government contracting industry marketplace outlook...• obtain an adequate proposal (e.g., within...

BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms.

Government Contracting Industry

Marketplace Outlook

March 12, 2014

Agenda

Legal Update – Hilary Cairnie, Partner, BakerHostetler LLP

DCAA/Regulatory Update – Eric Sobota, Partner, BDO

USA, LLP M&A/ Economic Outlook – Gregory Nossaman, Managing

Director, The McLean Group, LLC

Legal Update

Hilary Cairnie, Partner

3

Emerging Enforcement Trends: Small Business Affiliation

• GTSI Corp. – Settled with SBA, Oct. 19, 2010 (large business uses small businesses as cover to win set asides; Suspended with conditions)

• MicroTech – Settled with SBA, Jan. 27, 2014 (CEO gives false statements about affiliations with other firms; Suspended with conditions)

• Protection Strategies, Inc. (“PSI”)/Security Assistance Corp. (“SAC”) – E.D. Va., guilty plea Mar. 18, 2013 (contractor uses figurehead minority female CEOs to win 8(a) contracts which it then performs using shell corporation)

• United States v. White – Sentenced to prison/fined, S.D.N.Y. Oct. 2, 2012) (contractor falsifying veteran status to receive small business contracts)

• Agility Defense & Government Services v. U.S. Dept. of Defense – 11th Cir. Dec. 31, 2013 (suspensions of two affiliates of an indicted contractor upheld)

4

Debarment Risk Factor

• Increased scrutiny by agencies and rivals

• Generally smaller businesses are at higher risk for suspension and debarment than larger businesses

• But larger companies are still at risk (e.g. Micro Technologies, GTSI Corp, etc.)

5

Labor Violations – Large and Small Businesses

• Risk of suspension and debarment for a wide variety of general and contractor-specific labor laws

• December 2013 Senate report recommended increased suspension and debarment for companies that violate labor law

6

Small Business Certifications: SDVOSB

• Veterans Affairs is aggressive in referring companies for debarment

• Increased risk for companies that mistakenly represent themselves as veteran-owned

7

Related Companies – Risks of Affiliation

• Contractors at risk for suspension or debarment of affiliated companies – E.g. Agility Defense & Government Services

v. U.S. Dept. of Defense

• May apply to affiliates regardless of whether they were involved in wrongdoing

8

DCAA/Regulatory Updates

March 12, 2014

Eric Sobota, Partner Joseph McCaffrey, Senior Manager

Areas of Discussion

DCAA Audit Alerts & Recent Guidance Final, Interim, and Proposed FAR & DFARS

Regulations GAO Bid Protest Report

OMB Circulars Reform

DCAA Memo – Overdue Contractor Final Indirect Rate Proposals

February 3, 2014 - memo on overdue final indirect rate proposals, and plans for obtaining timely proposals.

Backlog is comprised of fiscal years ending in 2011 or earlier, for which DCAA has not received a final indirect rate proposal.

DCAA’s understanding is that DCMA plans to either: • Obtain an adequate proposal (e.g., within 30 days), or • Unilaterally establish contract costs as authorized in FAR 42.703-2(c)(1) and

FAR 42.705(c)(1).

In 2014, DCAA plans to: Provide an update of the delinquent proposals Add to the list of fiscal years for which a contractor has submitted a proposal that

lacks quality to audit

Annually in January, DCAA will provide DCMA with a list of all fiscal years which a proposal is overdue by more than six months (includes FY which proposals cannot be audited due to quality)

DCAA Audit Guidance – Revised Policies & Procedures for Low-Risk Incurred Cost Proposals Less than $250M in ADV

October 29, 2013 DCAA memo to revise policies and procedures for sampling low-risk incurred cost proposals previously established in MRD 12-PPD-023(R), dated September 6, 2012.

Changed prior year questioned cost threshold to:

**Auditable Dollar Volume (ADV)

DCAA Audit Guidance – Revised Policies & Procedures for Low-Risk Incurred Cost Proposals Less than $250M in ADV (cont.)

Proposals with less than $5M or $5M to $250M in ADV and no significant

costs questioned in last ICS audit should be considered low-risk; unless… • Significant relevant risk material to the incurred cost proposal exists • “Unacceptable” opinion from a pre-award accounting review or reported business

system deficiencies relevant to the incurred cost proposal ($5 to $250M only), • No previous experience (e.g., voucher processing, forward pricing effort, pre-award

accounting systems, etc.) (<$5M only), or • Specific relevant risk with the contractor that has material impact to the incurred

cost proposal (identified by the contracting officer or auditor).

