Wanted: A buyer for Blackwater and its baggage

FORTUNE -- Xe Services, what Blackwater became after civilian shootings, criminal indictments and civil lawsuits caused a rebranding push in 2009, wants someone to buy it. The question is whether any potential acquirer could stomach the risk.

It certainly has assets. Besides its training facility in the North Carolina swampland, Xe Services has contracts for military training and security staff in hotspots throughout the world, a growing presence in the lucrative Asian markets, and burgeoning manufacturing units that produce everything from defense vehicles and weapons to surveillance products.

Its contentious relationship with the United States government, which came to a head when Blackwater guards shot Iraqi civilians in a busy Iraqi intersection in 2007, has not stopped Xe Services from pulling in a multitude of extremely lucrative government contracts. One with the US Transportation Command in Afghanistan is worth more than $750 million.

More recently, it landed a coveted spot as one of five major contractors pre-qualified for a chunk of $15 billion being doled out by the Department of Defense in a far-reaching, go-anywhere narcotics interdiction effort. Revenues at Xe Services were projected at over $660 million in 2009, with plans to reach toward $1 billion in 2010.

Now Xe Services is putting itself on the block and -- on paper, at least -- it looks ripe for the taking. As the company noted in a prepared statement announcing its decision, "Xe's new management team has made significant changes and improvements to the company over the last 15 months, which have enabled the company to better serve the U.S. government and other customers, and will deliver additional value to a purchaser."

Private equity-backed military contractors

Xe Services has already had some success in finding a buyer for one section of the company -- in March it sold its aviation unit to a strategic buyer, AAR, for $200 million. But carving off a lucrative unit that was distanced from its Blackwater-era troubles is easier than selling what is essentially a renamed Blackwater with some additional bells and whistles.

With most of Xe's revenue dependent upon a few large public entities that are subject to public pressure, its future contracts and revenues can easily be threatened, notes Aswath Damodaran, a professor of finance at NYU's Stern School of Business. "If I ran a public company, I would not touch Blackwater with a ten-foot pole," he said. "The danger to my other businesses from contamination would be way too high."

One exception would be a large strategic buyer that is engaged in similar high-risk fields and that could find value in subsuming Xe Services into its ranks. For instance, DynCorp (DCP), which had over $3 billion in revenue in 2009 and just reported more than $1 billion in quarterly revenue, is an active competitor in Xe Services' main business areas. Buying Xe Services would further increase DynCorp's manpower and give the company access to additional contracts, such as the lucrative DOD narcotics intervention contract, for which it was not pre-qualified.

DynCorp would be wading into familiar territory, since it has already weathered a good deal of Blackwater-esque publicity itself. Just this January, the Special Inspector General for Iraq Reconstruction complained that DynCorp invoice errors and a lack of DynCorp documentation left more than $2.5 billion in U.S. Funds "vulnerable to waste and fraud."

However, DynCorp agreed last month to be acquired by Cerberus, the secretive private equity firm, in a transaction that, at first blush, appeared to knock any marriage between Xe Services and DynCorp out of contention.

Absorbing risk, tolerating the spotlight

Private equity firms have been extremely active in the defense and government technology services markets -- they're attracted to their fragmentation and, with terrorism and war seeming evergreen, their growth prospects. They are also generally better able to withstand "headline risk," which Xe Services still carries in spades.

Although a private equity buyer generally sees existing management as one of the assets that make an acquisition valuable enough to grow, in Xe Services' case, they would likely rather have top management depart. Perhaps sensing this, Xe Services has been reorganizing the ranks over the past year; in March, the company's controversial founder, a former Navy Seal named Erik Prince, stepped down as CEO, perhaps to bring more distance with the past.

So what might the private equity suitor look like? The Carlyle Group, which owns several defense contractors, including United Defense Industries, could be a buyer. But Cerberus, with $23 billion under management, seems to fit the bill especially nicely. Since it plans to take control of DynCorp, and already runs IAP Worldwide, which provides logistical support for the Pentagon, Cerberus will have a deep bench of capable management at its disposal.

Importantly, it also has a good idea what Xe Services might be worth, having kicked the tires at Blackwater back in 2008, just as the contractor's hill of trouble was revealing itself to be an ever-expanding mountain of risk. Back then, the secretive private equity shop chose to pass, citing a "myriad of reasons." Earlier that year, Cerberus CEO Stephen Feinberg had noted in a letter to investors, "We do our best to avoid the spotlight..."

While Cerberus declined to comment as to whether it was bidding for Xe Services, with its planned acquisition of DynCorp, the private equity firm has certainly signaled that it is now willing to handle the type of spotlight that a Blackwater could bring.