customers and contract vehicles. The result is a robust and dynamic market for mergers and acquisitions.

However, doing business with the federal government adds a layer of complexity to growth and risk considerations. Investors must understand these complexities when estimating the value of potential M&A targets. Below we analyze several factors: how contract waterfall features affect future cash flows, the role of the federal government in establishing competition, and how market dynamics can drive acquisitions and valuations.

Contract waterfall

The most critical aspect of a valuation analysis is a contract waterfall, which serves as a roadmap of a potential target’s future revenue streams and cash flows. It offers investors and business operators transparency and a quantifiable glimpse into the future.

A contract waterfall depicts projected revenue on a contract-by-contract basis. It also denotes the key terms and features of a company’s contract backlog and future pursuits. Features include win probability, customer demographics, contract duration, prime versus subcontractor status, competitive environment and contract cost structure.

At its core, valuation is the practice of estimating a business’s future cash flows and assessing how risk affects its ability to achieve them in an uncertain and ever-changing world. Failure to appropriately consider these factors may result in overstating or understating the target’s market multiple (i.e., market/relative valuation) or its discount rate (i.e., income/intrinsic valuation). 

Win probability

All contracts in the contract waterfall must be assessed for achievability of their projected cash flows. Each contract generally falls into one of three categories:

It is important to understand whether revenue estimates in the contract waterfall reflect 100% of the potential revenue associated with each contract or are already adjusted for the estimated win probability (e.g., 70% of the annual projected revenue associated with a contract).

Indefinite delivery, indefinite quantity (IDIQ) contracts and task-order contracts are unique in that contractors are awarded the opportunity to bid on an individual task order when the customer identifies a specific need. Though the contractor is already approved as a vendor, its chances of winning an individual task order depend on the requirements of the specific order and competition from other approved vendors.

Valuation implications: The more speculative the projected cash flow, the riskier the investment. The greater the percentage of new business revenue in a company’s forecast, the higher the risk and the lower the value. Conversely, a greater percentage of backlog contracts relative to total revenue would suggest lower risk and a relatively higher valuation, all else being equal.

Customer concentration

As with any business, customer composition and concentration are distinguishing characteristics of the firm’s risk profile.

Customers consist of government agencies such as the Department of Defense (DOD) and the Department of Health and Human Services. However, each agency can have a variety of subagencies or groups within it, each with unique procurement offices, decision makers and demands.

For example, a contractor serving the DOD could hold contracts with the U.S. Army, U.S. Navy, U.S. Air Force, Defense Logistics Agency, Defense Intelligence Agency, National Geospatial-Intelligence Agency, Missile Defense Agency and more. A contract waterfall helps to identify the company’s customer quantity, revenue distribution among customers and reliance on key contracts.

Valuation implications: The greater the diversity and number of customers and contracts, the lesser the risk and the higher the value. Alternatively, a company that relies on the renewal of a single contract or a small collection of contracts is riskier and would be valued lower, all else being equal. For this reason, you rarely see a company go to market just before being awarded a key contract or contract renewal.

Contract duration

The duration of contracts is another critical feature. High-volume, short-duration contracts are less certain and provide less long-term visibility, but they provide smoother growth trends. On the other hand, low-volume, long-duration contracts provide more certainty into the future until the contract expires or is once again up for recompete.

Valuation implications: Contract duration affects the forecast period of a discounted cash flow model and how management views a business cycle. Additionally, the level of certainty or uncertainty inherent in the forecast drives risk. A large contract coming due in the near term can make or break a company’s long-term growth and profitability forecast.

Prime vs. subcontractor status

A prime contractor engages directly with a federal agency to deliver requested goods and services. Subcontractors are selected by and dependent on the prime contractor.

Valuation implications: A company operating with a backlog consisting of mostly prime contracts is of greater value than one that relies on subcontracts. Prime contractors often maintain control over the engagement and are better able to maintain a relationship with the end customer. This often leads to greater insight into and control over recompete opportunities.

Contract cost structure

Government contracts are explicit as to the costs that are the responsibility of the contractor versus those that can be passed on to the government. As a result, the cost structure of a company’s contracts directly affects the business’s earning capacity. The three most common structures are the following:

Valuation implications: The contract mix dictates the level of control a government contractor has over the operating margins it can achieve. In recent years, the prevalence of cost-plus contracts has largely caused profit margins among large, diversified government contractors to fall within a narrow range. Understanding contract mix and its implications for earning capacity is critical to identifying the business’s underlying profitability. This is why government contractors, when mature and profitable, are typically valued and purchased based on multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) as opposed to revenue.