There will be no sampling for low-risk proposals with ADV <$1M.

DCAA Audit Alert on Professional Consultant Services Costs (FAR 31.205-33) and Purchased Labor

Consultant Service Costs: December 19, 2013, DCAA issued an audit alert to emphasize audit

guidance on the evidence necessary to satisfy the FAR 31.205-33(f) documentation requirements for professional and consultant services.

FAR 31.205-33(f) contains three documentation requirements to ensure

that professional and consultant service costs can be determined allowable: • An agreement that explains what the consultant will be doing for the contractor; • A copy of the bill/invoice for the actual services rendered, including sufficient

evidence for time and nature of the services; • Consultant work product, related documents, or an explanation of what the

consultant accomplished for the fees paid o This could be information on the invoice, a drawing, a power point presentation, or some

other evidence of the service provided.

DCAA Audit Alert on Professional Consultant Services Costs (FAR 31.205-33) and Purchased Labor (cont.)

Purchased Labor: An agreement that explains what the consultant will be doing for the

contractor will suffice.

Contractor should have adequate documentation to: • Support the reasonableness of amounts paid, • Demonstrate the person who provided the service, • Represented allowable activities.

Auditors will likely question the costs, if: • Payment was not reasonable for the services performed (FAR 31.201-3) • Contractor made payment without adequate support that the person provided the

service (FAR 31.201-2d).

Regulatory Updates New FAR Rules

FAR Case Title Synopsis Rule Type

2010-010 Service Contracts Reporting Requirements

This rule amends the FAR by requiring service contractors for executive agencies, except where DoD has fully funded the contract or order, to submit information annually in support of agency-level inventories for service contracts. FAR 4.1703 establishes service contractor reporting requirements based on type of contract and dollar. Reporting required on all cost reimbursable, T&M, and labor-hour contracts and orders above the simplified acquisition threshold (SAT). Phased thresholds for FFP contracts, starting at $2.5M in 2014 to $500,000 in 2016 Required to report: Contract number, dollar amount invoiced & direct labor hours expended. Data also required for first tier subcontractors.

Final

Effective Date: January 30, 2014

Regulatory Updates New FAR Rules


2012-031 Accelerated Payments to Small Business Subcontractors

Requires the prime contractor, upon receipt of accelerated payment from the Government, to make accelerated payments to small business subcontractors subsequent to the receipt of a suitable invoice and associated sufficient supporting documentation from the subcontractor. This rule will be inserted into all new solicitations issued after the effective date of this rule and resultant contracts.

Final

Effective Date: December 26, 2013

Regulatory Updates New DFARS Rules


2012-D038 Unallowable Fringe Benefits Costs

This rule adds paragraph 231.205-6(m)(1) to explicitly state that fringe benefit costs that are contrary to law, employer-employee agreement, or an established policy of the contractor are unallowable. These existing policies make fringe benefit costs expressly unallowable when such costs are unreasonable or conflict with law, employer-employee agreements, or an established policy of the contractor. Penalties may be assessed if unallowable dependent healthcare costs are contained in a final indirect cost rate proposal, a final statement of costs incurred, or estimated to be incurred under a fixed-priced incentive contract.

Final

Effective Date: December 6, 2013

Regulatory Updates New DFARS Rules


2011-D039 Safeguarding Unclassified Controlled Technical Information

DoD issued a final rule amending the DFARS to include a new subpart and associated contract clause addressing the requirements for safeguarding unclassified controlled technical information. Controlled technical information is defined as technical data, computer software, and other technical information covered by DoD Directive 5230.24, Distribution Statements on Technical Documents. The goal is to prohibit unauthorized access and disclosure, and to prescribe reporting to DoD with regard to certain cyber intrusion events that compromise DoD information resident on or transiting through the contractor’s unclassified information systems.

