Late last year, a small Alabama defense firm hit the big leagues.
Founded in 1989, Chandler/May makes UAVs and UAV ground stations. Sales took off in the mid-2000s as the military’s desire for unmanned aerial technology hit a fever pitch. After notching 600 percent growth in seven years, the company was acquired in 2012 by Lockheed Martin. No one is saying the price, but it was understood to be a mammoth deal.
Chandler/May’s remarkable transformation from small ISR specialist to a division of the world’s biggest defense contracting firm was not an act of chance. Behind the scenes, like a kind of Henry Higgins of the world of intelligence technology, was a venture capital fund named Arlington Capital Partners.
In 2005, Arlington bought a majority stake in Chandler/May from the founders, Jesse May and Jay Chandler.
The new part-owners carefully built up the firm. Arlington acquired other intelligence and drone business to tuck into it, to grow it. Like a patient gardener, Arlington had encouraged the business, invested in it, trimmed where it could. And then, it brought Chandler/May to market.
With a $1.5 billion war chest, Arlington Capital is a member of a small yet influential group: the money men who finance the ever-evolving technology of modern-day intelligence. Others include Monument Capital, Fedcap Partners Paladin, and White Oak. These investors back the budding companies that design and manufacture the aerial surveillance systems, the cameras and sensor imagery equipment, and even the cyberwar technology that have been seeing such accelerating advances.
They are the ones who can make an innovative company succeed and grow. And if they aren’t interested, even the most inventive ISR firm may find itself unable to raise capital that it needs.
A SOUP-TO-NUTS ISR COMPANY
Peter Manos, Arlington’s managing partner, said the work takes an unusual expertise.
“Most of our brethren in private equity don’t do government contracting because they don’t understand the nuance of how it works,” he said. “Particularly in a budgetary environment like this, they get scared off.”
Manos said the Chandler/May deal was a textbook model of financial play in the unmanned aviation field.
“We knew UAVs would be a growing part of the defense budget, but they’ve grown even faster then we’ve expected,” he said.
He said the owners of Chandler/May knew in 2005 that they were poised for growth if they could find the money.
“They knew they were on to something great,” said Manos, “but they needed somebody with the right capital and domain expertise with C4ISR and defense investing.”
Manos said Arlington bought the company, which specialized in ground control stations, and mated it with another small firm company called Aermech, which made the small Desert Hawk and Fury UAVs.
“And we now had a pure-play, soup-to-nuts UAV company and it continued to grow,” he said.
Seven years later, the firm was a juicy target for Lockheed Martin, and Arlington’s bet paid off big.
Another ISR kingmaker is Monument Capital Partners. Based in Arlington, Va., the firm boasts a star-studded advisory board that includes former Defense Secretary Frank Carlucci, former Secretary of State James Baker, and former White House Chief of Staff Tom “Mack” McLarty.
And yes, all three of those political powerhouses on the Monument Capital Board also have long-standing ties to one of the best-known investment funds in the world, the venerable Carlyle Group, which has $170 billion in assets under management. One of Monument’s founders, Robert Dunn, is another Carlyle veteran, and the other founder is Douglas Baker, James Baker’s son. (Manos, of Arlington Capital, also once worked at Carlyle.) At Monument’s offices, Baker and Monument dealmaker Jason Rigoli explained that huge funds like Carlyle don’t get involved in small C4ISR investments.
Carlyle is just too vast — a financial whale — to fish in these waters, and C4ISR companies tend to be small and specialized.
Moreover, intelligence technology is one of the few businesses where even the investors get cleared for classified material. A clearance “is not a requirement, but it helps,” said Baker, who has let his lapse. Rigoli still maintains one. Without it, an investor might not be able to perform due diligence on a firm: What are the contracts with the NSA or CIA? What are the receivables, and what is the true nature of the technology? Baker said when he and Dunn set up Monument Capital, they set down strict parameters for its investments.
Monument plays by a self-imposed rule: nothing lethal, nothing that goes “bang.”
“We will not invest in ammunition, gun manufacturers, missiles, anything which in essence brings headline risk,” Baker said. “We made a decision early that we didn’t want to invest in anything with lethal capabilities or even security companies that hire security guards.”
Instead, Monument looks at tools like Persistent Sentinel: ISR command-and-control software that integrates data from cameras and other types of sensors to set up automated responses to threats. Last year, Monument bought Persistent Sentinel with part of the $300 million it’s raising from investors. Rigoli said the software grew out of a shipboard protection system developed after the destroyer Cole was bombed in 2000. It has since been expanded to protect a wider expanse of military and civil infrastructure.
This year, Monument made a huge score in an overseas deal, selling a Turkish C4ISR company, Promena, to a Turkish consortium.
The company won’t say exactly how much it made, but it say it paid investors four times what they put in five years ago, for an individual rate of return of 70 percent.
A 'FRAGMENTED' INDUSTRY
Another fund that specializes in the C4ISR sector is the White Oak Guggenheim Aerospace and Defense Fund, managed by the White Oak Group. Based in Atlanta, the fund prefers to buy companies doing $10 million to $30 million in annual revenue.
