Guest Article: Due Diligence

The aerospace, defense and government services sectors have been an area of significant investment for middle market investors for decades. In the past eight quarters (Q4 2010-Q3 2012), more than 500 transactions have been announced: 177 in commercial aerospace, 148 in defense, and 212 in government services.

These sectors now face divergent trends that create both risk and opportunity. Demand for commercial aircraft is growing significantly, while budgets for defense and civil agencies face political uncertainty and decline. This creates real challenges for M&A, as many target companies are active across multiple segments - leaving middle market buyers with questions regarding near-term and long-term prospects for growth.

This uncertainty can be addressed through a systematic approach to strategic due diligence. Buyers need to evaluate macro market dynamics, competitive pricing pressures, contract positions, supplier relations, political and budgetary factors, regulatory issues, and ultimately company-specific concerns which affect both the tactical chances for a successful transaction and the strategic, long-term prospects for a compelling return on investment. At the core of this analysis is the evaluation of management's forecast. The central analytical tool and the key output of a proper strategic diligence effort is a transparent, bounded, high-fidelity forecast of the expected financial performance of the target, integrating all of the factors noted above. The strategic diligence forecast establishes a basis for both transaction valuation and post-acquisition strategic planning.

Start With The Forecast: The Basis For Sound Diligence

The financial models offered by target companies are often provided with two key objectives in mind - utilization of existing internal reporting systems (which may or may not offer any strategic insights) and presentation of future financial projections in a manner favorable to the seller. A more thorough understanding of the target's historical and forecast financial performance can be achieved by disassembling, evaluating, reorganizing and reassembling the financial model in a strategic manner. A successful strategic diligence model will establish a clear view of financial trends at the customer, contract, product, program, platform and market sub-segment levels. It will clarify and quantify the relative risk or certainty of expected revenues (funded backlog, unfunded backlog, follow-on work, new business) across each of these same dimensions. This process requires iteration with the target's management team and transaction advisers, who can offer additional details and clarification necessary to reshape the model in support of a more comprehensive and thorough strategic diligence effort.

The trends observed through the strategic diligence model allow for discrete comparison of future expectations with past performance along those same parameters. Key questions to be addressed across all sectors include the following:

* Are projections in line with broad market trends at the segment level (aerospace, defense, government services)? If not, what is the basis for above-market growth? Share gain within a static or declining market? Favorable positioning for relatively faster growing niche market opportunities?

* For existing contracts and long-term agreements, what are the duration, total funded value, unfunded value, sales to date, and volume and pricing terms? What are the prospects for the target at contract recompete, given anticipated competition and evolving customer requirements?

* For new business opportunities, what is the exact nature of the pursuits? Are target customers new or existing? Similarly, are the products, services or capabilities on offer new or existing? What additional investment in business development, R&D, or capex is required to compete? What is the target's track record for new business generation?

* For companies with distinct program, system, or platform-specific roles, what is the demand outlook for each of these served programs or platforms? How might that demand change as customer requirements evolve, particularly in the defense market?

* For companies that serve platforms or programs where ship set value (revenue per platform) is of relevance, what are those values today? How have ship set values changed historically, and how are they projected to change in the future? What are the barriers and risks to ship set value growth?

* What are current gross margins at the product, program, platform and customer level? How do those margins compare with the company's historical performance and projected market trends?

* How strong are the target's customer relationships? These relationships - and their impact on specific line-items in the strategic diligence model - must be validated through discussions at a very strategic, sophisticated level.

Sector-Specific Issues And Concerns

Key questions also arise at the market segment level. For commercial aerospace companies (or portions of the forecast serving the commercial aviation market), the following factors bear consideration:

* Value chain position - strengths and vulnerabilities versus customers, peers, and suppliers

* Aftermarket positioning - exposure to favorable, sustained aftermarket demand - and visibility to know with accuracy whether orders are supporting OE production or aftermarket/MRO requirements

* Regulatory factors - creating barriers to entry, but also increasing costs

* Performance history - what is the company's record of cost, quality and schedule conformance

* Learning curve - past performance and projected cost trends for new products, programs, and technologies

* Pricing power - particularly the impact of existing LTAs on price trends, and pricing potential for aftermarket components or products which represent a low percentage of total system cost

For defense companies (or portions of the forecast serving the defense market), other questions apply:

* Market - fit with evolving priorities and exposure to optempo and supplemental funding

* Impact of changing acquisition paradigms - especially "low price technically acceptable"

* Political factors - noting influence and issues for relevant members of Congress

* Small business and 8(a)/disadvantaged status - impact on the forecast, in particular where this status will change following the transaction (also a key consideration for government services companies)

For government services companies (or portions of the forecast serving the government services market):

* Overhead - management of G&A expenses and associated rate structures

* IDIQ contracts - positioning on Indefinite Quantity/Indefinite Delivery contracts, notably task order win rate

* Sub-segments - differentiated capabilities in relatively faster-growing market sub-segments

* Cost-plus contract milestones - can be a significant driver of payments critical to achieving the forecast

Conclusion

The strategic diligence process is one of discovery, wherein critical risks and opportunities are uncovered as the effort proceeds. Issues must be identified, prioritized and resolved within the aggressive timelines mandated by the deal process. A strategic diligence forecast resides at the core of this process and is an essential element in establishing a sound, rigorously validated view of projected financial performance. Middle market investors are certain to find significant returns in the aerospace, defense and government services markets in the coming years - as long as investment decisions are grounded in the clear understanding that strategic due diligence provides.