Final

Effective Date: November 18, 2013

Regulatory Updates Interim DFARS Rules


2013-D016 Limitation on Use of Cost-Reimbursement Line Items; effective January 29, 2014

NDAA Section 811(a) requires DoD to modify the acquisition regulations to prohibit DoD from entering into cost type contracts for the production of major defense acquisition programs for contracts entered into on or after October 1, 2014, with one exception in section 811(b). Under section 811(b), the Under Secretary of Defense for Acquisition, Technology, and Logistics may submit to the congressional defense committees: (1) A written certification that the particular cost-type contract is needed to provide a required capability in a timely, cost effective manner; and (2) An explanation of the steps taken to ensure that the use of cost-type pricing is limited to only those line items or portions of the contact where such pricing is needed to achieve the purpose of the exception.

Interim

Comments should be submitted on or before March 31, 2014

Regulatory Updates Proposed DFARS Rules


2013-D029 Payment in Local Currency (Afghanistan)

DoD proposed to amend DFARS 212.301 and 232.72 on the use of a new solicitation provision at 252.232–7XXX, Notification of Payment in Local Currency (Afghanistan), concerning payment for contracts for performance in Afghanistan. This provision provides notification that the payment currency to be used for contracts for performance in Afghanistan shall be dependent on the nationality of the vendor. The solicitation provision, 252.232– 7XXX, provides that if the contract is awarded to a host nation vendor (Afghan), the contractor will receive payment in Afghani (local currency) via electronic funds transfer to a local (Afghan) banking institution. Contracts shall not be awarded to host nation vendors (Afghans) who do not bank locally. If awarded to other than a host nation vendor, the contract will be awarded in U.S. dollars.

Proposed

Comments should be submitted on or before March 31, 2014

GAO Bid Protest Report

Annual Report to Congress for Fiscal Year 2013; • Lists federal agencies that did not fully implement a recommendation made in

connection with a bid protest decided the prior fiscal year • Contains statistics covering overall bid protest filings for the fiscal year.

New requirement in 2013 requires GAO to report on the most prevalent

grounds for sustaining protests. Report states they were: • Failure on the part of federal agencies to follow their stated bid or proposal

evaluation criteria; • Inadequate documentation of the record; • Unequal treatment of offerors; and • Unreasonable price or cost evaluation.

In 2013, GAO received 2,429 cases, including 2,298 protests, 56 cost claims,

and 75 requests for reconsideration;

GAO Bid Protest Report

Bid Protest Data Comparison for FY 2009 through 2013

FY 2013 FY 2012 FY 2011 FY 2010 FY 2009Cases Filed 2,429 2,475 2,353 2,299 1,989Cases Closed 2,538 2,495 2,292 2,226 1,920Merit (Sustain and Deny) Decisions 509 570 417 441 315Number of Sustains 87 106 67 82 57Sustain Rate 17% 18.6% 16% 19% 18%Effectiveness Rate 43% 42% 42% 42% 45%Alternative Dispute Resolution (ADR) 145 106 140 159 149ADR Success Rate 86% 80% 82% 80% 93%Hearings 3.36%

(31 cases)6.17%

(56 cases)8%

(46 cases)10%

(61 cases)12%

(65 cases)

OMB Reform Guidance – “Supercircular”

OMB issued Uniform Administrative Requirements, Cost Principles, and

Administrative Requirements for Federal Awards on December 26, 2013

Changes and consolidations include:

• Provides a single resource for requirements that apply to all recipients • Includes new measures designed to ensure merit-based grant awards and identify

problems early in the process • Introduces more formal requirements for certification of compliance and disclosure of

noncompliant or criminal acts • Attempts to streamline and standardize the cost principles in many ways, including

new options for the recovery of indirect costs

Spring Government Contracting Marketplace Outlook

March 12, 2014

Gregory A. Nossaman, Managing Director

After a 10-year period of growth and positive market dynamics, the federal contracting environment was significantly impacted in late 2012 through 2013 by rapidly changing market forces

The past 18 months have been characterized by budget uncertainty, heighted pressure on margins, longer procurement cycles, and increased competition

Current Market Dynamics Market Backdrop

26

2013 Market Challenges

Budget uncertainty and shifting federal priorities created a difficult planning environment for middle market companies and large primes

Impact and looming threat of government shutdown

Delays within program offices for new business and recompetes slowed organic growth

Many programs and contracts decreased or cancelled outright

Fierce competition and the Government’s focus on LPTA procurements squeezed margins and caused large primes to chase smaller contracts that were historically below their size thresholds