Competition

Unlike a typical commercial competitive environment, the federal government controls the level of competition in the marketplace by requiring a contractor to meet certain criteria to be awarded a contract. Government programs seek to limit competition for contractors meeting certain criteria in order to support disadvantaged people, groups or small businesses. The table below summarizes a few common competitive environments:

On the buy side, purchasers must closely monitor the competitive environment, as certain regulations may prohibit a contractor from transferring and continuing to fulfill such contracts or rebidding on them in the future.

Valuation implications: The more speculative the projected cash flow stream, the riskier the investment is. The greater the percentage of new business revenue in a company’s forecast, the higher the risk and lower the value. Alternatively, a greater percentage of backlog contracts relative to total revenue would suggest lower risk and a relatively higher valuation, all else being equal.

Market landscape

Industry fragmentation, consolidation and heightened private equity influence have defined the government contracting ecosystem for decades. In addition, federal government spending and policy decisions directly affect the ecosystem.

Fragmentation and consolidation

The sector is fragmented between large conglomerates that deliver a breadth of services and small, privately held businesses that provide specialized, niche offerings. Government programs, like the SBSA and 8(a) programs discussed previously, generate a constant flow of new and emerging small businesses. The government’s focus on price, in an effort to steward taxpayer dollars responsibly, incentivizes economies of scale and efficiency.

Increased competition often hinders understanding the future scalability and opportunities of small and midsize business. This, in turn, enables the bigger and more sophisticated conglomerates to pounce and acquire smaller rivals, allowing them to grow inorganically. The wave of consolidation within the ecosystem over recent decades can lead to a less competitive bid process, leaving a greater share of proposals to the conglomerates. Every so often, the Federal Trade Commission or Department of Justice will enforce antitrust laws to maintain competition among the largest players in the industry.

Strategic vs. financial buyers and private equity influence

A key, yet not readily identifiable factor is the premium investors are prepared to pay for a business that offers synergistic and strategic benefits, compared to one that is merely a financial target.

Consistency in government spending trends, visibility into future cash flows and insulation from economic recessions make the ecosystem an attractive target for private equity firms seeking stable cash flow streams to round out their portfolios.

Many private equity firms, particularly those that specialize in the government contracting ecosystem, are implementing investment strategies more aligned with strategic than financial buyers. Specifically, private equity groups often invest in a platform company and complete one or more bolt-on acquisitions before selling the larger, combined firm. This blending of financial and strategic investment strategies is common in the ecosystem and can drive private company transaction multiples up.

Valuation implications: Relative value market approaches can be difficult given significant differences in size and risk between large, public conglomerates and small, privately held contractors. Given this fragmentation, the rise in market multiples is not necessarily directly attributable to small, privately held businesses. Private equity’s impact is most visible in the middle market, where businesses typically transact at lower multiples compared to the rest of the industry, enabling investors to enact multiple arbitrage. Investors are willing to pay relatively lower multiples for smaller businesses, which they can integrate and resell as larger businesses at higher valuations.

Government spending trends

Ultimately, the success of private equity investors depends on the demand for and availability of fiscal resources for public investment. For instance, investor sentiment was strong following the passage of major spending packages like the Infrastructure Investment and Jobs Act in 2021 and the CHIPS and Science Act in 2022. Periods of heighted civilian or military need, like the COVID-19 pandemic or geopolitical conflict, also drive demand.

Sequestration in 2013, on the other hand, caused funding delays and increased uncertainty, thus dampening investor sentiment. Similarly, government shutdowns can negatively affect the timing of payments, business operations and services to be performed. Payments to affected government contractors are often delayed in these situations, inhibiting their ability to pay their employees and subcontractors.

Valuation implications: Government contractors must secure funded contracts with government agencies that have been allocated portions of federal, state and/or local budgets. Contract opportunities increase during periods of increased allocation of public resources. However, an uncertain political environment—elections, budget disputes, congressional stalemates, government shutdowns—can translate into increased risk or volatility. Market valuation factors like market multiples and beta (industry risk) naturally include broader economic and industry challenges. However, a company’s essential or nonessential status, or its level of exposure to a government shutdown or sequestration based on the agencies served, could be a meaningful differentiator.

The takeaway

Doing business with the U.S. federal government requires specialized knowledge around contracting requirements, competitive environments and the constantly evolving market landscape. A company’s ability to navigate these complexities has a direct impact on its future cash flow and value.