Focusing On “Guiding Lights” In M&A Due Diligence to Drive Value Creation

By Mike Kotarski and the Team at Arena Strategic Advisors

M&A continues to play a critical role in the growth of businesses of all sizes in the government contracting industry, and the vast majority of current executives (and employees) have been involved in M&A in some fashion over the last 25 years. Yet, despite this collective experience, mergers and acquisitions remain filled with pitfalls, and there is, at times, surprisingly little consistency in how companies and investors assess potential M&A targets. For seasoned acquirers, often a false sense of security and/or confirmation bias takes hold. New buyers may not fully appreciate the underlying business complexity and specificity of certain markets and associated competitive dynamics. Coupled with lower cost debt, low tax rates, a large amount of private equity money waiting to be deployed, and investment bankers doing their best to portray companies in the most favorable light, it is easy for executives and investors to fall into the trap of pursuing acquisitions that fail to create meaningful value.

To make matters worse, there are new market dynamics that make today’s M&A a bit more challenging. Though activity has begun to resume after the COVID-induced hiatus that began in the spring, the M&A environment today is far different than in prior years. COVID-related impacts to 2020+ financial performance in many companies add new layers to already complicated financial forecasting. The upcoming presidential election adds meaningful uncertainty around mission and spending priorities. Beyond the politics, future discretionary federal budgets are likely to be impacted by the economic burden of COVID stimulus. In addition, for larger strategics and private equity firms, the reality is there is a decreasing supply of “traditional” M&A candidates with truly differentiated capabilities and limited reliance on Small Business Set-Aside (SBSA) contracts (more on that later).

And yet, despite these challenges, M&A still offers routes to market and growth options that are often impossible to accomplish organically. A rigorous due diligence process can bridge the gap between the risks and benefits of M&A and provide a buyer with an objective and unvarnished truth about a potential target to help inform strategy, financial performance expectations, and valuation. Of course, at times, rigorous due diligence is not congruous with winning a deal, particularly if there is an irrational or uninformed buyer willing to pay far more than a target is worth. The paradox of disciplined investing is that being better informed can sometimes be a disadvantage, but most deal teams we know will assume that risk.

Having worked with both strategic buyers and private equity investors, Arena has supported a wide range of perspectives and experience levels in M&A. Our team has been involved in buy-side due diligence support of more than 300 services and products companies since 1999. It has been an interesting vantage point, to say the least.

From a due diligence perspective, apart from early identification of obvious deal killers such as legal, tax issues, and/or fraud, the most successful acquirers employ a robust due diligence process focused on what we term “guiding lights” or key anchor points, questions, and analysis related to strategy, culture, and financial performance:

Does the acquisition target fit with the buyer’s strategy?

Are the cultural policies and norms of the target compatible with the buyer’s?
Does the financial forecast justify the price?

A rigorous due diligence process provides objective and unvarnished truth about a potential target to inform strategy, financial performance expectations, and valuation.

Fit with Acquisition Strategy

The best acquisitions are focused on customers, capabilities, contract access, and/or the combined ability to pursue upcoming new business opportunities. The due diligence process should carefully assess how well a target company aligns with a buyer’s objectives, answering key questions about strategic fit:

Do the target’s capabilities align with the buyer’s strategy and are those advertised capabilities real and differentiated? It seems nearly every company for sale today is a “cutting-edge, differentiated, Cyber, Cloud, C4ISR, AI, Space powerhouse…” A buyer must establish a detailed understanding of the actual capabilities of the target and go deeper than the latest buzz words.
Does the target have access to the necessary contract vehicles and relationships to achieve growth within its customer base(s)?
Successful acquisition strategies are forward looking; they do not assume past is prologue. Does the target have the recruiting, training, project management processes, certifications, IR&D, or other internal business engines necessary to remain a leader in the capability areas for which it is being acquired? If not, the buyer must understand the necessary investments and how the costs of those investments will impact both near and long- term revenue growth and profitability.
Assuming general strategic fit, does the target have any true “franchise” positions – i.e. deep domain expertise, technical differentiation, proprietary solutions, sole source positions, and/or significant market share in certain customers or in targeted capability areas?

