Despite a host of unusual deal challenges, private equity firms have made many significant investments in defense, aerospace and other companies with military operational elements. Important examples include Cerberus Capital Management LLP's pending agreement to acquire DynCorp International LLC, Kohlberg Kravis Roberts & Co. and General Atlantic LLC's acquisition of TASC Inc. in 2009, Carlyle Group's acquisition of Booz Allen Hamilton's government consulting arm in 2008, and Goldman, Sachs & Co. and Onex Corp.'s acquisition of Hawker Beechcraft Corp. in 2007. Many analysts are cautiously optimistic about growth and related merger activity in this sector in the coming year, citing, for instance, low leverage at many defense-related companies and growth in foreign military sales. More generally, rampant worldwide security concerns seem to make for a bullish environment for investment in this sector.

Don't be dismayed by the many special legal and regulatory challenges for private equity investment in this space. For the determined sponsor, it is not as bad as it may seem at first blush.

Most private equity sponsors are unlikely to have on staff anyone with active security clearances. This poses significant challenges to the diligence process, because the sponsor will not only be denied access to important contracts and facilities relating to the target's classified projects, but also may not be entitled even to be told of the existence or nature of the project or who the customer is (what branch of the government or military). This can force the buyer to fly blind on important operational aspects of the target, greatly complicating valuation and other risk allocation judgments.

The process for obtaining a security clearance is not for the faint of heart and can be intrusive and take up to a year to complete. But it is doable. Of course, if nobody at the private equity firm is willing to endure the aggravation of obtaining the needed clearances, the sponsor can move forward without diligencing the classified projects. There are many public companies with classified projects whose stockholders make investment decisions on the basis of limited disclosure in the companies' public reports. The private equity buyer may also attempt to shift the risk of what it doesn't know about the projects to the seller via representations and indemnities. Still, it is difficult to negotiate appropriate contractual protections in a vacuum, and in any event, they do not afford a buyer the same perspective as reading the contracts and discussing the actual projects with management.

Another alternative is to retain a third party, ideally one whose business judgment is strong and well-known to the sponsor, with the necessary clearance to perform diligence on the classified projects. While that person would be restricted from disclosing its particular findings to the buyer, there is at least the opportunity to raise a red flag.

Unfortunately, none of this changes when the sponsor wins control of the target. Unless and until someone obtains the required security clearance, the sponsor must rely on the target's management and will be left in the dark as to its black box projects.

Under the Exon-Florio Act, private equity firms constituting "foreign persons" may need to obtain clearance from the Committee on Foreign Investment in the United States prior to acquiring control of a U.S. defense-related business. Exon-Florio authorizes the president to "suspend, prohibit or require the unwinding of any transaction by or with a foreign person that could result in foreign control of a U.S. business, if the president concludes that (1) the foreign interest exercising control might take action that threatens to impair U.S. national security and (2) other laws do not provide adequate protection."

An acquirer may voluntarily file with CFIUS, triggering a review of and waiting period for the proposed transaction. If CFIUS clears the transaction without further review, the parties can close without fear of subsequent presidential interference, unless the parties submit false or misleading material to CFIUS or materially breach their mitigation agreement. By contrast, if no filing is made, the president has the power to unwind the transaction after it has closed. It is, therefore, almost always prudent in this context for a foreign buyer voluntarily to make the appropriate filing with CFIUS.

Exon-Florio was amended in 2007 by the Foreign Investment and National Security Act of 2007. Prior to Finsa, so-called mitigation agreements were informally entered into from time to time between the relevant federal agency and a foreign person exercising foreign ownership, control or influence (FOCI) over a company with a U.S. national security interest. The purpose of such agreements was to mitigate the effect of FOCI by, for instance, limiting involvement by foreign personnel on the company's board of directors and in certain sensitive tasks.

Finsa now specifically authorizes CFIUS to enter into mitigation agreements with buyers as a means of enabling them to receive clearance of particular transactions. The new regulations and related executive orders contain helpful provisions preventing CFIUS in most cases from coercing a company into complying with authority to which it would otherwise not be subject. On the other hand, CFIUS is now authorized to reopen any transaction at any time if the parties materially breach their mitigation agreement.

