Defending M&A from the DOD
More than any other industry, federal regulators of defense sector deals can burst the bubble on a deal.
July 11, 2008
Prior to its agreement to sell to Finnmeccanica, the US-based defense company DRS Technologies was sought at a higher price by another bidder, it was reported after the American company struck a deal with its Italian acquirer.
Shareholders would take umbrage, no? Turning down a higher bid could amount to a rigged auction; should the New Jersey-based DRS anticipate SEC investigators at its door? Well, not in this case.
Thanks to very stringent oversight of the M&A process from the US Department of Defense and the US Department of Treasury’s Committee on Foreign Investment—aerospace and defense, more than any other industry, is poked, prodded and inspected by federal regulators—it is likely that the other bidder or bidders that DRS Technologies spurned prior to making a sale in June were deemed suspect enough by the seller to not pass a government smell test, multiple experts said. Indeed, making the sale to a trusted ally in Finnmeccanica—even though it is one-third owned by the Italian government—is better than having the M&A process pass a company by, should its move to take a higher bid be rejected, leaving DRS in the wake created by its gamble to sell to the highest bidder and what might be the Italian firm’s subsequent acquisition of a different competitor.
Italy, France and Israel are each on what one source described as “solid, but shaky ground” with American defense officials, meaning that they should be able to execute M&A, but that they should also expect scrutiny. It is better treatment than what most foreign acquirers should expect. Obviously, and especially in the post-9/11 era, there are some countries, many actually, with which American defense officials would never allow one of their contractors to work.
And in the current M&A environment—in 2007, seven of the 10 largest defense and aerospace deals were for US-based targets—the stakes are high for American government officials, not to mention the business’ sellers, to maintain a balance between regulation and security, with security taking priority over profitability. The $8.5 billion spent in 2007 by European organizations on defense plays represents four times what they collectively spent the prior year. Further, the 27 deals executed last year are a significant jump in deal volume compared to 2006, when just nine transactions took place, according to a report by defense and aerospace analytics firm Jane’s, a subsidiary of IHS Inc.
The sum of these factors is perhaps the most sensitive climate the US has ever had in turning a cautious eye toward foreign investment in the defense industry. Increased M&A combined with political volatility and backlash to foreign acquirers could flummox potential dealmakers coming into the US, even allow a more trusted ally to score a bargain.
Hector Cuellar, president of RSM EquiCo Capital Markets, an investment bank concentrating on mid-market firms, cited Middle Eastern DP World’s attempted acquisition of American ports in 2006 that was jeered into oblivion by American politicians as “a perfect example” of a collision of defense and M&A that failed to meet the sniff test.
The same leery attitudes to some foreign investors persists today. Reports abound of Dubai sovereign wealth funds pre-empting government regulators by rejecting potential investments before they are even put on the trial before the proverbial, and often verbose, jury of Washington DC politicians—never mind the real authorities, the regulators. Because these sovereign wealth funds are controlled by foreign governments, while most defense companies making US-based acquisitions from abroad are instead run in majority by stockholders, SWFs looking to make plays in the US economy are perhaps given harsher scrutiny thanks to their being attached directly to nations the US either might not trust, or just regards as unfriendly.
The UK, Canada and Australia are three nations that have, historically, had a generally painless process in dealing with American officials. The UK and US have been united on the fronts of two world wars; Canada is a neighbor with which the US shares a large border and has had longstanding goodwill.
Even then, nobody is guaranteed a free pass when it comes to guarding defense and intelligence.
The source cited the deal in which UK-based Cobham, a defense and aerospace firm, bought Sparta Inc., an American defense technology firm, as one that raised eyebrows at the Pentagon, which pushed regulators there to begin unrolling the red tape.
The $416 million deal “was delayed for months because the DOD scrutinized it,” the source said. Eventually, it was greenlighted, but the pains which a close US ally like Cobham endured to secure what was called a highly specialized intelligence company shows the level of scrutiny applied to every M&A process by defense specialists.
“The DOD gets to be a lot more sensitive” when a company like DRS, which produces technology for specific US defense systems applications, enters the M&A process, Cuellar said. Still, as the DRS-Finnmeccanica deal continues to see government scrutiny, it remains to be seen whether the company runs any highly specialized, clandestine programs that—while legal to keep from shareholders, due to high sensitivity—might imperil their sale to the Italian acquirer.
The level of a company’s involvement with its national government also might trigger stateside concern, the experts agreed.
Whereas Finnmeccanica is 34% owned by the Italian government, experts said that it would likely take a friendly nation to own a control stake in a defense company before a deal with a firm with a consistent history ran aground.
“I think, if you had a company that was 80% [owned by another government], some questions would be asked,” Cuellar said.
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