Strategic Drivers of M&A in the Middle Market, Part 2: The Perils and Opportunity of Middle Market Contracting
As mentioned in the most recent blog in this series, we continue to witness the growing prevalence of middle market acquisitions and “mini-mergers.” A key driver of this phenomenon is the increasingly divided nature of today’s contracting markets. More specifically, the flow of funding dollars can be classified into three areas – (i) the small business / set-aside procurement environment; (ii) the landscape for large contracts and IDIQs that is dictated by large defense prime contractors and system integrators; and (iii) the middle market, for firms generally over $50 million in revenue that no longer qualify for set aside programs. This third area has recently become a tumultuous one, especially within a pressured budget environment, that has motivated contractors to consider strategic alternatives in order to spur growth and augment competitive positioning.
A pressing growth challenge in the government contracting market is the procurement squeeze facing mid-sized contractors. Having grown out of most set-aside categories, mid-size companies retool their business development teams to focus on larger F&O contracts. This transition can be disruptive and often overwhelming. The sheer size of the contracts / IDIQs available for capture allows for a new, stiff competition in the form of larger, less resource constrained prime competitors. Growth goals also become more difficult to achieve – for example, for a typical ~$100M contractor to achieve 10% growth per annum, assuming ~20% of its base is up for renewal and a typical contract term is three to five years, the firm must bid and capture ~$90M – $150M in contracts each year, a tall order in even a normal budget environment, much less a constrained one.
With revenue continuity and growth being the primary goal, many middle market firms are compelled to chase subcontracting opportunities or a multitude of smaller prime efforts (for which they eligible, which represents a small subset of the opportunity landscape). Other contractors, however, have chosen to reinvent their organization and acquire new scale, capabilities, and expertise to remain competitive with the large primes. For example, Noblis and National Security Partners completed a combination in 2014 that provided competitive scale, capability depth, and customer relationships for the combined company that rivals that of much larger prime contractors. Generally speaking, these types of mergers and smaller acquisitions can create revenue synergies and market presence that help companies to overcome the typical obstacles of the middle market and establish themselves as challengers for large, multi-$100M procurements typically reserved for the industry’s largest incumbents.
As noted in the recent KippsDeSanto Marketview newsletter, the middle-market M&A environment has played a major part in the emergence of “alternative” transactions, which have comprised the bulk of acquisition activity in the past two years. We expect this trend to continue in the near term, as middle market firms continue to refine organizational strategy and acquire capabilities and expertise to help catalyze growth in the competitive F&O market.