As the federal budget climate stabilizes after a turbulent 2013, a group of large prime contractors are adding more small companies to their business portfolios, a trend that’s likely continue in 2016.

There are about six government service providers with more than $5 billion in annual revenue, said Ed Caso, managing director and senior analyst at Wells Fargo Securities, during the Morrison & Foerster’s 11th annual federal M&A outlook in Virginia Oct. 8.

“We definitely see a group of large players emerging in the market,” he said. “We think the midsized players are going to be challenged.”

The group of investment experts largely agreed. Mergers and acquisitions in the federal market will continue, but just how big  some of those companies will get and how many will remain active players, are important questions that still need answers.

“If you were ever going to spend or sell, now is the time to do it,” said Jean Stack, managing director at Houlihan Lokey. “You have very healthy financing markets, very eager to lend money, you have private equity that’s flush with capital, you have strong valuations that continue on the pure-play government services side.”

As federal budgets begin to stabilize somewhat, contractors are gaining more confidence in the market and feel more comfortable to make big moves.

“There is some fear of missing out, a little bit of FOMO, going on; where if you really accept the idea there’s going to only be five to seven companies left on that list, you have to actually make a decision as a board, do I want to be a consolidator or do I want to be an active participant in these merger discussions,” said Jason Kaufman, managing director at the Chertoff Group.  “If you’re not, then there’s a real possibility that if you look 18-24 months downstream, you may not necessarily be on that list anymore.”

The recent budgetary climate is just one reason why companies are getting more creative with their acquisition strategies, said Kevin DeSanto, co-founder and managing director at KippsDeSanto & Co.

“Most of the conversations that we’ve been having with buyers or investors has been around very specific issues … trying to create beachheads that are going to lead to five or 10-year growth propositions for them,” DeSanto said. “So repositioning into new markets or customers, access to vehicles, those types of things have been really the main drivers of a lot of the consolidation that we’ve seen.”

This comes as Frank Kendall, undersecretary of defense for acquisition, logistics and technology, recently said he feared too many mergers among prime defense contractors might limit competition and innovation.

“With size comes power, and the department’s experience with large defense contractors is that they are not hesitant to use this power for corporate advantage,” Kendall said in a statement. “The trend toward fewer and larger prime contractors has the potential to affect innovation, limit the supply base, pose entry barriers to small, medium and large businesses, and ultimately reduce competition.”

There is the potential for too much consolidation, some investment experts said.

Stack emphasized companies shouldn’t merge just for the sake of acquiring new business. The big question — for the companies that do merge — is how that consolidation gets executed and what it means for their customers, she said.

“What is the benefit [for] any of those companies by combining at that kind of a scale,” Stack said. “I still do not believe that being bigger and having revenue for the sake of being bigger is a value proposition in this market. If there is enough difference between those companies and if the combination can create synergies and enough growth momentum, I think it makes sense.”

Hot topics for 2016

Federal agencies still are interested in the typical buzzwords like “cyber,” “cloud” and “data consolidation,” in 2016, investment experts said.

Though federal budgets are slowing rising 1 percent to 2 percent each year, Kaufman said agencies are saving more when they move to the cloud, which will open up their budgets for other projects.

“There are some real cost savings that are happening below the line as a result of moving to the cloud,” he said. “Just because you have that overall top line staying flat at 1 percent, those cost savings that are resulting from a drive to the cloud, those budgets are getting allocated to other places, to IT. So you’re having real growth below the line.”

Companies who specialize in cybersecurity, particularly in the aftermath of 2015’s OPM breaches, will continue to be attractive for federal agencies — and large companies looking to buy.

But companies that specialize in cyber and are looking to sell and score a major deal will need to deliver, Stack said.

“You really have to have the substance behind the buzzword, because the buzzword doesn’t drive the multiple,” she said. “What you’re doing, the real work, is what drives the multiple.”

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