Resulted in Decreased

M&A Interest and Activity

as Many Buyers Became

Inward Focused

Source: OMB

Current Market Dynamics Graphic Representations – Federal Discretionary Spending Authority

27

Market Evolution

$0.0 B

$200.0 B

$400.0 B

$600.0 B

$800.0 B

$1,000.0 B

$1,200.0 B

$1,400.0 B

$1,600.0 B

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

DoD Civilian

Golden Era 1997 – 2008 CAGR of 8%

2009 Impacted by Relief Spending

Market Headwinds 2010 - 2012 CAGR of -3%

The budget environment for 2013 was characterized by confusion and lack of clarity

– In FY13 alone agencies had to contend with four different spending levels and plans

– This tumult resulted in unprecedented contract delays, program disruptions, and even cash shortfalls

PSC, OMB

Current Market Dynamics Uncertainty Paralysis - Budget Chaos in 2012 and 2013

28

FY13 Budget Swings BCA Projected Discretionary Spending Limits

$1,224 B $1,157 B

$1,301 B

$0.0 B

$200.0 B

$400.0 B

$600.0 B

$800.0 B

$1,000.0 B

$1,200.0 B

$1,400.0 B

FY13 CR - ATRA 3/1/13Sequestration

FY13 CR - HR933

Defense Civilian

$600 B

$700 B

$800 B

$900 B

$1,000 B

$1,100 B

$1,200 B

$1,300 B

2013BCALimit

2014 2015 2016 2017 2018 2019 2020 2021

Clarity finally restored through the budget agreement reached in December 2013

– Reduces the impact of sequestration, increasing 2014 discretionary spending from $967 billion to $1.012 trillion – providing $63 billion in sequester relief

– Provides for 2015 discretionary spending to grow by a nominal level

Additionally the budget agreement allows for targeted reductions to spending rather than across the board cuts as well as spending on new projects and initiatives

Discretionary budget authority levels are adjusted for inflation and exclude OCO / War, Disaster, Program Integrity, and Emergency Funding Source: Congressional Research Service, “Trends in Discretionary Spending,” February18, 2014

Current Market Dynamics Sequestration & the Bipartisan Budget Agreement

29

Discretionary Budget - Replacing Sequester

$1,091B

$1,050B $1,043B

$988B $968B

$1,012B $995B

$1,014B

$800B

$850B

$900B

$950B

$1,000B

$1,050B

$1,100B

$1,150B

FY10 FY11 FY12 FY13 FY14Sequester

FY14 Current FY15Sequester

FY15 Current

The budget uncertainty of 2012 and 2013 drastically impacted the growth profiles of companies in the sector

– Public government services companies on average saw growth of 12% in 2009 and 7% in 2010 drop to -6% in 2012 and -2% in 2013

– Industry analysts estimate that up to 66% of all privately held government services companies experience a decline in revenue in 2013

Industry growth was directly impacted by an 11% reduction in contract spending across the federal government

Government Services Index consists of the following: BAH, CACI, DRCO, EGL, ICFI, MANT, NCIT, SAI, VSEC Large Diversified Primes Index consists of the following: BA, GD, HON, LLL, LMT, NOC, RTN, UTX

Source: S&P Capital IQ, USA Spending

Current Market Dynamics Impact to Growth

30

Average Public Company Growth Federal Contract Spending

23%

12%

7%

2%

-6%

-2%

17% 15%

11%

6%

-6%

-2%

2008 2009 2010 2011 2012 2013

Government Services Index Large Diversified Primes Index

$250 B

$300 B

$350 B

$400 B

$450 B

$500 B

$550 B

$600 B

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

10-Year CAGR = 4%

2013 Annual Decline = 11%

M&A activity decreased in 2013 as many buyers reassessed strategy

Since 2010, activity among public buyers has declined while private equity and privately held strategics have become more active

– Privately held companies and financial buyers now account for over 70% of total deal activity in the sector, more than twice the level of just three years ago

Source: S&P CapitalIQ, DACIS, Washington Technology, TMG Research

Current Market Dynamics Impact to M&A

31

Defense and Gov. Services Transaction Activity M&A Transactions by Buyer Type

70

102

134

72 70

93 92 87

65

0

20

40

60

80

100

120

140

160

2005 2006 2007 2008 2009 2010 2011 2012 2013

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2005 2006 2007 2008 2009 2010 2011 2012 2013

