Government Contractor Mergers & Acquisitions: Making the Most of the Diligence Process

Breakout Session #: F10

Todd Overman, Partner, Bass, Berry & Sims

Aaron Raddock, Senior Manager, Baker Tilly

Lance Novak, CFO, Military & Veterans at United Healthcare

Date: Tuesday, July 26

Time: 4:00pm-5:15pm

2

Agenda

• Overview of the diligence process • Structure of a transaction • How contracts professionals can add value • Pre and post-transaction risks for

contractors • Top Diligence Issues for 2016 • Questions

3

Overview of the Diligence Process

4

Overview of the Transaction Lifecycle

Prepare

Engage banker

Understand market

Identify strengths/ weaknesses

Assess readiness/ timing

Identify buyers/ approach

CIM development

Marketing

Contact approved parties

Develop/deliver tailored message

NDA

CIM distribution

Management meetings/

presentations

Negotiate/ Select

LOIs

Scope

Compare

Negotiate

Selection

Due Diligence

Buyer’s diligence

Financial modeling

Transaction

Structuring

Purchase agreements

Transaction closing

Integration

Analyze

Develop integration plan

Execute and measure success

5

Looking at a Deal: Due Diligence Process • The due diligence process typically involves a comprehensive review

of documents related to the business being acquired, and may include visits to the Seller’s locations and discussions with the Seller’s management team (including management presentations)

• The Purchaser typically assembles a multidisciplinary due diligence team, including inside and outside counsel, business and financial personnel, and accounting and tax personnel

‒ Legal subject matter experts involved in a transaction often include tax, employee benefits, IP, real estate, environmental, and where applicable, regulatory counsel

‒ Many Purchasers also engage outside accounting firms to assist them in the due diligence process, especially in larger acquisitions

• Due diligence is almost always performed under significant time constraints

6

Looking at a Deal: Due Diligence Process • Due diligence serves to:

‒ Confirm the valuation of the Seller’s business ‒ Justify the Purchaser’s business reasons for the transaction ‒ Provide a knowledge base to more effectively negotiate the

definitive agreement and mitigate risks associated with the Seller’s business

‒ Allow the Purchaser to effectively review the Seller’s disclosure schedules

‒ Identify contingent liabilities and other risks associated with the business (e.g., pending litigation, potential environmental liabilities, organizational conflicts of interest, etc.)

‒ Identify legal and contractual requirements for the proper transfer of ownership of the business to the Purchaser (e.g., corporate approvals from Seller, novations, third-party consents, etc.)

‒ Facilitate the successful integration of the Seller’s business into the Purchaser

7

Typical Document Requests

• Contracts (not closed out) ‒ Types of Vehicles ‒ Modifications ‒ Task Orders ‒ Correspondence ‒ Subcontracts/Vendor Agreements

• Pipeline/Backlog (sample on next slide) • Teaming Agreements/Joint Ventures • IP/Software Development Records

‒ Funding ‒ Marking

• CPARs/Audits

8

Sample Pipeline

Structuring the

Transaction

9

10

Structuring the Transaction

• How to structure the transaction? ‒ Stock sale ‒ Asset sale ‒ Merger

• Change of Name vs. Novation • Novation Process

‒ To allow for the assignment and transfer of contracts, the FAR provides a process known as a novation by which the government will give consent and waive the prohibition of the Anti-Assignment Act

‒ Through a three-party novation agreement, the government expressly agrees to the transfer of a government contract from one contractor to another

11

Structuring the Transaction

• It’s the USG’s decision when to allow for a novation: ‒ “when it is in the Government’s interest not to concur in the

transfer of a contract from one company to another company, the original contractor remains under contractual obligation to the Government, and the contract may be terminated for reasons of default, should the original contractor not perform.” FAR 42.1204(c) (emphasis added)

• It is good practice to engage the Contracting Officer (at

the appropriate time) to have the seller/contract holder socialize the potential sale and transfer of the contract

12

Structuring the Transaction

• Types of transactions that trigger novations ‒ Structure of the transaction is critical (stock vs. asset/merger) ‒ Generally no government consents are required for stock

purchase ‒ Whereas novations are required for asset purchases (and

mergers). FAR provides several examples: • Sale of assets used in performing government contract with a

provision for assuming liabilities; • Transfer of assets incident to a merger or corporate consolidation;

and • Incorporation of a proprietorship or partnership, or formation of a

partnership • Tips:

‒ Include novation as a condition subsequent in post closing covenants

‒ Include rescission and unwind provisions or purchase price reduction if novation is not approved within a set period of time

