C4ISR Market Update – April 2024

AI/ML Integration Offers New Growth Opportunities in the C4ISR Market

The Command, Control, Communications, Computers, Intelligence, Surveillance & Reconnaissance (C4ISR) sector merger and acquisition (M&A) market experienced a year-over-year (YOY) decline in transaction volume in 2023, in line with broader dealmaking trends. A widespread slowdown in activity among sponsors curtailed both deal volume and value across the board in 2023. In the Federal marketplace, four Continuing Resolutions passed by Congress since the beginning of fiscal year (FY) 2024 (October 1, 2023) have delayed the start of new Department of Defense (DOD) programs while disrupting lucrative contract processes. Comparatively, Congress passed the Omnibus Appropriations Bill for FY 2023 in December of 2022, effectively funding the DOD before the new year. Despite the headwinds to M&A, heightened demand from government customers for artificial intelligence (AI)- and machine learning (ML)-integrated C4ISR technologies is expected to provide a boon to dealmaking in the sector. Demand has been bolstered by the White House’s executive order on “Safe, Secure, and Trustworthy AI,” which developed a National Security Memorandum on AI. The memorandum “ensures that the U.S. military and intelligence community use AI safely, ethically, and effectively in their missions, and will direct actions to counter adversaries’ military use of AI,” according to a press release.¹ Research and development (R&D) investment in this space has also coincided with equity market fervor for AI-driven products, solidifying demand in the near-term. While the timeliness of budget procedures continues to be a challenge for Aerospace, Defense, Government & Security (ADGS) industry participants, AI/ML integration into the C4ISR landscape is anticipated to be one of the leading drivers of growth and a resurgence in sector dealmaking.

Defense AI implementation will provide decision advantage from intelligence collection, strike operations to battle damage assessment at machine speed.

Tess OxenstiernaManaging Director and Head of Capstone’s Aerospace, Defense, Government, and Security Group

Capital Investment and Contract Opportunities Drive Innovation

AI integration into C4ISR operations is expected to make intelligence analysis and subsequent decision making a more efficient process. Intelligence gathering has traditionally produced copious amounts of data that a limited number of analysts have had to manually evaluate. Through ML, a subset of AI, intelligence analysts can now synthesize large amounts of data, make comprehensive target classifications, and deliver pattern outputs at rates beyond human cognition. Target classification has become the most mature AI-enabled ISR capability available. The ability of AI/ML to take satellite outputs and not only distinguish targets such as vehicles, but also their make and model, has greatly improved the ability to analyze geospatial information. These factors have fostered a competitive environment among sector players for both external capital investment and government R&D contracts.

Leading sector players have helped facilitate the development of AI technology for ISR applications. Of note, Raytheon Technologies’ (NYSE:RTX) venture capital arm RTX Ventures has participated in four funding rounds for AI-driven startups in the Defense space since 2022. EpiSys Science, RTX Ventures’ flagship growth investment in the AI-driven ISR space (December 2022, undisclosed), incorporates “Tactical AI” into its signals intelligence (SIGINT) solutions. EpiSys has won multiple prime contract awards supporting AI R&D efforts. These include 15 separate awards from the Air Force Research Laboratory (AFRL) totaling $16.2 million for development projects such as a “Common framework for networked collaborative autonomy with tactical AI,” and “AI maneuver and battlespace optimized timing,” according to USAspending.gov.² Additionally, EpiSys was one of multiple award winners on the Air Force’s $950 million contract for the Joint All-Domain Command and Control (JADC2) program in 2022, the DOD’s highest-priority C4ISR initiative, according to a press release.³ RTX Ventures has committed $109.6 million in disclosed investments to similar companies of EpiSys’ scale and capabilities since 2022.

Government customers have already seen tangible results from AI investment in the C4ISR space, providing optimism for a continued relationship between the DOD and sector participants. The DOD’s Chief Digital and Artificial Intelligence Office (CDAO), established in June 2022, has become the face of the Pentagon’s AI initiatives. Playing an essential role in the development of major weapons systems programs, such as the Joint Light Tactical Vehicle and the MQ-9 Reaper, the CDAO has played a crucial role in helping the DOD achieve its 2022 National Defense Strategy of technological competition with China. Recently, the CDAO’s Global Information Dominance Experiments (GIDEs) helped the DOD achieve a basic, minimum viable capability for the JADC2 program, according to Deputy Defense Secretary Kathleen Hicks.⁴

While  some key AI-enabled technology in the C4ISR space is currently in development, Capstone expects leading sector players to become active buyers of startups and middle market businesses with mature AL/ML capabilities, driving a rebound in dealmaking activity. Capstone has already seen this trend take hold, advising Spin Systems, an AI/ML-driven data analytics and visualization government contractor, on its sale to Diné Development Corporation, a Navajo Nation company .

• Capstone Partners Advises Spin Systems (SpinSys) on its Sale to Diné Development Corporation (December 2023, Confidential) – Capstone Partners advised SpinSys—a data analytics and AI/ML-driven intelligence visualization government contractor—on its sale to Diné Development Corporation (DDC), a Navajo Nation-owned company in December 2023. Terms of the deal are confidential. An award-winning software company focused on big data aggregation, virtualization, governance, and predictive modeling, Spin Systems has amassed success throughout its 25-year history in delivering cloud-based sustainment and modernization solutions for the U.S. government, specifically for the DOD. “Our extensive experience in big data, visualization and cloud migration complemented DDC’s already robust IT (information technology) services businesses,” noted SpinSys CEO, Wael Ali.

