Aug. 29 (Bloomberg) -- After investments in food, telecommunications and cleaning-product companies in the early 1990s, CM Equity Partners bet on a little-known U.S. government contractor that would shape the firm’s future.
It bought Intermetrics Inc., which designed software for NASA, in 1995 and sold the company five years later after more than quadrupling its revenue. Following that success, the New York-based private equity firm in 2004 dropped its “generalist” investment philosophy to concentrate exclusively on federal contractors, said Peter Schulte, a founder and managing partner.
CM Equity is now one of at least 38 private equity firms backing companies that sell primarily services to the federal government, an increase from fewer than 10 a decade ago, according to investment firm Stifel Nicolaus Weisel. Carlyle Group LP and Cerberus Capital Management LP, the two biggest private equity firms in federal contracting, own or control companies that had $8.9 billion in U.S. awards last fiscal year, government procurement data compiled by Bloomberg show.
“It’s a sign of the maturity of the sector,” said Charles Chappell, president of Chantilly, Virginia-based Caliber Consulting LLC, which advises firms seeking to buy federal contractors. “You’ve finally had some companies reach a size” that commands the attention of private equity investors, he said.
Heightened interest from private equity came as spending on federal contracts more than doubled to $531 billion in the fiscal year that ended Sept. 30 from $221 billion in fiscal 2001, according to data compiled by Bloomberg.
“The budget was growing at a tremendous rate, and more of it was being outsourced,” said Thomas Peltier, who leads the government services investment banking group at Stifel Nicolaus Weisel. It estimates that the services contractors controlled by private equity firms receive about $16.8 billion in annual revenue, said Peltier, who is based in Baltimore.
Recent acquisitions include Cerberus’ 2010 purchase of DynCorp International Inc., a security contractor that has trained Afghan police, for $1.47 billion, and Providence Equity Partners Inc.’s $1.37 billion acquisition of technology contractor SRA International Inc. last year.
Washington-based Carlyle, the world’s second-largest private-equity firm, bought Booz Allen Hamilton Holding Corp., a consulting firm that’s the 16th biggest federal contractor according to a Bloomberg ranking, for $2.54 billion in 2008. It took the company public in 2010 and holds 70 percent of the contractor’s shares, which have returned 22 percent since the initial public offering.
Both Cerberus and Carlyle have counted on the expertise of former top government officials. Dan Quayle, vice president under George H.W. Bush, is chairman of Cerberus Global Investments LLC, and John Snow, a Treasury secretary under George W. Bush, is chairman of Cerberus Capital Management. Frank Carlucci, a defense secretary under President Ronald Reagan, joined Carlyle in 1989 and stepped down as chairman in 2003. Both firms declined to comment for this article.
Profitable deals such as CI Capital Partners LLC’s 2006 sale of Anteon International Corp. to General Dynamics Corp. for $2.2 billion sparked broader interest in the federal contracting sector, said Jean Stack, a McLean, Virginia-based managing director at investment bank Houlihan Lokey.
“Once private equity saw the success, additional private equity firms entered the industry in a big way,” she said in a phone interview.
Deals for government contractors by private equity firms or by contractors with private equity backing peaked in 2007 at 72, compared with 16 in 2001, according to BB&T Capital Markets. There were 45 such transactions in 2010, the most recent year for which complete data were available.
Federal spending on contracts reached an all-time high of $551 billion in fiscal 2009, before declining 3.6 percent to $531 billion in fiscal 2011. Contractors face the possibility of additional cuts as Congress and the White House seek to reduce the nation’s deficit.
National security and domestic programs would experience $1.2 trillion in across-the-board reductions over a decade if U.S. lawmakers and the president don’t reach a deficit-reduction agreement before Jan. 2.
Even as the government reduces spending on contracts, private equity “is going to be a mainstay of the industry,” Stack said. “It’s just a question of at what price and at what level of risk.”
Private equity ownership in the sector has risen in the past several years as contractors such as Lockheed Martin Corp., the world’s biggest defense company, and Northrop Grumman Corp. maker of the Global Hawk drone, have sold divisions to help boost profit margins and avoid conflicts of interest.
Northrop in 2009 sold TASC Inc., its government consulting unit, to a partnership of Kohlberg Kravis Roberts & Co. and General Atlantic LLC for $1.65 billion. The sale was made to comply with rules intended to prevent companies from advising government agencies on weapons systems while also bidding for contracts to build them.
New York-based Lindsay Goldberg LLC last year bought Pacific Architects and Engineers from Lockheed after the biggest weapons maker decided it didn’t want to be in the business of training judges in Afghanistan. Terms of the deal weren’t disclosed. Pacific Architects was awarded federal contracts valued at $902 million last year.
Low valuations for services contractors also may entice private equity buyers, said William Loomis, a Baltimore-based equity analyst at Stifel Nicolaus & Co.
For example, the price-earnings ratio of SAIC Inc., the biggest government contractor focused on services, fell to 8.8 times profit yesterday, from 10.4 times earnings a year earlier. The price-earnings ratio for technology services contractor CACI International Inc. declined to 8.8 times profit, from 11.9 times earnings a year ago.
“Private equity is willing to step in in front of significant uncertainty like we have,” Loomis said in a phone interview. “You could see a private equity deal close anytime.”
Alex Hamilton, an EarlyBird Capital analyst in New York, said the decline in the value of contractors that provide services may prevent some deals.
“From what I’ve heard, nobody wants to sell at the depressed valuations,” he said in a phone interview. “Nobody knows what it’s going to look like in two years.”
CM Equity, after acquiring 37 federal contractors, is sticking with its focus on the industry, said managing partner Schulte.
“It’s what we know and understand,” he said. “It’s better, we think, to be a specialist where there’s a lot of opportunity than to be a generalist and to dissipate our energies.”
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