Private Equity Fueling Growth of Defense Mergers
iStock illustrationIt was inevitable after pent-up pandemic demand drove mergers and acquisitions to record levels in 2021 that there would be a slowdown in 2022.
Still, mergers and acquisitions in the defense sector hit the second highest number of transactions ever in 2022, in large part because of growing private equity investment, according to a recent industry report.
There were 433 transactions in the aerospace, defense and government, or ADG, sector in 2022, according to market intelligence firm HigherGov’s report “Aerospace, Defense, and Government M&A Review.” While that was a 10 percent drop from 2021, the transaction volume continued an overall upward trend in transactions since 2018, the report said.
“If you took out COVID-19, I don’t know that  was really a decrease,” said Justin Siken, founder of HigherGov. The general trend is a growing demand for companies doing government business, he added.
And while the transaction volume dipped in 2022, aerospace, defense and government transactions beat the overall mergers and acquisitions market, which was down about 40 percent last year, he said.
“So, it’s definitely been much more resilient than the market as a whole,” he added.
There are several reasons for the resilience of these mergers and acquisitions, he said. One is the growth of global defense spending since Russia’s invasion of Ukraine.
Within ADG, transactions in the defense products and services sector jumped 12 percent, “driven by defense spending in the U.S. and Europe to counter expanding nation-state threats,” the report stated.
Space and cybersecurity have grown from niches into “major pillars of the sector and transaction volume,” the report said.
Another trend that continued in 2022 was a decreasing dollar value of mergers and acquisitions even as the number of transactions increased.
The dollar value of transactions peaked in 2015 at $197 billion. By comparison, the transaction volume in 2022 was $46 billion. And there were 10 transactions “with an enterprise value of greater than $1 billion” in 2022, down from 27 such transactions in 2021, according to the report.
Reasons for the decrease in value include rising interest rates — since larger transactions typically involve more debt financing — the pullback of the special purpose acquisition company, or SPAC, market and concerns raised by the Defense Department about the level of consolidation in the defense sector, the report stated.
The report noted that government opposition to Lockheed Martin’s attempted acquisition of Aerojet Rocketdyne, the Department of Justice’s unsuccessful effort to block Booz Allen Hamilton’s acquisition of EverWatch and Defense Department warnings about excessive consolidation have changed the “calculus of large M&A transactions.”
However, when it comes to smaller transactions, private equity is feasting. “Private equity has become a driving force in the ADG market after years of persistent growth and now accounts for 47 percent of transactions and 41 percent of deal value,” the report stated. Nearly 90 private equity firms completed transactions in the defense space in 2022, the report said.
Private equity firms are growing more comfortable with the defense sector and the nuances of Defense Department contracts and acquisitions timelines, Siken said.
“I think there’s just a greater recognition — despite the budgetary concerns on the defense side — these are five-year contracts,” he said.
In the commercial space, companies are facing budget cuts, and they don’t have multi-year contracts to help stabilize their businesses and make them appealing to acquire, he said.
“Here, you have people locked into five-year contracts. You have people that have been on defense platforms … that are decades old. And they’re pretty entrenched on there, and they’re one of two or three suppliers.”
Hence, private equity firms see those defense companies as having stable revenue streams, he said.
Plus, the private equity playbook makes sense in a defense sector where there are many small companies popping up, Siken said.
“One of the things [private equity firms] do is they buy a company … and they buy a bunch of smaller companies, and they try to get economies of scale,” he said. “They try to find sub-scales — companies that aren’t run very well — and run them better.”
A private equity firm will often buy four or five small companies and “roll them up,” he added.
Private equity firms have also become more aggressive in trying to grab companies earlier in their life cycles, he said.
“If you have a unique technology, people are so worried that someone else is going to get it before they do that they’re willing to go earlier and earlier in the corporate lifecycle,” he noted.
Plus, because of the nature of private equity where a fund doesn’t make money until it deploys its assets, “you are heavily incentivized to deploy your money as quickly as possible, because it just gives you more time to own that company in your portfolio,” Siken said.
Another reason for the increase in private equity investment is that firms have grown comfortable with the risk factors of the business. They recognize the “lottery ticket” nature of defense companies competing for a large contract and look for ways to reduce investment risk. One way is simply to buy more companies, thereby holding more lottery tickets, he said.
It is common now to see private equity firms buy a company that is competing for a Defense Department contract, Siken said.
“They will go out, they will make a couple of those small add-on transactions to try to increase their chances,” he said. “They will go and say, ‘Okay, here’s the capability my competitors have on this program that I don’t have,’ and so they will go out and they will buy those capabilities” to present a more complete solution.
Furthermore, the fact that cyber, space and other commercial technology companies are now selling to the Defense Department and government gives private equity firms that avoided makers of kinetic weapons an opportunity to enter the defense sector with less reputational risk, the report noted.
While many private equity firms are new to the aerospace, defense and government world, others like Veritas Capital, Sagewind and Spark Capital have been in the sector for a long time, Siken said.
“A lot of the time what they are buying, it might be a carve out or something that’s not focused on defense and doesn’t know how to run defense,” he said. There are a lot of small companies that are not run well that could benefit from the professional management private equity can provide, he said.
“I think the private equity playbook has changed a lot over the last 10 to 20 years,” he continued. “Whereas it used to sort of be — and I think they still have a little bit of the stereotype of — we come in and we slash a bunch of jobs and we shut down competition and all those sorts of things.”
That’s no longer the approach, he said. “They’re very much more about building franchise value and having companies be professionally run and adding value in those ways.”
Even so, the volume of transactions and the ongoing consolidation is raising concerns in the Defense Department, which last year released a report “State of Competition in the Defense Industrial Base.”
The report stated that in the 1990s, “the number of aerospace and defense prime contractors shrank from 51 to 5.”
“The trend toward consolidation has continued in the last five years, due to vertical and horizontal integrations and the entry of private equity firms performing roll-ups,” the report stated. As a result, the department is monitoring potential transactions and making recommendations to antitrust agencies.
The Biden administration is taking a stronger look across the board at acquisitions and consolidation than the previous administration did, Siken said. “I think the DoD in particular is getting concerned about just the number of cases where they have one customer — that one company that can do something — or there’s two companies that can do something and if they merge, there’s only one company that can do something.”
In the past, Defense Department concerns have focused on the consolidation of product makers, ending up with only one supplier of a component, he said.
“I think there’s also concern that the defense services base has gotten maybe too consolidated, or there aren’t enough people with the specialized skills to do some of these sort of niche things that are needed for things like hypersonics or robotics,” he said.
“There’s just a limited number of people who can do the services in that space to not just make the hardware,” he continued. “When you thought about antitrust or competition concerns in the DoD, it was really a product thing. I think now it’s a product and service concern.”
According to an email from a Defense Department spokesperson, the department has identified five critical focus areas where consolidation is of concern: “castings and forgings, missiles and munitions, energy storage and batteries, strategic and critical materials and microelectronics.”
The department’s 2022 competition report included five recommendations for spurring competition in the defense base: strengthening merger oversight; addressing intellectual property limitations; increasing new entrants; increasing opportunities for small businesses; and implementing sector-specific supply chain resiliency plans.
“The department will confront the challenges posed by industry consolidation and work to ensure sufficient domestic capacity and capability,” the spokesperson said.
Siken said that there are private equity companies that are conscious of the impact of mergers on the defense base and national security.
“I think people legitimately — the investors in this space and the buyers in this space — as much as they want to make money, I think they do also want the defense base to be strong,” he said. “I think that people are thinking about that when they’re making acquisitions, both how it will be perceived and just, honestly, is this good or bad for the country on some level?”