Higher interest rates have dampened mergers and acquisitions in the defense market

The Defense industrial base is always a concern for the Pentagon. It worries both about capacity and whether it has a competitive market. That’s why planners keep an eye on mergers and acquisitions aka M&A. M&A activity is highly sensitive to interest rates. For insight on what to expect now that the federal reserve rate is 5%, Federal Drive Host Tom Temin spoke with Venable law firm partner Joseph Schmelter.

Interview Transcript:

Tom Temin And first of all, just for those that may not understand all of their subordinated debentures and other managerial finance questions, the interest rate from the Federal Reserve, how does that affect the market in general? What is the effect of higher interest rates? Does it tend to dampen M&A?

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Joseph Schmelter It does a little bit, particularly for a segment of the buyer market, which is comprised by private equity firms. So unlike your big strategic buyers, publicly traded integrators that everyone has heard of, the other half of the buyer market are private equity firms and sort of hybrids that are sponsored by private equity. And they finance their deals typically on a one off basis. So if there’s an acquisition that a private equity sponsored buyer is going to do, they’re going to have to go out and get financing for that deal. And when interest rates are increasing or higher than they normally are and what credit generally is tightening, and by that I mean covenants are becoming more difficult, underwriting is taking longer. That means it’s a heavier lift for a private equity buyer. Deals take longer to get done. Offers from private equity may become somewhat less competitive when judged against offers being made by your strategic publicly traded government contractors. So higher interest rates does put a damper. That is certainly a headwind for M&A activity for sure.

Tom Temin And just again, as background, would it be fair to characterize mergers and acquisitions in three basic buckets, publicly traded taking over or merging with publicly traded, they finance it themselves through stock and cash. Then the second tier would be publicly traded, or big buying little, in which case they also finance it with stock or cash and then middle size and small buying, other midsize and small. And that’s where the venture capital comes in, or the equity capital.

Joseph Schmelter Yeah, I think that’s a fair way to allocate the universe of these deals, although on the private equity side, you know, some of those funds can be quite large. And I would distinguish between, you know, venture capital where private money is perhaps making a minority investment in a technology company or a startup or something like that, versus private equity generally where they’re outright making acquisitions and buying control of the target companies that they’re going after. And some of those PE funds, the Carlyle’s and the Bane capitals of the world are quite large. So they rival, you know, the Lockheed’s and the Northrop Grumman’s and the Leidos is of the world in terms of their buying power. That’s a good breakdown.

Tom Temin All right. And how would you characterize activity this year, especially in that equity capital type of market that we’ve been talking about? Is it up, down, level? And we had a watershed year recently, correct?

Joseph Schmelter We certainly did. 2021 was the high watermark for M&A activity in the Aerospace, defense and government services market. What people would typically refer to as government contracting M&A 2022 was not far behind. There was a little bit of a slowing down last year, especially in the second half of the year as interest rates started to increase quickly. But nevertheless, I believe 2022 in this Aerospace defense and government services market was the second highest year in terms of transactions and deal volume. So, 2023 is off from those two very robust years. Probably, we will end up, if I had to guess somewhere around, you know, pre-pandemic levels for M&A activity in that government space.

Tom Temin We’re speaking with attorney Joseph Schmelter. He’s a partner at Venable. And to what extent are these driven by purely financial considerations? This company has a nice set of contracts or it has a good potential for contracts and we like the cash flow, whatever the case might be, and that’s a good target versus a hot technology. For example, the emergence of artificial intelligence. Does that drive activity or is it simply a financial calculus?

Joseph Schmelter No, Certainly there are areas that over time become hot markets, sort of sexy acquisition targets, if you will. Over time, I can think of health care, I.T., intelligence, contractors, cyber. And currently, I think one of the biggest pushes in the federal government would be I.T. modernization or digital transformation. So if you are a contractor who’s successfully winning contracts, especially if you’re a prime contractor, you know, in direct privity with your government contractor and you’re in an area like I.T. modernization, digital transformation, where the federal budget is increasing, you’re going to demand higher valuations, higher multiples, and you certainly will be a hot commodity for potential buyers.

