Mergers, Acquisitions Not the Only Way to Foster Competition in Defense Industry

By Jerry McGinn

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The antitrust agencies responsible for reviewing proposed mergers and acquisitions to assess their impact on competition released their updated “Merger Guidelines” just before Christmas.

Not surprisingly, the guidelines reflect the current administration’s preference for increasingly stringent reviews across industries. Within the defense and broader government contracting market, this increased scrutiny has resulted in several contentious reviews and government suits to block proposed transactions involving numerous major defense firms.

Competition is the lifeblood of the defense industrial base. Some observers have regarded merger and acquisition activity as a consolidation of the defense industrial base that undermines competition and limits the government’s choices in acquisition. There is little empirical evidence to buttress this contention, however. In many cases, the activities help government contractors scale to enter new or larger markets, thereby increasing competition and decreasing costs to the government.

A better way to foster competition across the government contracting industrial base is to harness its inherent nature as a monopsony market — where there is only one buyer — and adopt practices that spur recurring competition across the industrial base.

Some degree of consolidation is a natural business outcome in any market segment, commercial or otherwise. Drawing on the heritage of the Sherman antitrust regime and today’s Hart-Scott-Rodino Act, the Federal Trade Commission and the Department of Justice rightly work to protect consumers and prevent consolidation that results in monopolistic behaviors.

The defense and broader government contracting markets, however, are substantially different than commercial markets because there is one “consumer” or buyer, specifically the U.S. government. As a monopsonist, the government substantially drives the government contracting market through its spending and buying practices.

That is key to understanding the current and potential future state of competition in the defense industrial base.

Consolidation in the defense industrial base is a condition that has been present since the initial post-Cold War flurry of mergers in the wake of former Deputy Secretary of Defense Bill Perry’s so-called “Last Supper” in 1993, where he urged consolidation.

As Under Secretary of Defense for Acquisition and Sustainment Bill LaPlante has frequently noted, dropping defense spending from roughly 6 percent to 3 percent of GDP during that period naturally led to a significant consolidation of the defense industrial base.

A famous chart showing 51 companies merging over time to become the five major primes in today’s marketplace: Lockheed Martin, Northrop Grumman, General Dynamics, Boeing and Raytheon — now called RTX — tells the heritage of those firms, but that is only part of the story. Since 2000, the overall shape of the industrial base has stayed remarkably consistent with five major primes, around 100 tier 1 and tier 2 mid- to large-sized firms that serve as primes or subcontractors on various programs, and thousands of small businesses.

Within that broad structure, mergers and acquisitions continue to be a major thrust of activity in the government contracting industry, greater than in most other industry verticals.

Some of this focus is driven by the heavily regulated nature of the federal space, which makes organic growth challenging. For example, because past performance is a critical evaluation factor in most government procurement competitions, companies often use acquisition as a major component of any growth strategy. By merging with a firm that has significant past performance in a different market, a company can expand into new market areas that would not otherwise be addressable.

Surprisingly, there is extremely little fact-based analysis about whether consolidation has meaningfully impacted competition over time. A 2018 National Bureau of Economic Research report, “The Impact of Industry Consolidation on Government Procurement,” is one of the few examinations of the impact of defense consolidation, and its findings did not support a definitive conclusion. Specifically, the report found that “concentration leads to an increase in the award of noncompetitive contracts.”

At the same time, the report also notes that they did not find “any evidence that [consolidation] increased total acquisition costs.” Even the 2022 Pentagon report, “State of Competition Within the Defense Industrial Base,” which called for heightened merger and acquisition reviews, acknowledged the lack of “a strong correlation between consolidation and increased program pricing.”

The Baroni Center at George Mason University recently examined the level of market concentration in the defense and broader government contracting industrial base using the Herfindahl-Hirschman index, or HHI, the standard used by the antitrust agencies when examining market segments. The report, “Effective Competition and Market Concentration Trends in the Department of Defense Contractor Base,” tracked with that of the National Bureau of Economic Research analysis. Specifically, the Defense Department’s effective competition rate and level of market concentration have been consistent over time and track closely with other federal agencies.

Looking at all contracts from fiscal years 2010 through 2019, the department’s HHI score was under 1,500, or moderately concentrated, for all but one year. In the top five product categories over the same period, four — info-tech and engineering, program management and other professional services — had scores around 500, or unconcentrated, and one — drugs and biological — was highly concentrated, with scores about 2,500.

