April 2014 M&A Market Update: Use of Debt by Government Contractors

ACP Market Update
May 19, 2014

Executives and business owners of government contractors are constantly evaluating new opportunities that can grow their business and add value to shareholders. To finance these opportunities, business owners have two primary funding options: equity or debt. Each option has different characteristics and a unique impact on the Company’s earnings, taxes, and financial strength. Equity capital is typically a more time consuming and expensive source of funding for smaller private companies. Debt capital is generally the optimal source of funding for future expansion. Debt is a quicker and less expensive option, provides significant tax advantages, and allows shareholders to maintain their ownership levels.

There are two main types of debt: senior debt and mezzanine. Senior debt is the less expensive and more common form of borrowing. Most senior debt lenders expect a company to have the debt collateralized by assets; therefore, a company’s balance sheet capacity typically determines the funding level they can raise. Sometimes, a private company’s balance sheet cannot support the level of debt needed to fund their capital needs, which may lead a borrower to explore other options in the debt market. Another option is mezzanine debt (also known as subordinate debt) which is typically not fully secured by a company’s assets. Mezzanine debt is subordinate to senior debt in its claim to company assets in the event of bankruptcy; as such, it carries a higher interest rate than senior debt and may include some form of warrants or stocks. Mezzanine debt is most frequently used to finance acquisitions and recapitalizations.

Having a reasonable amount of debt will help enhance shareholder return. Given the current interest rate environment, firms are more incentivized to use debt in their financing activities. Most firms can lower their cost of capital or fund investments through debt until they reach an optimal capital structure. While there is no magic number when it comes to the optimal amount of debt on a company’s balance sheet, the industry as a whole seems to be under-leveraged. The exhibit below shows the trend of leverage across public government contracting companies over the last five years.

Tier 1

Tier 1 contractors on average have recently maintained a steady level of debt. Mid-tier contractors have taken a different approach and have increased their debt ratios over the last two years. Mid-Tier firms continue to express interest in expanding their M&A programs, and given the low interest rate environment, some are optimizing their .. Continue reading this article HERE, as well as the additional topics in Aronson Capital Partners’ April Market Update:

1. International M&A Environment
2. Selected M&A Transactions
3. Government Services Industry Performance
4. Public Company Comparables
5. Recent Industry M&A Transactions – Last 12 Months
6. Representative ACP Transactions