Barbarians at the Beltway?
Ernst Volgenau is one of the good guys, and the government contracting firm he started 33 years ago is one of the crown jewels of the Washington region’s economy. Which is why we should pay attention now that his Fairfax-based SRA International is about to be sold to a private equity firm for a premium price of $1.89 billion.
How Volgenau and SRA got to this point is an interesting tale, one that says a lot about the life cycle of entrepreneurial firms, the state of government contracting and the crazy economics of corporate dealmaking.
Volgenau is one of the founding fathers of the modern government contracting industry. He started his career in the Air Force, where he served for 20 years, including a stint analyzing weapons systems and command structures at the Pentagon as one of Robert McNamara’s “whiz kids.” He was, literally, a rocket scientist, helping to develop boosters and satellites and teaching astronautics. He capped his government career with two years as director of enforcement at the Nuclear Regulatory Commission.
Volgenau launched SRA International from his home in 1978. The company provided analysis, advice and information technology solutions to both military and civilian agencies. Although it has had a reputation for aggressively pursuing new contracts and earning above-average profits, Volgenau always considered the work he and his colleagues were doing to be public service, for the good of the country. His commitment to “honesty and service,” as corny as it may sound today, has always been genuine and is hard-wired into the company culture. SRA grew rapidly not in spite of it but because of it, winning the loyalty of both customers and talented employees (for a decade it was on Fortune’s list of 100 Best Companies to Work For).
By the time Volgenau stepped down as chief executive in 2005, intending to spend his time giving away his fortune, SRA had become a public company with more than $1 billion in sales, 6,400 employees and an unbroken record of profitability.
(Full disclosure: Volgenau is rector, or chairman of the governing board, of George Mason University, where I will be a professor starting in the fall.)
It was perhaps inevitable that SRA’s growth trajectory would slow after Volgenau kicked himself upstairs to the chairman’s office. SRA had been growing by 30 percent a year during the outsourcing boom that followed 9/11, but it was unlikely that any company that size could maintain such a growth rate once those contracts were complete. Indeed, as the decade wore on, it began to dawn on investors that federal spending would need to be reined in, leading to slower growth and tighter profit margins. SRA stock, which had been trading above $32 per share in 2006, fell to $12 in late 2008.
But it wasn’t just the economy, the weak stock market and looming budget cuts that dimmed SRA’s prospects. Two sizeable acquisitions near the top of the market — one in the health-care area, another in air traffic control — proved so unsuccessful that the company is now in the process of selling them off or shutting them down. Around the same time, SRA suffered the loss of major contracts with USAID and the National Guard, giving a black eye to a company that prided itself on customer service.
Much of the blame for those setbacks fell on Stan Sloane, who was recruited as the new chief executive in 2007. Sloane had been a top executive at Lockheed Martin, where the strategic focus is much more on proprietary products than professional services and where the culture is decidedly more formal, bureaucratic and top-down than people had been used to at SRA. When many longtime employees began to leave or were pushed out, Volgenau — who still owned 20 percent of the company’s stock and controlled 70 percent of its voting shares — reluctantly concluded he had to step back in. Just before Christmas 2008, SRA issued a little-noted press release announcing the establishment of the “executive office of the chairman,” which would focus on “strengthening the company’s operations.”
Not long after that, Volgenau began to give serious consideration to selling SRA. Over the previous decade, hardly a month had gone by that he hadn’t received an inquiry or expression of interest from a potential buyer. But with the stock price depressed and the company losing its momentum, he began to think that a sale would be his last, best chance to realize the full value of his controlling stake while putting the company back on track.
Volgenau’s introduction to Rhode Island-based Providence Equity Partners was made by “Renny” DePentima, a former deputy commissioner of the Social Security Administration who served as a top executive at SRA for a decade and briefly succeeded Volgenau as chief executive. Providence had brought on DePentima as a “special adviser” to help it move beyond its original focus on media acquisitions into the information technology sector, and one of DePentima’s first calls was to his old boss at SRA.
Not long after an initial meeting with Providence in March 2010, Volgenau appointed a committee of outside directors to effectively auction off the company.
Over the next year, the committee played “strategic” bidders, like Serco Group, the giant British defense contractor, against a bevy of private equity firms, including Providence, the Carlyle Group, Veritas Capital and General Atlantic. Volgenau’s clear preference was to preserve SRA as an independent company rather than seeing his creation swallowed by a big competitor, but he also understood that the company had an obligation to get the best deal possible for other shareholders. Providence’s final offer of $31.25 per share — $1.89 billion, in all, or 11 times operating cash flow — accomplished both goals. A 30-day “go-shop” period following an initial announcement in April failed to turn up any higher offer.
In many ways, Providence is a good fit for SRA. It is among the most successful private equity firms, skilled enough at spotting and adding value that its returns have consistently ranked in the top quartile of industry rankings. With $23 billion under management, it also has plenty of additional capital to help SRA grow through acquisition, which seems to be part of the strategy going forward. Providence also has a history of entering into successful partnerships with entrepreneurs such as Volgenau, who will continue to own 20 percent of SRA and remain actively involved on the company’s board.
That said, nobody — least of all Volgenau — should kid himself about Providence’s methods and intentions.
To finance the purchase, Providence will saddle SRA with $1.4 billion in debt, or eight times this year’s expected operating cash flow, uncomfortably above the six times cash flow that is considered safe for leveraged acquisitions. That doesn’t seem to faze the banks, which have apparently been tripping over each other for the chance to finance deals involving government contractors because of their reliable cash flow. But with government spending and industry profit margins under pressure, it may take Providence longer than it expects to pay down that debt. In the meantime, SRA will be much more vulnerable financially if it is forced to take a big loss on a contract or loses a major piece of business.
The other worry is that SRA will be sold again in five to seven years — that’s what private equity firms do. There’s no guarantee that this time it won’t be to a strategic buyer who will incorporate it into its own operations and snuff out whatever remains of SRA’s unique culture.
Of course, there’s always the possibility that Providence can make the most money by taking SRA public again. You have to wonder, however, about a financial system that increases the value of a company by taking it public in 2002, confers another premium by taking it private in 2011 and then creates yet another premium to take it public again in 2018. All this wheeling and dealing creates lots of wealth for investment bankers and lawyers and company insiders — even philanthropic ones like Ernst Volgenau — but it’s hard to see how it creates value for customers or the broader economy.