The headlines focus on inflation at a 40-year high and rising interest rates. While these headwinds are formidable, we believe deal activity in the GovCon market will remain stable.
During boom times, commercial company valuations can balloon to historic highs, only to come crashing down when the economy takes a turn for the worse. But the GovCon market is far steadier than other sectors of the economy. Valuations for GovCon companies are more dependent on contract vehicles (such as Best in Class, Indefinite Delivery, Indefinite Quantity Contracts); sector expertise (cybersecurity or health care IT); strength of backlog; client agencies; prime vs. subcontractor status; facility clearances; and other matters that are unique to the GovCon market and do not fluctuate dramatically based on external economic data.
Economic challenges will not change the fundamentals of the GovCon market: Entrepreneurs will continue to create new entities to serve the needs of the federal government. Regardless of rising interest rates, the government will still need facilities management for military bases, replacement parts for planes and missiles and products to modernize their IT. The founders of companies addressing these needs will at some point want to move on to their next chapter by transferring ownership of their healthy, viable businesses. Inflation and rising interest rates won’t change this.
And buyers will continue to be interested in acquiring these GovCon companies for two reasons:
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First, lower middle-market companies (private companies with $25 million to $150 million in revenue) are known to bring strong returns to acquirers. Regardless of the headwinds in the economy, the opportunity to accelerate growth by acquiring smaller privately held companies by investing capital and achieving operational efficiencies will continue. Lower middle-market companies are known to be attractive investments, and this will keep valuations attractive.
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Second, even with rising interest rates, there is a historic amount of capital available to invest in lower middle-market companies. Private equity firms are currently looking to deploy nearly $1 trillion in equity and are becoming more active in the GovCon market, either by providing capital to larger GovCon companies seeking acquisitions or by purchasing lower middle-market GovCon firms directly.
If you have built a good company and managed it well, you should remain optimistic about this year, even if the headlines have been grim. There is a tremendous amount of capital on the sidelines, and investors want to put it to work.
And since the lower middle-market is known to generate value for smart investors who are patiently investing in long-term growth, we expect the M&A environment for these GovCon companies to remain stable.