Adding Value as a Contracts Professional

13

14

Contracts Professionals Add Value

• Join the Diligence team − Government contracting expertise should be utilized in all due

diligence efforts involving Government contractors − Whether on the buy side or sell side, leadership needs individuals

who understand the unique pre and post transaction risks associated with government contractors

− Contracting Professionals can serve as a key facet of this cross functional team and can supplement outside experts

• Share your Contracts Knowledge − Much of the valuation of the seller company and its key risks stem

from the contracts − Help compile and/or evaluate the pipeline − Explain customer relationships and identify the nature of current

and future revenue sources

15

Contracts Professionals Add Value

• Identify Key Risks − Help explain key contractual risks and obligations − On the buy side, perform a detailed review of the seller’s contracts − Engage with seller contracts personnel − Share high risks clauses and compliance obligations with the

diligence team for follow-up

• Compliance Controls − Assist in the evaluation of compliance controls designed to fulfill

the contract obligations identified − Review audit findings and related documentation − In smaller companies, contracts and compliance may be the same

function

• Provide Assistance during Integration − Closing is just the beginning − Consider Integration pre-transaction and begin planning (e.g.,

novations, name changes, customer notifications, additional controls needed, etc.)

Pre and Post-Transaction Considerations

16

17

Pre-Transaction: Buyers of Government Contractors • Considerations and potential impacts vary based on intended post-

merger entity (i.e., consolidation vs. acquisition of separate business unit)

• Revenue and Contract Mix − Contract types (i.e., firm fixed price, time and materials, cost plus, etc.) − Small business contracts, set aside – will they transfer to Buyer?

• Look for set aside clauses (e.g., FAR 52.219-6) • Generally set asides will transfer but 8(a) contracts will not

− Prime vs. sub contractor, teaming arrangements − Agencies, markets − Revenue concentration

• Funding Status

− Estimates to complete on incrementally funded awards − Value of unexercised options − Value of IDIQ contracts (maximum award value is a poor indicator)

18

Pre-Transaction: Buyers of Government Contractors • Cost Allowability Considerations

− Costs of financial restructuring and mergers and acquisitions are unallowable pursuant to FAR 31.205-27 (this does not include post-transaction integration)

− Determine where to draw the line between transaction and integration activity − Establish project accounts to capture costs of unallowable activities

• Unique Contract terms

− Indirect cost or other ceilings; allowability requirements − Unusual or delayed payment terms, milestones, fee structures − Assignment and change in ownership provisions, or cancellation terms − Other restrictions

• Contract Backlog and Pipeline

− Option terms, renewal dates − Funded vs. unfunded, incrementally funded contracts − Margins − Bid and proposal process, capture rate − Potential lost contract revenue and post deal considerations − Synergies

19

Pre-Transaction: Buyers of Government Contractors • Unbilled Receivables

− Size and age of federal contract receivables − Invoicing system effectiveness − Status of unaudited or incomplete Incurred Cost Proposals − “Buyer” cannot invoice until novation process is finalized

• Subcontract Agreements

− Key relationships / status − Controversies and disputes − Pending claims − Assignment restrictions

• Classified Contracts and Security Clearances

− Secret contracts limit due diligence capabilities − Importance of retaining key personnel − Additional complications / impact if Buyer is a foreign-owned entity

• Changes

− Nature and frequency of constructive changes − Contractor identification of changes, and success rate / recoverability under REAs

20

Pre-Transaction: Buyers of Government Contractors • Cost Accounting Standards (CAS) Impacts

− CAS coverage triggers (if not previously covered) − Necessitates indirect rate restructuring? − Affects cost accounting practices − Results in changes to disclosed practices

• Business and accounting systems − Many government contractors are subject to one or more of the six DFARS

business systems clauses (accounting, estimating, purchasing, government property, material management and accounting systems, and earned value management system)

− Covered systems are subject to periodic review by DCAA or DCMA − Deficiencies seriously impact contract payment flow, contractor responsibility

determinations, and eligibility / competitiveness for award of new contracts − Existence of any compliance reports or negative audit findings related to such

systems − Quality of existing systems − Systems incompatible with Buyer’s systems? − Future investment required to improve systems? − Potential integration issues

21

Pre-Transaction: Buyers of Government Contractors • Organizational conflicts of interest

− Review for existence of potential conflicts − Does Target have a strong conflict identification process? − Assess transaction and financial impacts − Mitigation strategies possible?