Contracting with the government can be a complex and frustrating affair. All government contracts between a target in this sector and the government are subject to the extensive Federal Acquisition Regulations. Given the unique position of the government, many legal principles that govern contracts between two commercial parties in other contexts may be inapplicable to a government contract. A government contract may also simply be illegal, and thus void. A contract where the contractor's profit is based on the costs incurred is a good example. Once a contract is found to be illegal, it is not always clear whether the contractor can recover from the government any of the costs the contractor already incurred, even if the government has received a benefit. It is therefore wise to include in the acquisition agreement robust representations regarding the target's government contracts. In many cases it may be worthwhile having a government contracts lawyer look at the contracts (subject to security restrictions) and help tailor the representations in the acquisition agreement.

Read literally, the Anti-Assignment Act, which prohibits the assignment of government contracts, is triggered by virtually all deal structures involving the acquisition of a government contractor. Courts, however, have developed a "by operation of law" exception that has been interpreted to except an assignment pursuant to an acquisition after which the contracting party survives intact (such as a reverse merger or a stock acquisition) and its rights and obligations are unaffected. However, asset purchases and some forward mergers likely do not fall within the exception. If the Anti-Assignment Act applies to a transaction, the parties to the transaction and the government will typically enter into a novation agreement, a standard form of which can be found in the Federal Acquisition Regulations. Negotiating one or more novation agreements with different branches of the government may be daunting and may involve potentially intrusive diligence by the government on the buyer. Accordingly, structuring a deal so as to avoid the application of the Anti-Assignment Act can play a significant role in the formative stages of an acquisition.

A contract in which the government funds any "experimental, development or research work" may fall under the Bayh-Dole Act. Many agreements with defense contractors may include provisions relating to expenditures for the research and development of a component, a system, a newly designed weapon or vehicle, or the like. If so, Bayh-Dole in most cases allows the contractor to retain title to an invention developed under the agreement. In return, the government receives a non-transferable, irrevocable, royalty-free license to use the invention. The government also obtains "march-in" rights, allowing it to force the contractor to grant licenses in the invention to third parties if the contractor fails to reduce the invention to practical application in a reasonable amount of time. Thus, if a contractor develops a new missile launcher at the government's expense but does not take steps to make actual missile launchers available within a reasonable time period, the government can require the contractor to license the invention to one of its competitors. While these sorts of issues do not often plague contractors, they are worth keeping in mind as a sponsor diligences its defense-related target.

There are three basic sets of export controls that may affect the products and services of a defense company. These controls, which are complex and often confusingly interrelated, focus among other things on licensing, registration and the imposition of penalties for violations. Understanding how a target is regulated under these regimes and whether it is complying with the regulations or subject to non-monetary penalties that can affect its ability to continue doing business with the government is critical to the diligence process, the valuation of the company and the drafting of the risk allocation provisions in the acquisition agreement.

First, the State Department, through the Directorate of Defense Trade Controls (DDTC), controls the export of "defense articles" and "defense services." Items that have been so designated are set out in the United States Munitions List, which is part of the International Traffic in Arms Regulations (ITAR). Registrants must give advance notice to the DDTC of any proposed transfer to foreign ownership or control, a process that may dovetail with the Exon-Florio filings.

The Bureau of Industry and Security administers a second set of export controls found in the Export Administration Regulations (EAR). These controls are less likely to affect a defense company's business, because in practice they are generally limited to "dual-use" items, that is, items that may be adapted to either military or nonmilitary use. If the item has been expressly designed for military use or its export is exclusively controlled by the DDTC, the EAR likely will not apply.

Finally, the Office of Foreign Asset Control administers economic sanctions programs, including export or import embargoes relating to designated persons, entities or countries. The relevant regulations sometimes overlap with the ITAR and EAR.

Acquiring a defense company can be daunting, but the mission is possible. Remember that the government is like no other customer. Alerting the government's point persons on the target's important projects early in the process, keeping them up to speed and obtaining their approval of the transaction can often be what makes or breaks a deal. Teaming up with a strategic partner may also ease some of the challenges, but going solo is perfectly feasible when you know what questions to ask and have assembled the right team to ask them.

Andrew L. Bab is a partner in the corporate department of Debevoise & Plimpton LLP and focuses his practice on public and private mergers and acquisitions, as well as corporate and securities law matters. A version of this article originally appeared in the winter 2010 issue of the Debevoise & Plimpton LLP Private Equity Report.