Government IT Consulting M&A Report Summer 2009

President Obama’s commitment to improving federal information technology (IT) will be achieved by increasing the number of IT government contractors. IT revenue in the management-consulting sector is expected to increase by 3.4 percent during the final three quarters of 2009 and we expect the government segment, which makes up almost 30 percent of the sector, to outperform the private sector. President Obama’s 2010 budget calls for increases in information technology spending throughout most government agencies. The Department of Homeland Security (DHS) will receive over $400 million more than in 2009 for systems that help protect infrastructure IT. The Department of Defense (DOD), the agency, which spends the most on information technology, will receive over $57.2 billion for communications and mission support systems and $10.5 billion for command, control, and computer systems. The budget also includes $1.2 billion in new, across-the-board, broadband spending. President Obama also has made it his goal for every American to have electronic health records by 2014, which will require a significant investment in healthcare information technology. Although President Obama wants to reduce federal spending by $40 billion by using fewer contractors, we are confident that, because the IT spending initiatives require highly skilled personnel, the projects cannot be completed without increasing the number of contractors. Therefore, IT contracting will be one of the few government contracting sectors that is positively impacted by the new budget. Although IT spending will increase for most government projects, there will be a reduction in spending on some projects that are used for combat missions, such as a decrease in $600 million in spending on the Future Combat Systems initiative. Therefore, Wyatt Matas and Associates believes that IT contracting firms that specialize in combat technology, to shift their research, development and staffing priorities to align more closely with President Obama’s. Currently, 18 percent of all government contracts are awarded to 8(a) firms, that is, firms owned by women or minorities. President Obama wants 30 percent of all government contracts awarded to 8(a) firms, which combined with the new administration’s commitment to make winning contracts more competitive, should provide an opportunity for small and middle-market firms to gain market share. Merger and acquisition activity in the IT consulting sector will likely be high in 2009 and 2010 as firms reposition themselves in the changing marketplace. Increased merger and acquisition activity should also result from increased competition for government contracts. The government encourages 8(a) companies to merge with larger companies, an agreement called “mentor-protégé.” Mentors provide technical and management assistance, financial assistance in the form of equity investments and/or loans, subcontract support, and assistance in performing prime contracts through joint venture arrangements with 8(a) firms. Middle-market and large firms are incentivized to enter into such agreements by being given access to 8(a) reserved contracts. We are confident that, because President Obama intends to nearly double the percentage of government contracts awarded to 8(a) firms, there will be a large increase in the number of “mentor-protégé” mergers. Since the new budget calls for an increase in spending for healthcare information technology, firms that possess data storage and medical technology competencies will attract high valuations. IT firms without data storage or healthcare IT capabilities will acquire firms that have such competencies. In addition, until employment in the private sector begins to grow, government contracts should be able to attract higher value contractors at a lower rate, thus driving margins higher. The economy will continue to improve, which will motivate private equity firms to add IT government contracting companies with recurring revenue streams and well-defined competencies to their portfolios. The index for pending sales of previously owned homes improved from 84.6 in March to 90.3 in April. This is the third consecutive month that the index rose and the index is up by 3.2 percent from the same time last year. The improvement signals that consumers are gaining confidence in the market and are taking advantage of low interest rates and favorable housing prices. As consumers become more confident in the housing market, the general economy will improve, which will create more opportunities for mergers and acquisitions. Also encouraging, according to data released by the Commerce Department, incomes rose 0.5 percent in April. Consumer spending fell by only 0.1 percent, beating the 0.4 percent drop economists had expected. Americans also saved 5.7 percent of their disposable income in April, which is up from 4.5 percent in March. Although the economy is showing significant signs that the recession is slowing, it may be a while before we see the level of deal flow that we saw in prior years. During April and May of 2009, banks recorded $2 billion in transaction fees, which is down 78% from the same period in 2008 when banks recorded $9 billion. The drop is a result of little debt available for financing takeovers. However, deal volume should increase significantly during the final three quarters of 2009 as the economy continues to improve.