• Intellectual property

− Patents, copyrights, technical data, software – what is the portfolio of the Target? − Who owns intellectual property and under what terms (e.g., unlimited rights vs.

government purpose rights)? − Target’s ability to justify intellectual property value, and rights restrictions if

challenged

• GSA / VA Schedule Contracts − Existing compliance issues (OIG investigations, audit reports, CAV reviews) − Hidden issues – current disclosures, PRC / BOA tracking mechanisms, etc. − Labor category harmonization

22

Pre-Transaction: Buyers of Government Contractors • Labor Law Compliance

− Exposure to higher risk labor laws such as Service Contract Act (SCA) or Davis-Bacon and related Acts (DBRA)

− Status of compliance with 14 labor laws identified in proposed “Fair Pay and Safe Workplaces” rule

− Ability to report on historical compliance from prior years • Open Audits / Investigations

− Status of open audits and historical activity − Potential impact of unresolved audits and investigations (risk and likelihood)

• Joint ventures: Know what you’re really buying

− Most government contractors are a party to one or more joint ventures and enter JVs for a variety of reasons

− Understand the legal form of the JV and the implications of that legal form − Does the JV create antitrust issues? Impose covenants not to compete on affiliates

of JV members and if so, how will that affect the purchaser? − Does the JV create organizational conflicts of interest for the purchaser? − How will a change of control of the Target affect its rights as a JV member? − What rights does the Target have to participate in management of the JV? − Understand consolidation requirements and financial reporting post closing

23

Post-Transaction Considerations for Government Contractors • Revisit Indirect Cost Structure for New Organizational Structure

− Definition of a segment / business unit − Impacts to home office allocations and service centers − Additional or revised indirect cost rates − New Provisional Billing Rates or Forward Pricing Rate Proposal?

• Cost accounting practice changes

− Not all organizational changes equate to cost accounting practice changes − Assess need for GDM or cost impact − Revise disclosure statement as needed

• Consolidation of GSA Schedules / SINs / Labor categories

− Streamline duplicative offerings

• Consolidation / Revision of Business System Descriptions − Align business systems and compliance processes − Update policies, procedures, and system descriptions to reflect new organization

• Notifications / Disclosures

− Novations and Agency-specific requirements (e.g., DOD contractors with restructuring costs > $2.5M)

Top Diligence Issues in 2016

24

25

Top Diligence Issues for 2016

• Past Performance ‒ With increased competition, past performance ratings can dramatically

influence the award of future work ‒ Structure of transaction can result in loss of past performance history

• Fair Pay and Safe Workplaces / Labor Law Compliance ‒ Requires contractors to disclose their compliance with 14 different labor

laws within the past three years, and to update that information at least twice a year, as a determination factor during award

‒ Raises the stakes on contractor labor law compliance ‒ New FLSA salary thresholds and proposed sick leave rule further impacts

contractors obligations • Data Rights

‒ Government is increasingly aggressive in obtaining rights to intellectual property (e.g., Better Buying Power 3.0)

‒ Proper compliance and management of intellectual property rights, including technical data and computer software, is a must

26

Top Diligence Issues for 2016

• Supply Chain Management ‒ The proliferation of counterfeit parts and increased scrutiny over supply

chain practices is leading to additional consequences for government contractors that have not yet been fully realized

‒ The government’s expectations of prime contractors and higher tier subcontractors with respect to the management of their supply chain has changed

• IR&D costs under DOD Contracts ‒ Proposed rules relating to increased scrutiny and additional disclosures

in connection with IR&D costs under DOD contracts may give buyers another item to examine

‒ Such rules place additional risk on allowability of IR&D • Small business compliance

‒ The transferability and/or future qualification of set aside work will continue to be a mainstay diligence issue

27

Top Diligence Issues for 2016 • Cybersecurity

‒ This past year has seen a host of security issues an new/impending regulations to comply with

• Federal Supply Schedule Risks ‒ Manufacturers using resellers are at risk as a result of VMware and

Carahsoft $75.5 Million FCA settlement with GSA in June 2015 ‒ Increased scrutiny of Trade Agreement Act compliance ‒ Additional pricing pressure (e.g., horizontal pricing and Contract Awarded

Labor Category (“CALC”) tools)

28

Aaron Raddock, CPA, CFCM, CFE, Senior Manager Baker Tilly Tel: 703-923-8411 aaron.raddock@bakertilly.com Todd Overman, JD, Partner Bass, Berry & Sims Tel: 202-827-2975 TOverman@bassberry.com Lance Novak, CFO Military & Veterans at United Healthcare Tel: 952-931-6063 lance_novak@uhc.com

Questions?