Evaluating Culture – More Tactical Than You Might Think

For all companies, but especially for government services contractors, employees are the key to success. Company culture plays an important role in retaining the right people. Many executives contend that their companies’ cultures are intangible, unable to be described in detail, but critical to their success. In our experience, culture is less mysterious. It is the manifestation of company values, policies, and norms that have a direct impact on employee job satisfaction and performance for customers. A buyer should assess how its own culture differs from the target’s and how this may impact recruitment, retention, performance, customer and market perceptions, and ultimately long-term success.

At some companies, “values” are just marketing slogans, but at others they are a direct driver of the company’s success. If a company’s values play a key role in its culture and day-to-day performance, the buyer needs to be confident they will be able to maintain those values post acquisition. Legitimate values are not just high-minded ideals, they are specific and visible means by which a company executes work, interacts with customers and the community, and promotes and rewards employee performance. Such values can take years to root and mature but can be quickly eroded or even destroyed by a careless or arrogant acquirer.
Employee benefits are one of the most quantifiable outputs of a company’s culture. Salaries, bonuses, health benefits, and 401K contributions are fundamental to attracting and retaining talent. Importantly, if the target has significantly different compensation policies than the buyer, it may be difficult to integrate both entities without losing key talent. Constructing separate fringe pools or compensation plans is a possible solution but comes with added complexity and can alienate legacy employees.
Another key manifestation of culture is employee access to top leadership and how much impact employees feel they have over the direction of the company. Employees who are used to voicing concerns and participating in strategic decisions with the C-Suite in a smaller company often find it impossible to work in an environment where they have no interaction with top corporate leadership or where they feel their direct managers are not sufficiently advocating for their concerns.
The reputation and brand of both the buyer and the target will also impact cultural fit. A buyer should maintain a clear-eyed understanding of its own and the target’s reputations in the marketplace and how the employees and customers of both companies may react to the combination.
Assessment of cultural fit is more important than simply judging if a target’s culture is “good” or “bad.” The focus of due diligence should be to assess the differences between the buyer’s culture and that of the target. Significant differences may make integration difficult and lead to employee retention challenges.
That said, some underpinnings of company culture are inherently more difficult to overcome. Companies with mature and “cult- like” behavior may be harder to integrate than those with less cultural cohesion. Similarly, when target companies are owner-led or have only a handful of key leaders, an acquirer can be exposed to what we call the “Pied Piper” effect, where the departure of an executive can cause a significant number of other employees to follow.
When attempting to understand a target’s culture, a buyer must speak with middle management and the target’s human resources leadership. Relying on a C-suite executive who is trying to sell the business may not be enough to determine how a company’s day-to-day operations and on-the-ground leadership styles have shaped real and perceived cultural norms.

Detailed Revenue & Profit Analysis to Prove the Business Case

With valuations seemingly high, proving the financial case for a deal is critical. Even if strategy and culture are perfectly aligned, if the forecast cannot justify the price, value creation is unlikely. Determining realistic and achievable forecasts in government services businesses requires more than just run-rate sensitivities, Monte Carlo analysis, or similar processes that purport to be in-depth due diligence but fail to capture major risks, upside potential, and, most importantly, the most likely forecast for revenue and profit performance. There are several industry-specific elements to consider when forecasting existing contracts and a new business pipeline. Evaluating them as part of due diligence requires specialized market, customer, program, financial, and operational experience.

