Leading up to the election
Contractors in the US government services space have always been hugely dependent on one key element: the federal budget. The state of the economy, stock market and interest rates have had their ups and downs, but we believe the true direction of which government services sector will flourish depends heavily on the spending priorities of both Congress and the President.
Going into 2020, many felt the strong M&A activity in the ADG sector we’d seen over the last several years would soon peak. However, deal flow appeared to show no signs of slowing down. Defense spending continued to rise as ongoing investments were made to recapitalize the US Department of Defense (DoD). These spending trends provided a favorable backdrop for several notable deals completed in 2020 YTD, including Raytheon’s merger with United Technologies, Leidos’ acquisition of Dynetics, ASGN’s acquisition of Blackstone Federal, and SAIC’s acquisition of Unisys Federal.
Despite the ongoing pandemic, one sub-sector that has seemingly held strong is ‘next generation digital services,’ such as AI, machine-learning, cloud computing, mobility and big data. Regardless of the administration, IT modernization — and with it, cyber security — remains a top priority for the US government, and Congress has not waivered on allocating sufficient funds to modernize technology foundations and increase efficiency. We anticipate a continued increase in tech-enabled M&A transactions in the government services space, and many more opportunities for government contractors and PE firms to invest in companies prioritizing next generation digital services.
A turn in taxes
As we approach the US Presidential and Congressional elections, a few topics are front of mind across the market. Namely, what the impact of tax reform will be on valuations and opportunities to divest, and if overall government budget and spending priorities between defense and civilian will alter M&A strategies.
Democratic candidate Joe Biden has laid out his plan for capital gains tax. Under his administration, he would recommend long-term capital gains and qualified dividends be taxed at the ordinary income-tax rate of 39.6% on those with incomes above $1 million. The success of implementing such legislation would be dependent on the political majority in Congress as well. But should all things go ahead as Biden suggests, capital gains tax in its current form could be coming to an end as soon as 2021. For some investors, that means either holding onto their investments longer than they might have otherwise done, or rushing to sell before any changes become effective.
The government services space has been relatively steady going into the second half of this year, but we can’t rule out a possible shift in deal activity should Democrats take the White House and Congress. In the days following the 2012 re-election of Barack Obama, many corporates, private equity and VC firms assumed tax increases were imminent as they faced the ‘fiscal cliff’ — the combination of expiring Bush-era tax cuts and automatic, across-the-board government spending cuts that were set to take effect at the end of the year. But by the end of 2013, the economic catastrophe many anticipated had been avoided; M&A was on the rise and the majority of investors were confident that an even more robust deal-making environment was on the horizon.
Today, we believe many have already hedged their bets and are moving ahead with investments as planned, with the federal elections and the uncertainty of government spending having little to no impact on their M&A strategy. Therefore, seasoned dealmakers who are quick to adapt to the reality of this economic climate and sector landscape could be well positioned to maximize value.
What’s next for the US government budget
The start of the New Year will mark a crossroads for the US politically, and possibly economically. Under a Democratic administration, the budget would likely move incrementally away from military spending and towards healthcare and education. That said, there is bipartisan consensus that funding key national security capabilities should continue. We believe that under a Biden administration, military spending, and subsequently deal flow for DoD-centric government services contractors, would remain flat or increase modestly over the next several years.
Conversely, we have a more bullish view on the Department of Defense’s spending should the Republicans maintain the White House and a Senate majority. We expect this scenario to drive continued M&A opportunities in the government services space as a larger portion of the budget is dedicated to advancing key technologies and modernizing the IT infrastructure and weapon platforms.
Beyond the uncertainty of the November election, there is concern in the sector that Covid-19-related stimulus spending could crowd out discretionary civilian and defense spending. The Congressional Budget Office (CBO) projects that the federal debt will be 101% of GDP at the end of fiscal year 2020 (up 22% from last year), increasing to 108% of GDP by 2021  if existing laws governing taxes and spending generally remained unchanged.
Both buyers and sellers should be mindful of these potential budget shifts and their impact on valuations. We believe scale alone is no longer a driver of premium valuations. With an abundance of capital in the market, private equity investors who are looking to drive consolidation and build attractive mid-size platforms, are likely to be a key driver behind M&A in the government services space in the coming months.
The US government services sector is facing some potential adjustments as a result of the upcoming federal elections and the impact of Covid-19 stimulus spending. However, we believe opportunities for M&A in certain subsectors — like next generation digital services, IT modernization & cyber security — are ripe for opportunities. We’re seeing financial and trade buyers in this space looking to align their portfolios to invest in the key areas of the government’s spend in the coming years. For sellers, we believe the strength of the current market, coupled with attractive contractual visibility, will leave companies well-positioned to monetize from this environment.
 What We're Hearing: Investor Feedback from the Launch, Morgan Stanley Research, September 2020
 CBO’s Current Projections of Output, Employment, and Interest Rates and a Preliminary Look at Federal Deficits for 2020 and 2021, Congressional Budget office, April 2020