Additional research is therefore necessary to make definitive conclusions about whether consolidation has had a positive, negative or negligible impact on competition in the industrial base. Fortunately, however, the monopsonist nature of the government contracting market means that the government agencies can directly shape the market by their buying practices.

The federal government buys products and services from approximately 200,000 firms. In the services area, there are many companies competing for prime and subcontract positions for major procurements of IT enterprise, professional and technical services. With low barriers to entry, companies regularly expand and contract their positions in services depending on their performance on various programs.

In product markets, however, the number of companies varies significantly because of higher barriers to entry and specialized products with few commercial uses. The Defense Department, which has the most product-focused programs, publishes its annual “Industrial Capabilities Report to Congress” that illustrates the competitive environment in markets such as aircraft, radars, ground vehicles and ships. Pentagon offices work to actively manage market segments through initiatives such as split buys, mitigative actions and even recommendations to deny certain transactions that can lead to monopoly positions such as the 2018 denial of the attempted merger of Ultra and Sparton in the sonobuoy market.

Solid rocket motors are a prime example of the dynamics at play in the defense market. They are predominantly defense-unique items used in missiles and rocket propellants. There have been two domestic providers of the technology for decades. With the retirement of the space shuttle and unpredictable episodic demand for missiles, these providers — Aerojet Rocketdyne and Orbital ATK — struggled at times, particularly Aerojet.

Northrop Grumman acquired Orbital ATK in 2018 and ultimately received approval from the FTC with a consent decree requiring Northrop Grumman to be a merchant supplier to all competitors for missile contracts. Lockheed Martin’s bid to acquire Aerojet Rocketdyne, however, was blocked by the FTC in early 2022. The company’s continued need for a buyer did not go away, though, and L3Harris’ bid to purchase it was approved by the commission in 2023. The bottom line for the rocket market was that there were two domestic providers before and after the mergers.

Interestingly, the solid rocket motors market situation has quickly changed as demand has increased significantly because of U.S. military support to Ukraine. The recently established U.S. subsidiary of Nammo, a Norway-based solid rocket motor and munitions provider, won a $97 million award in late 2021. Anduril, a software-focused, nontraditional defense contractor, also entered the rocket motor space by acquiring Adranos in mid-2023 as it seeks to grow and compete with larger defense primes by expanding its capabilities into new areas.

The incentive driving these firms’ entrance into the domestic rocket motor space is clearly the fact that market opportunities have increased.

As the solid rocket motor market illustrates, opportunities are what ultimately drive competition. While the Defense Department cannot control market forces, it can control how it buys. Since the 1990s, it has focused on maximizing efficiency and cost effectiveness in major programs. This has resulted in a tendency for decades-long franchise programs that maintain a single production line, but do not foster competition. Companies are in the business of making a profit, so they are not going to stay engaged in markets where they do not have a market position or there is not a foreseeable opportunity.

Fortunately though, recent department efforts are moving to create more market opportunities throughout the program lifecycle. This is a promising trend that needs to be reinforced wherever possible. There has been a dramatic increase, for example, in the amount of experimentation and prototyping opportunities through innovation-focused organizations such as the Defense Innovation Unit, AFWERX, NavalX and Army Futures Command. This has been facilitated by the expansion and expanded use of acquisition approaches such as Other Transactions Authority and Middle Tier of Acquisition. These strategies enable the department to work with innovative companies to rapidly prototype novel solutions, then advance successful ones to produce at scale.

In major programs, there has also been a greater focus on agile acquisition practices to help drive competition throughout the lifecycle of a program. Modular open systems approaches are becoming increasingly central to many of today’s major programs. These open architectures will enable greater opportunities for technology upgrades and the replacement of systems and components over time as opposed to closed-loop proprietary systems.

Merger and acquisition reviews are important regulatory tools to forestall monopolistic business combinations, but making them more stringent will not lead to more competition in government contracting markets.

To foster competition, federal agencies should harness the strength of their positions as monopsonists and vigorously pursue initiatives like those outlined above to help unlock new levels of competition across the defense and wider government contracting markets.

This will result in a more robust, resilient and effective industrial base to meet today and tomorrow’s national security challenges. ND

Jerry McGinn, Ph.D. is the executive director of the Greg and Camille Baroni Center for Government Contracting in George Mason University’s Costello College of Business and former acting deputy assistant secretary of defense for manufacturing and industrial base policy, where his responsibilities included reviews of mergers and acquisitions.

Topics: Acquisition, Defense Department

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