Eric Brothers // Senior Editor //

According to Mesirow Financial’s recent report “Aerospace and Defense 2016: Year-end Review,” merger and acquisition (M&A) activity in the aerospace and defense (A&D) sector slowed during 2016 after reaching new heights in 2015. Only 197 deals were struck last year, compared to 216 the previous year, and deal values dropped to $18.1 billion in 2016 from the extraordinary $67.9 billion in 2015.

North America continued to dominate, with 105 M&A deals announced in 2016, 53% of global deal volume. Private equity continues to drive aerospace M&A activity, but those investors perceive the commercial sector is nearing the end of a cycle. The report notes investors are now focusing on earnings quality and sustainability, seeking product and customer diversification as new commercial aircraft sales slowly decline.

If private equity investors become wary, there’s another source of renewed M&A activity – internal needs. As the commercial aircraft ramp-up continues, A&D companies want to diversify or complement their core businesses. Examples: engine and equipment-focused Safran’s offer of $9.8 billion to purchase aircraft seats and cabin- specialist Zodiac Aerospace in January, and cockpit avionics firm Rockwell Collins’ October 2016 deal to acquire cabin interior products company B/E Aerospace for $8.3 billion.

The report notes these large transactions “portend an active aerospace M&A environment in 2017 and will likely embolden other strategic consolidators.”

Where is this headed? I asked Andrew Carolus, who leads Mesirow Financial’s A&D sector and was one of the report’s authors. Most consolidation, he said, is driven by economies of scale, but being late in the cycle is also a factor. The backlog of commercial orders increases pressure to consolidate as companies in the supply chain try to meet increases in capacity, throughput, quality, and price. Firms that seek economies of scale are more likely to explore M&A to reduce costs, improve responsiveness, and obtain resources to invest in product innovation, people, and capabilities.

When I asked Carolus what potential acquirers are seeking most now, he replied that beyond a strong balance sheet, buyers are looking to add capabilities or content, along with insourcing some capabilities.

M&A activity may also return as defense spending increases and investors see new opportunities for consolidation. The report notes that promises of higher defense spending have generated “renewed enthusiasm from financial sponsors for companies participating in the defense industry which is viewed as having significant growth potential after years of decline.”

Mesirow’s experts don’t foresee much consolidation among major defense companies, but they note, “independent software developers, surveillance equipment manufacturers, and cybersecurity providers are prime targets for acquisition.”

Carolus says the biggest target is the middle market, valued under $300 million, with proprietary or highly-engineered content. Buyers are looking for product or platform diversity.

Mesirow Financial’s report can be found at – Eric