Public Company Private Company PEG

Buyer activity and confidence has already shown signs of significant improvement in 2014

– The first two months of 2014 has seen more closed transaction than the same period in 2013

Current Market Dynamics Defense Technology and Government Services M&A Activity

32

2014 Market Drivers

Budget agreement reached, providing clarity in spending and program priorities

Pipeline of contract opportunities being released across the government

Reduction in the severity of sequestration

Buyers emerging from past 12 months with new acquisition strategies

Public company valuations have rebounded and stabilized

Capital remains readily available

Driving Increased M&A

Interest and Activity

Jan – Feb Transactions

• Transaction activity up over 40% YTD 2014 compared to 2013

• Public buyers reemerging – over half of YTD transactions consummated by public companies

This environment has altered acquisition strategies for most buyers

– Capital remains readily available (both cash on hand and leverage multiples)

– Buyers today are focused on acquiring highly differentiated businesses that provide key contract vehicles, access to new agencies, capabilities, and/or unique technology and IP

Current Market Dynamics Evolving M&A Preferences

33

Scale

Robust infrastructure

Diversification

Capabilities

Commoditized services

Key contracts / IDIQ vehicles

Minimal post – closing synergies

Stand – alone growth opportunities

Strategic positioning

Focus (on growth areas)

Solutions

Technology / IP

Highly differentiated services / capabilities

Prime contracts

Depth (franchise positioning)

Key contracts / IDIQ vehicles

Synergistic growth opportunities

Evolving M&A Preferences

Activity driven by access to select markets:

Cyber

Big Data

Healthcare IT

Intelligence Community

Prior to 2012 2012 - 2013 Today

Current Market Dynamics Summary of Industry Value Drivers

34

High Neutral Low

● ◑ ○ Threshold Value Drivers

Contract Award Basis Not a concern 20% or less 20% or more SB exposure

DL vs Sub > 90% Direct Labor 75% to 90% <75% Direct Labor

Prime vs. Sub >75% Prime 50% to 75% <50% Prime

% of OCI No concern 15% or less >15%

Growth 20% or higher 5% to 20% <5%

Margin 12% or higher 8% to 12% <8%

Strength of Infrastructure Best in class Solid, but may need upgrades Needs major upgrades

Revenue Visibility Strong backlog and long-term contracts

Good backlog; a few near-term recompetes

Low backlog; several near-term recompetes

Management Depth and Quality Very strong; long tenures Good management team Lacking in leadership

Synergistic Value Drivers

Mission-Focused >50% 25% to 50% Non-mission focus

Strategic Contracts Large opportunity with limited players Solid, but no strategic contracts None

Customers Predominately IC; well-funded DOD; healthcare

Mix with a toehold in attractive accounts

Mix of non-strategic DoD or Civilian

Capabilities High-end / in-demand Mix Commoditized Services / IT

IP / Technology Strong suite that provides scalability Some IP but not a driver None

Employee Credentials Highly cleared, well educated, certified Solid but not a differentiator Not a selling point

The decline in growth opportunities in the federal market coupled with the associated pull-back of public buyers, who in the past have been among the most aggressive buyers, has caused average valuation levels to recede from the historic highs of the past several years

However, companies with impressive growth prospects and specialized products or capabilities continue to garner attractive valuation multiples

Current Market Dynamics Current Valuation Drivers

35

Company Characteristics Driving Premium Valuations

Strong Financial Performance • Attractive, Sustainable Margins • Rapid Growth, Scale • Significant Revenue Visibility (Strong Backlog) Attractive Contract Base • Full and Open, Prime Contracts • Hard to Penetrate Customers • Key Contract Vehicles Strategic Rationale • Specialized Capabilities / Technology • Positioning for Large Contract Opporunities Discriminators • Highly Cleared Employee Base • Management Quality, Depth and Breadth

EBITDA Multiple Spectrum

10.0x +

4.0x

5.0x

6.0x

7.0x

8.0x

9.0x

Highly Specialized Product / IP

Oriented Cyber & Intelligence Community

Companies

Companies with Significant Access to High Growth Market

Segments

Generalist IT Services, High Percentage of

Work from Subcontracts, Some Set Aside Exposure

Serv

ices

Com

pani

es

BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms.

Contact Information

Hilary Cairnie: [email protected] Eric Sobota : [email protected]

Gregory Nossaman : [email protected]