A detailed understanding of what is driving the forecast is critical, both in current contracts and for new business pursuits. Anyone with a red pen can reduce forecasts to get to a “Downside Case.” Isolating a mostly likely or “Base Case” and an achievable “Upside Case,” while creating convictions and defining variables for both, requires a more detailed understanding of market conditions, customer buying behavior, contracts, and often a multi- variate approach to forecasting.
Probability of Win (“p-win”) is often the foundation of forecast models for services contractors, but this expected value method often prioritizes simplicity at the expense of precision or even realism. The most basic objective of forecast due diligence is to determine how likely it is for the target to win recompetes and new business pursuits. Effective due diligence tests p-win assumptions from several different angles, assessing competitive position, prime versus subcontractor roles, incumbent performance, changing contracting dynamics, pricing sensitivities, key personnel, customer perceptions, and a host of other factors. Additionally, at times, some opportunities are so large that it makes more sense to view them as a binary win or loss rather than a statistical uncertainty that skews the forecast.
The rubber meets the road in profit forecasts. Do the forecasted increases in Gross Profit and EBITDA margins make sense, particularly when considering the target’s current and future mix of contract types (Cost Plus, Fixed Price or Time and Materials), the buying behaviors of their customers, and future competitive dynamics? Do assumptions about direct labor vs. subcontract labor and other direct costs (ODCs) support the gross profit forecast? Does the financial model accurately depict how wrap rates are applied to each contract? Do the forecasted Overhead and G&A costs reflect the necessary infrastructure and business development resources required to achieve the forecast and scale the business, or is the cost structure hollowed out to present the best possible margin profile as part of the sale?
Wrap rates and the indirect cost structure of a target are often afterthoughts in typical forecast models. Disaggregating Fringe, Overhead and General & Administrative expenses and understanding current and future wrap rate competitiveness are critical to establishing realistic revenue and profit forecasts in a services business. In addition, a buyer must pay careful attention to how the acquisition will impact the wrap rates of the combined entity. Often the cost structure and margin profile of a smaller business appear very attractive but would be uncompetitive or significantly less profitable when burdened with a larger company’s costs.
Smaller firms transitioning away from heavy reliance on small business set-aside contracts are often attractive targets, but the buyer must fully understand the target’s lingering exposure to SBSA awards. Small business contract exposure is not necessarily a deal killer for a larger acquirer, but the details do matter. The ability to retain SBSA work after an acquisition, as well as the ability to continue using SBSA contract vehicles, differs from contract to contract and across customers. Many targets assert their SBSA contracts are likely to be recompeted as unrestricted. This assertion needs to be carefully validated, keeping in mind customer preferences within the program office can often be overruled by other parties (contracting officials, small business officials). Importantly, the shift from SBSA to a full and open competitive environment, as well as the requirements to onboard subcontractors as the prime (at the expense of direct labor), almost always result in profit margin erosion.
Subcontracts to other prime contractors are often a material part of a target’s overall portfolio. Most subcontracts have contract clauses that require the prime contractor be notified in the event of a change of control. If the new buyer is competing directly with some of the prime contractors to which the target company is subcontracting, those primes may decide to end the relationship(s). Moreover, the prime contractor may be receiving small business subcontract credit which may no longer be possible if the target is acquired. It is critical to determine if, and to what extent, the target will be able to maintain roles as a subcontractor to the buyer, both immediately post close and longer-term.
Revenue Synergies are one of the leading justifications for M&A. While 1 plus 1 sometimes does equal 3, the underlying assumptions need to be carefully assessed. Are there specific upcoming opportunities the buyer and seller alone cannot bid, but for which together they would be competitive? Would the combined entity have a higher probability of success on upcoming opportunities in their respective pipelines? Are there real prospects to cross-sell capabilities into each other’s customers or on each other’s contract vehicles? The underlying thesis supporting expected revenue synergies needs to be clearly articulated and supported by specific business development pursuits. It is not enough to be notional or wave hands at the “story.”
Cost Synergies can often bridge the gap between the output of a stand-alone financial forecast and the required price to win the deal. These synergies can be real, but it is important they are built from a bottoms-up analysis, based on expected consolidation of functions and systems and with future combined wrap rates in mind. “Finger in the air” guesses of future cost savings rarely translate into actual value post close.

A Note About Integration

If an acquisition makes it through the due diligence process and the purchase agreement is signed, significant work remains to ensure the acquisition creates value. Careful and detailed integration is vital to manage the inevitable cultural and financial challenges and to achieve desired revenue and cost synergies. Importantly, a rigorous, cross-functional due diligence process should provide a buyer with a strong starting point for understanding a target’s operations, back office functions, employee base, and business systems, enabling more seamless integration planning.

Summary Takeaways

While due diligence is a very broad term that includes Legal, Accounting, Human Resources, Information Technology, and nearly all other business functions as part of the review of target, from our perspective the true “guiding lights” of due diligence are strategic fit, cultural compatibility and a detailed understanding of the revenue and profit forecast.

M&A is often a watershed event in corporate growth, and many of the leading companies in the government services market were built through numerous acquisitions. M&A comes with significant risks and uncertainties, but these can be mitigated by asking the right questions and thoroughly vetting potential acquisition targets.

This article was featured in the 2020 PSC Annual Conference Thought Leadership Compendium. See the full PDF version here.