Founded in 2004, Diné Development Corporation has been committed to providing government agencies with high-quality IT, professional, and environmental services. Wholly owned by the Navajo Nation, DDC strives to deliver exceptional solutions while generating sustainable economic prosperity for the Navajo Nation and advancing communities across the world.

2023 Sees M&A Downturn, Leaving Optimism for Rebound in 2024 and Beyond

Although Capstone has experienced significant buyer interest for AI/ML-driven businesses, M&A activity in the C4ISR sector moderated significantly in 2023, falling 22.7% YOY to 51 transactions announced or completed. An elevated interest rate environment, general unmet valuation expectations among sellers, and a lack of sponsor-led dealmaking, suppressed the M&A market compared to its peak in 2021. Additionally, multiple continuing resolutions for the DOD’s FY 2024 budget slowed the flow of contracts and the start of new DOD programs, contributing to the moderation in sector deal activity. Despite static levels of deal volume, C4ISR transaction activity marginally outpaced the broader M&A market in 2023 which declined 24.1% YOY across all enterprise value ranges.

Strategic buyers accounted for 74.5% of deals in 2023, offering optimistic forecasts for dealmaking in the sector as strategics have typically pursued synergistic deals despite the macroeconomic conditions and interest rate environment. Financial buyers are likely to re-enter the M&A market due to strict investment fund requirements and growing limited partner (LP) expectations for capital returns. Additionally, sponsors have historically favored sectors aligned with government services due to the non-cyclical nature of federal spending. Despite the DOD’s budget for FY 2024 and FY 2025 projected to remain flat compared to previous years, the prospect of continued supplemental defense funding will likely drive continued buyer interest in the space.

Private Equity Shows Signs of Reentering C4ISR M&A Market

Although early in the year, a rebound in deal volume has yet to materialize through year-to-date (YTD) 2024. There have been five sector transactions in YTD 2024 compared to 12 in YTD 2023. Optimistically, the deal market has seen financial buyers return to the table, accounting for four out of the five total transactions through YTD 2024. Notably, Arlington Capital Management-backed BlueHalo, an engineering and technology solutions provider to the DOD and intelligence community (IC), merged with Eqlipse Technologies in February for an undisclosed sum. The combined company is expected to generate $1 billion in revenue with 2,400 employees across 11 U.S. states, according to a press release.⁵ Eqlipse’s portfolio of SIGINT engineering solutions, electronic warfare operations, and R&D capabilities was a highly attractive complement to BlueHalo’s 20 product lines across the Space, Unmanned Autonomous Systems (UAS), Cybersecurity, and AI domains.

Of the recent transactions by financial buyers in 2024, BlueHalo’s acquisition of Eqlipse Technologies offers the clearest glimpse into near-term private equity dealmaking in the C4ISR sector. While the broader Private Equity industry’s M&A appetite reduced drastically between 2022 and 2023, the starkest contrast between strategic and financial buyers was the prolonged lack of buyout deals due to tightened lending conditions. Most other sectors across the ADGS industry in 2023, such as Government IT Services, experienced robust add-on dealmaking from sponsors and a dearth of platform acquisitions. The C4ISR sector witnessed a lack of transaction activity from financial buyers on both fronts with add-on deals accounting for 17.6% of total transactions in 2023, falling from 22.7% in the prior year. A return of sponsor-led add-on transactions to the C4ISR M&A market might signal the beginning of a rebound in dealmaking in the sector.

To discuss AI/ML investment, provide an update on your business, or learn about Capstone's wide range of advisory services and C4ISR market knowledge, please contact us.

Joe Collins, Analyst, was the lead Market Intelligence contributor to this article.

Endnotes

1. The White House, “FACT SHEET: President Biden Issues Executive Order on Safe, Secure, and Trustworthy Artificial Intelligence,” https://www.whitehouse.gov/briefing-room/statements-releases/2023/10/30/fact-sheet-president-biden-issues-executive-order-on-safe-secure-and-trustworthy-artificial-intelligence/, accessed March 28, 2024.

2. USASpending, “EpiSys Science, Spending by Prime Award,” https://www.usaspending.gov/search/?hash=9eab048491ad6d8f775907b61e671bd1, accessed March 8, 2024.

3. Defense Daily, “Raytheon’s Venture Arm Invests In Autonomy Solutions Company EpiSci,” https://www.defensedaily.com/raytheons-venture-arm-invests-in-autonomy-solutions-company-episci/business-financial/, accessed March 8, 2024.

4. C4ISRNet, “Pentagon achieves ‘minimum viable’ version of CJADC2, Hicks says,” https://www.c4isrnet.com/battlefield-tech/c2-comms/2024/02/21/pentagon-achieves-minimum-viable-version-of-cjadc2-hicks-says/, accessed March 8, 2024.

5. PR Newswire, “BlueHalo and Eqlipse Technologies Combine to Create Global Defense Technology Leader,” https://www.prnewswire.com/news-releases/bluehalo-and-eqlipse-technologies-combine-to-create-global-defense-technology-leader-302060433.html, accessed March 8, 2024.