Tom Temin But on the other hand, when you take over a company like that, you’re just buying people, You’re not buying any real capital. What about companies that maybe make a certain connector that the military has to have by the thousands every year? It’s prosaic, it’s Bakelite or, you know, molded plastic and metal and some people standing there stamping out these things. But sometimes the margins are amazing on those products. What about that type of company that someone might just like because the cash flow is good and they’re going to need those connectors for the next 50 years?

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Joseph Schmelter Absolutely. We spoke earlier about how private equity has become a real competitor with your larger strategic buyers. You know, private equity has figured out that sleepy government contractors with steady margins and really solid customers, there isn’t a better customer in the world than the U.S. federal government. And so, even though you may not get the sexy margins that you would in a pure technology startup, nevertheless, as you say, over time, you’ve got a solid customer. You’re in a niche production area and you’re going to command some of those higher multiples as well. I mean, I think right now we talked about I.T. modernization, but another driver is the reset, which is happening and will happen for defense contractors in light of the war in Ukraine. I think NATO in Lithuania is discussing increasing NATO’s member defense budgets, and that’s only going to spur greater activity and greater valuations of your very traditional defense manufacturing firms. So, absolutely, it’s not limited to who’s doing cyber work or who’s doing AI and machine learning work, but it’s also very traditional manufacturers without whom the Defense Department and Defense departments around the world cannot reach the goals that they’ve set out to achieve.

Tom Temin Yeah, you can almost rewrite that old movie line. I have just one word for you, young man, hundred and 55 millimeter Howitzer shells.

Joseph Schmelter Or plastics or something like that. Yeah. Right. Absolutely.

Tom Temin And in your experience, at what point, if ever does anyone say from the Pentagon, say, golly, I really wish that company would not get bought? I mean, sometimes they can have a say in the really big mergers and acquisitions, but at what point do they ever, or do they ever express, golly, we like the competition this one is providing with that one?

Joseph Schmelter Yeah, I think there’s two things going on, two levers that the federal government can push when they’re really concerned about a particular transaction. You mentioned one, and that’s if there’s just an outright anti-competitive result. There’s the federal Hart-Scott-Rodino statute, which when you get to a certain deal, size, needs to be vetted in order to determine whether two companies coming together will have unnecessarily anti-competitive effects. But the other has to do with organizational conflicts of interest. This is something that you see in the GovCon M&A world that you may not see in the private sector. And that simply has to do with whether or not because of an acquisition or a merger, you’ve got two different functions happening within the same contractor, which the federal government is loathe to allow to go forward. So by that I mean you may have contractor A, the target who is being acquired and they’re in the business of helping their federal government, customers and agencies put together their procurements, set out their requirements. So that’s the job they’re doing for their customers. And then they’re being acquired by somebody who’s in the business of pursuing the very contracts that are going to be let in the short term. So when you’ve got an organizational conflict of interest, you’re like that an OCI, they call it. That’s a second area where the federal government is quite concerned and will really do their due diligence and may require one or the other of the two companies coming together to shed one of those businesses to get rid of those OCIs.

Tom Temin Sure. And just a final question. What’s the outlook for 23? Remainder and calendar 24. Do you think?

Joseph Schmelter I mean, I think right now we’ve sort of got competing headwinds and tailwinds which are fighting to a stalemate. We’ve got sort of the headwinds being just the federal government’s reset that I mentioned in Ukraine for defense contractors. You’ve got a positive political picture in the sense that we narrowly avoided a debt ceiling crisis only a few months ago. So the risk of default is off the table and it doesn’t look like we’ll have a redux of sequestration and the Budget Control Act that we had under the Obama administration. So those are all the tailwinds, but the headwinds are higher rates. You mentioned that at the outset of our conversation, general credit tightening, inflation. And so I think those things are sort of fighting themselves to a stalemate right now. I think we’ll see relatively steady deal flow through the rest of the year and into next year. We’ll have an election toward the end of next year. So oftentimes buyers will sit on the sidelines and try to read the tea leaves and see whether we’re going to have a Democratic or Republican administration in the White House before they pull the trigger on some of their M&A goals. So I think with all of that sort of neutralizing headwinds and tailwinds and a little bit of political uncertainty in an election year, I think you’re in for a sort of steady M&A activity. You know, below the high watermarks we hit in 21 and 22.

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