Clearance Sale

n January, a group of New York venture capitalists paid more than a half billion dollars for a 7-year-old company that conducts background investigations of government employees and contractors. The transaction went largely unnoticed outside the financial trade press and experts on the arduous process of obtaining federal government security clearances, for which background investigations are a key requirement.

The high price fetched by such a young company drew business analysts' attention. But in the deal, they also saw something else-the signs of a market poised for major growth. The sale revealed just how big the business of inspecting people's financial, employment and personal histories has become as the government has grown obsessed with shoring up security. Government's need for workers authorized to view sensitive information and to work in secret facilities is greater than ever.

The acquired company, U.S. Investigations Services (USIS), used to be a federal agency. In 1996, 700 employees of the Office of Federal Investigations, which conducted background investigations for most civilian agencies, left the government and became employee-owners of USIS. They received shares in USIS that accrued value based on employees' length of service and the company's financial performance. And USIS performed exceptionally well. The company has grown year after year, aided greatly by an exclusive contract it landed in 1996-without competition-to perform background investigations and related work for its former parent agency, the Office of Personnel Management. Hundreds of thousands of requests for background investigations arrive at OPM each year, many of them requiring face-to-face interviews with a security clearance applicant's friends, family and co-workers. The requests come from agencies seeking clearances for their employees or contractors.

Demand for security clearances has skyrocketed, producing a similar explosion in requests for background investigations. In fiscal 2002, OPM received almost 2 million requests for investigations and checks of financial and employment histories and other records. That was an increase of nearly 90 percent from the previous fiscal year. The vast majority of the work is handled by USIS, according to an OPM official who asked not to be identified.

The Defense Department still operates a clearance investigations unit, which employs 1,300 investigators and three contract investigation firms. Defense received nearly 400,000 requests for background investigations in fiscal 2002, says Judy Hughes, the official in charge of the investigations unit, which is part of the Defense Security Service.

Fears of another terrorist attack, recent call-ups of military reservists and planning for new homeland security and counter-terrorism initiatives have prompted government agencies to request more security clearances, officials say. State and local officials also want clearances so they can view intelligence and counterterrorism reports produced by the federal government. And government contractors want to stock up on cleared employees, knowing they bring a competitive advantage when firms bid on contracts for which clearances are required.

But the deluge of investigation requests, which promises only to grow, has created a backlog. Getting a clearance can take several months to more than a year, depending on the level of access required. There aren't enough trained investigators to meet the demand. The backlog also has created a market. A number of companies, including the investors who purchased USIS, hope to cash in on the government's insatiable appetite for security clearances.

CORNERING THE MARKET

The $545 million that New York investment firm Welsh, Carson, Anderson & Stowe paid for USIS was remarkable partly because it made some former government employees wealthy. Approximately 3,600 employees and about 1,400 former workers shared $500 million, apportioned depending on their length of service, says Laurence Goldberg, the attorney who represented the employee-owners in the deal. The remaining $45 million went to buy out outside shareholders, he says. Washington-based Carlyle Group, a minority shareholder since 1999 and the world's largest equity fund manager, reinvested $172 million in the company, along with senior USIS managers. USIS executives declined to discuss any aspect of the transaction.

But beyond the high price tag and high-profile investors, the buyout is significant because it has financially buttressed USIS to consume more of the background investigations market. In February, Defense officials decided to move the department's security clearances unit to OPM pending enactment of the fiscal 2004 budget. Once that happens, USIS' most important customer, OPM, will have central control over awarding background investigation contracts. In a statement in February, OPM said that merging its operations with Defense would benefit all contractors, because in the past "these companies had to compete for work [from] both agencies." However, OPM's history of awarding investigation contracts hasn't been all that competitive.

When OPM gave USIS its exclusive deal in 1996, no other company was conducting large numbers of background investigations on the government's behalf. USIS' position as the dominant player in the market today was nearly guaranteed by its sweetheart arrangement with the government. In 2001, OPM conducted a new competition for its investigations work, and USIS won the contract again. Today, three other companies do a small amount of work for the agency, the OPM official says, declining to name them. But as the Defense operation prepares to move to OPM, USIS' competitors are hoping the company doesn't swallow their share of the market as well.

Executives at the firms that contract with Defense declined to speak on the record about the implications of the merger on their business. But Peter LaMontagne, a senior corporate vice president at ManTech in Fairfax, Va., one of the three contractors, said the company is "very interested in learning how the transition from [Defense] to OPM works out," and that he hopes OPM will utilize the full array of investigation providers.

ManTech is gunning to take some of USIS' business, demonstrating that today's market is different from the one that was practically handed to USIS in 1996. In February 2002, ManTech and MSM Security Services of Greenbelt, Md., were awarded a joint contract worth $50 million to conduct background investigations for the Defense Security Service. The following month, ManTech acquired MSM and its investigations business at the Customs Service and intelligence agencies, including the National Security Agency-which process their own security clearances.

Also last year, Computer Sciences Corp., one of the largest government contractors, purchased DynCorp, another giant and also a Defense investigations contractor. DynCorp's work for Defense is valued at $50 million. Computer Sciences and ManTech will continue working on Defense investigations after the OPM merger is completed and while details of the transition are worked out. The OPM official expects the firms will compete for subsequent work from the agency. "It's going to take multiple contractors" to process the massive number of requests, the official says. USIS' contract is up for renewal next year.