“It’s a very fragmented industry and a lot of your innovation — not all of it, but a lot of it — is coming from small, what we call ‘founder-family’ run, companies,” White Oak chairman Chris Melton said.
In 2008, for example, White Oak invested in a sensor manufacturing firm called EOIR Technologies.
Its gear is classified, so Melton would only say that the company works “across a very broad set of issues” in thermal, infrared, standoff detection and more. Federal contracting records indicate the firm has contracts worth millions of dollars with the Special Operations Command and the U.S. Army. But such companies, no matter how innovative the technology and no matter what the relationship with the Pentagon or intelligence clients, can’t be integrated into huge companies early on, Melton said. Not without growing and capital.
“These companies are typically very small,” he said. “It is very hard for a Lockheed Martin or a [General Dynamics] or an L-3 to acquire them. They just get lost in the corporate enterprise.”
So why is it a good bet for investors like White Oak? Melton said C4ISR companies can be a relatively low-risk investment. Most small businesses face two major risks: receivables, making sure they get paid; and inventory, managing it so it is never too large or too small.
“Write off your inventory?” Melton said. “That can put a small company out of business.” In ISR, he said, those risks are manageable. The government will eventually pay its bills. And inventory, for a government contractor, is just a function of the contracts.
“There is less risk for an inventor,” Melton said. “We like those dynamics. We decided 10 years ago to focus on aerospace and defense, and within that C4ISR. We felt C4ISR would be an emerging sector.”
Investors aren’t looking for a lifelong marriage with a C4ISR company; they want a passionate, short-term affair. For firms like Arlington, Monument and White Oak, investments all follow a game plan. First, find a target company. White Oak hunts for firms with annual sales as low as $10 million, while Arlington and Monument draw the lower limit at $25 million. Then they invest heavily, merge their new acquisition with another company or two, make its sales skyrocket, and then sell it to a “strategic.”
“Over a function of time, usually two or three years,” said Rigoli, “we want that business to be twice what it is in size the day we acquired it.”
He said their maximum “hold” period for a company is seven years.
“We’re in the business of returning capital to our investors. Our investors are not going to remain patient forever,” he said.
Think of it like a rancher growing his cattle from calves to full-grown beef cows, fattening them up, so he can take auction, where they get sold to the stockyards.
Managing the risks of backing ISR firms starts with a solid evaluation of the technology, and that takes a lot of expertise, says John F. Lehman, a former Navy secretary turned defense technology investor.
“One has to really understand the sector to make an informed judgment about the risk and the quality of anything. In the last year, we looked at 30 UAV companies or UAV support companies,” Lehman said.
Not one, he said, was just right.
Lehman invests more broadly in defense technology, though he also looks at C4ISR.
“There are an awful lot of companies desperate to try to paint themselves in those colors,” he said, “desperately looking to ride the C4ISR wave.”
One arena that he and others are grappling with is offensive and defensive cyber companies. Cyber is huge, but getting past the buzz and into the heart of the business isn’t easy.
“Cyber, cyber, cyber!” Lehman said in frustration. “Everyone is repainting their signs to say cyber.”
Rigoli, at Monument, has been sifting through self-proclaimed cyber companies.
“It’s kind of like e-commerce in 1999 and 2000,” he said. “Everyone threw ‘e-commerce’ on their website.” He shrugged. “Even if you are installing McAfee software on a desktop, you say you are into cybersecurity,” he said.
And for real cyber companies, doing either classified “offensive” cyber contracts, or cybersecurity, Rigoli said cyber mania has thrown financial common sense out the door. Huge defense contractors are often buying what they can at exorbitant prices, so the most promising cyber companies have been priced off the market. There are few “pristine” companies left, he said.
“We haven’t been able to substantiate the valuations that these businesses are selling at. So that’s a bit of an issue for us. We just simply can’t get comfort buying an asset at 14 or 15 times their earnings or EBITA [earnings before interest, taxes and amortization]. That type of purchase assumes a model of growth of 30 percent indefinitely,” he said. That’s a growth rate that is just impossible. “Our calculators don’t have that many buttons.”
Monument said it’s looking more closely at data analytics software, hoping to buy a company with a solution to the “big data” problem. That’s the future, said Rigoli, because even if the intelligence community gathers less than it does now, it needs to figure out a way to automate the analysis. Fewer planes in the air will still be sending down their video, but the volume of video will still be massive.
In the meantime, the C4ISR investment business is shaking itself out. Wall Street firms that aren’t specialists in the field, the firms that just dabble in defense technology, are sitting out nervously because they are concerned about the Defense Department’s budgetary shuffling. That means the specialist firms like Monument can pick and choose more than ever, but they are still being cautious.
“Overall valuations in the space have dropped 25 percent,” Rigoli said. “We’re being a lot more prudent.” ■
(This story first appeared in C4ISR Journal's print edition.)