The number of UK acquisitions of US companies held fairly flat for the past six quarters despite a strong sterling and a rebounding US mergers and acquisitions (M&A) market. However, British defence and aerospace companies bucked this trend with an unusually high level of US M&A activity. British buyers made 26 out of 30 cross-border acquisitions of US defence firms in the past 18 months. And the value of acquisitions announced in the first six months of this year exceeds that of the last three years combined, due to the largest foreign acquisition of a US defence contractor ever: BAE Systems’ $4.2bn acquisition of United Defense Industries.

Four factors explain much of this activity: diverging national defence budgets within NATO, political and economic barriers to further consolidation in Europe, changes in the US business model, and increased US acceptance of overseas defence firms. The declining value of the US dollar against sterling has offered a further incentive to UK buyers shopping for bargains.

1. Diverging defence budgets
While US military, defence, procurement and R&D spending has risen sharply in the past four years, from $388.9bn in 2000 to $608.3bn last year (excluding supplemental spending in Iraq and Afghanistan), defence spending by well over half of NATO’s members is flat or declining. Although Deutsche Bank predicts procurement spending in the UK will rise 6% a year through 2008, 70% of these funds will go to nine existing projects.

British firms neither involved in these projects, nor poised to take advantage of the shift from large-scale systems, have two options for maintaining momentum and the economies of scale necessary for remaining competitive: consolidate or enter new markets. Such firms may look across the Atlantic to meet their long-term revenue growth goals.

2. Political barriers to European consolidation
Although the EU generally promotes competition among its members, defence remains a notable exception. There has been little cross-border consolidation of the industry, despite intra-national mergers, and cross-border collaboration on projects like the Eurofighter and the establishment of the European Defence Agency.

European Aeronautic Defence and Space (EADS) is the only large, pan-European defence company, and 73% of its business is Airbus and space systems, not defence. Rather than face the job losses and political fallout that would accompany industry consolidation on the continent, European defence contractors are looking for growth in North America. EADS has established a subsidiary with the requisite legal and regulatory structures for bidding on Pentagon contracts.

3. Changes in US defence industry’s business model
Under the old practice, the Pentagon bought equipment and “platforms” – aircraft, ships and tanks – from large defence contractors and integrated these into combat systems.

Today, major contractors are assuming programme management, systems design and integration responsibilities, subcontracting the manufacture of platform components and certain services to smaller contractors. By pushing manufacturing further down the supply chain, the new model has allowed large suppliers to emerge as attractive acquisition candidates with specific technological and/or manufacturing capabilities.

4. Greater acceptance of British defence firms
Tony Blair’s support of US war efforts in Iraq and Afghanistan may have contributed to the spike in British acquisitions of US defence firms, as policy-makers recognise that joint mobilisation of troops and equipment does require some industrial co-operation. Increased deal size may also signal a shift in the types of businesses regulators are willing to let British companies own, control, or influence. The largest cross-border deal in 2002 was Zodiac’s $62m acquisition of Engineered Arresting Systems Corp, while in June, BAE completed its $4.2bn acquisition of UDI.

CONSIDERATIONS FOR BRITISH BUYERS
Few sectors appear off limits to British buyers, especially after regulators gave Cobham’s acquisition of REMEC’s diversified defence and space unit the green light last year.Although regulators have not blocked a foreign acquisition since 1990, they often limit the control. Sometimes they require that certain assets be sold to a US firm, or placed within a secure US subsidiary, before allowing an acquisition to close. And they do not allow foreign owners to merge US and overseas operations. This often reduces cost savings, inhibits the repatriation of acquired intellectual property, and makes governance more complex and costly. Therefore a successful US acquisition requires thorough transaction and integration planning, especially with respect to governance and compliance processes for winning and delivering Pentagon contracts.

Less controversial sectors like information technology, logistics and base management are good choices for British companies making their first forays into the US defence industry, according to Michael Wynne, head of acquisitions for the US Department of Defense (DoD). “What I really need and I’ve yet to find are . . . trucks that don’t rust . . . fuel-efficient generators . . . faster, more efficient, more creative solutions to my logistic problems.” British defence companies should align their US investments with the strategies outlined in the Pentagon’s Quadrennial Defense Review, to be issued later this year. The DoD needs systems that support special forces, mobility, communication and intelligence. Its mantra is smaller, lighter, faster, and more networked, with an emphasis on joint control, net-centric command, and integrated capabilities. Acquirers should look for companies with a strong backlog of orders and the ability to generate business beyond their current books. This entails looking at a company’s entire portfolio, establishing where each product or service is in its lifecycle, and evaluating the promise of its R&D pipeline. A diverse customer base cushions a company against volatility in the awarding of contracts, and enables it to remain solvent if it loses a key contract.

The ideal target offers aftermarket services along with commercial and defence items, as the aftermarket generates a stable revenue stream largely insulated from the US budget process. However, new DoD contracts attempt to close the “sell at cost and make money on the service” loophole by linking the delivery and lifetime support of a defence asset to a single programme. Accelerated growth of the US defence budget, the Pentagon’s openness to British defence suppliers, and a strong sterling have created a favourable environment for British defence contractors seeking assets in the US. If the Pentagon is comfortable relying on a US/Italian consortium to supply the new presidential helicopter fleet, it is likely to use non-US contractors for other important projects, creating opportunities for British firms willing to do transactions and set up the necessary governance structures in the US.

Colin McKay is the global leader of PricewaterhouseCoopers’ Transaction Services practice. For more information contact him on +1 646 471 5200 or e-mail: colin.mckay@us.pwc.com