But USIS is entrenched. Since the company is privately owned, it doesn't have to disclose its finances. But observers and analysts say the company owes its good fortune primarily to its OPM contract. In 2001, congressional researcher Ronald Moe noted in an article in the journal Public Administration Review that, "By any account, [USIS] was given advantages and incentives not available to other startup corporations." The OPM official notes that more than 80 percent of the firm's employees work on the agency's contract. OPM even keeps offices alongside USIS' in a secure facility located more than 200 feet underground in Annandale, Pa. USIS officials refuse to discuss any aspect of their operations with the news media, says Barry Kingman, a company spokesman. "It's a distraction," he says, explaining that the company is "busy making our contribution to national security."

Goldberg, who counseled USIS employees on the buyout, says there's nothing surprising or sinister about the apparent coziness of the OPM-USIS connection. Any employee-owned startup must be guaranteed some source of initial revenue, he says. When USIS was formed, lawmakers were concerned about the job risk for employees leaving the protected confines of the federal government for the business world. Without the OPM deal, it is unlikely that USIS would have been created.

TALENT CRUNCH

While the background investigation business is hot, and competition is likely to get more intense, the government's demand for workers with security clearances reveals a broader trend. For companies such as ManTech, Computer Sciences and dozens of others engaged in government technology, intelligence and security work, a pool of cleared employees is a vital asset.

The Washington Post's classified section contains ad after ad from government contractors seeking workers who already have security clearances. Some clearances are valid for 15 years, so having one makes the holder distinctly marketable. The same is true for companies with cleared employees. "There's no question that if you have a multitude of cleared personnel, you have a decided advantage" when competing for contracts, says Jack Mallon, the managing director of Mallon Capital, a New York investment bank that specializes in the security industry.

For some companies, having cleared employees is a must. Last year, Convera, a Vienna, Va., company that makes software to search intelligence agencies' databases, signed a deal with the FBI for help with counter-terrorism measures. Any Convera employee who participates in the project must have a clearance, says Sean Alger, Convera's vice president and general manager of federal sales. There are no exceptions. Convera's recent success points to the growing importance of having a stable of cleared employees. In March, the CIA's venture group, In-Q-Tel, which invests in companies making technologies that fit the agency's long-term needs, invested $1.5 million in Convera to fund product development. Convera also has several contracts with federal law enforcement and Defense agencies that require employees to have security clearances to install and maintain software.

With budgets at intelligence agencies and the Homeland Security Department on the rise, demand for cleared employees will continue growing, says Steven Aftergood, an expert on the security clearance process with the Federation of American Scientists in Washington. Aftergood says that whether a company decides to start building its cleared pool depends mainly on who its client is. New employees of longtime government contractors working for national security and intelligence agencies are likely to be put through the clearance process as soon as possible, regardless of their age or experience, he says.

Some agencies are so adamant that contract employees have security clearances, and are so concerned about avoiding the lengthy process of obtaining them, that they limit competition to companies with sufficient numbers of cleared staff. In April, Lt. Gen. Robert Flowers, commander of the Army Corps of Engineers, defended a decision not to invite firms to compete against Kellogg, Brown & Root for a contract to extinguish oil well fires in Iraq. In a letter to California Democrat Henry Waxman, the ranking member of the House Government Reform Committee, Flowers said that to open the bidding for the contract would have been "a wasteful duplication of effort" that "would have delayed [the military's] war planning in order to obtain security clearances for potential competitors." Flowers gave no timetable for conducting new competitions. "The procurement strategy is to compete subsequent efforts at the earliest reasonable opportunity consistent with the needs of the mission," he told Waxman. The oil fire contract potentially is worth $7 billion.

Whenever the new competition takes place on contracts for which cleared employees are required, companies that don't have the workers must pledge to subcontract to firms that do.

Ultimately, the government's demand for cleared workers might exacerbate the clearance backlog. Judy Hughes, who manages Defense Security Service investigations, says that while the number of requests for investigations has increased, the number of investigators hasn't. "The main concern right now is there aren't enough investigators" to do the work, she says. Because there are so few qualified investigators, Hughes says, they're in extremely high demand. Thus multiple companies often end up hiring the same people on a part-time or contract basis. Many of the investigators are former federal employees, Hughes notes.

The investigations companies have little incentive to hire new people or keep them on staff permanently. Some investigators have let one company pay for their training, only to quit and farm themselves out to the highest bidder, Hughes says. It makes better financial sense for a company to hire investigators to travel across the country conducting background investigations as needed, rather than pay to keep them stationed in a city year round waiting for work to arise in that area. Hughes says Defense tried for a few years to "build the industry" of investigators by offering to pay companies for the training. But she says the efforts produced "limited success," primarily because it's still more profitable for companies to hire investigators as needed.

Consolidation of the companies providing background investigations may help increase the number of investigators, says investment banker Mallon. With fewer companies in the industry, investigators might be more inclined to stay with one employer for a longer period, he says, and then companies might be less wary of paying for their training. "I think it would help speed up [the investigation process], and it would also make it more efficient," Mallon says.

But for now, the promise of striking it rich in the investigations business is foremost on companies' minds. USIS won't disclose the details of its buyout, but Mallon says, "I would think that a lot of millionaires came out of that transaction . . . at all levels." That's music to the ears of executives at USIS' competitors, who hope government's thirst for clearances will bring them big rewards as well.