Geopolitical instability and technological innovation have put the defence sector back in investing fashion. But as Tom Williams reports, it is still a challenging space for private equity.
Defence or the procurement and supply of equipment to the military, has always been a difficult and, for many, taboo area to invest in. But even before the arrival of a new hard-power-driven US administration insisting its allies significantly up their military spend, investor enthusiasm for the sector was already rising.
It is estimated that in 2000 to 2021 about a quarter of the 3,700 US-based arms companies involved in market deals were funded by private equity. More recently reported figures suggested that by May of this year, private investors had already deployed over US$790m in defence. In February this year in the US, Berkshire Partners and Warburg Pincus acquired aerospace and defence component maker Triumph for nearly US$3bn (£2.3bn). Across the Atlantic in the UK another US private equity major, Bain Capital, had a £1.1bn (US$1.39bn) tilt at Chemring.
It would also be too simplistic to see the chronic darkening of the international security situation as a catalyst for more defence deals, as Alex Edmondson, a partner at UK law firm Macfarlanes, explains.
“We have a situation where countries are stating publicly ‘we need a lot more investment into the defence sector’,” says Edmondson. “That, on the face of it, creates more market opportunities for responsible private capital investment, which is clearly a good thing. Set against that is the fact that this has been fuelled by increasing geopolitical tension etc which puts the national security elements related to this area more sharply into focus. This creates two slightly conflicting consequences, in that more investment is desired and needed in the sector but making investments is going to be subject to even greater scrutiny because of the heightened national security concerns.”
Edmondson explains that equity investment thresholds at which this scrutiny kicks in are low (typically around 10%) and points out that even in a market like Europe, where a degree of regulatory collaboration is often assumed, “the actual underlying regimes and requirements can be quite different” necessitating the navigation of “half a dozen different regimes in different jurisdictions on different time scales.”
Edmondson doesn’t think however that national security regulatory issues, which in a typical defence M&A tend to coalesce around who a GP’s ultimate investors are but can also involve other areas like technology licensing, are insurmountable.
Others point out that the nature of government, which is ultimately the end client for the products of most defence companies, creates its own problems which could continue to effectively restrict the field to a smaller number of major or very specialist/experienced investors.
“These are programmes that are very large and run for multiple years,” says Kasper Wichmann, cofounder and CEO of private equity fundraising site Balentic. “Which is also why procurement departments are probably not going to take in whatever little venture startup might be growing and at a pretty brusque clip right now when they simply can’t keep up with it.”
This could be a problem for new investors in defence and particularly those hoping to take advantage of the consolidation of a market which is particularly fragmented in Europe.
Wichman suggests there could be “disconnects in how this actually works and a GP is actually positioned to how an LP can actually invest into that” adding that GPs need to ask themselves some fundamental questions before getting caught up in what could be another bout of investment exuberance. “You can follow a hot trend to raise money but can you actually deploy it profitably? Do you have the skills set internally to do this just because you hired someone who was the top supplier to aerospace, that doesn’t mean he should be running a defence fund necessarily. And are there enough people out there to hire to do this? Do they understand private equity? Do they have the security clearance for these types of things in the network that they lead.”
But as Wichman and Edmondson point out, suppliers to the military and aerospace sector are seldom one-trick ponies, and it is through such “dual-use” companies that private equity can get and hedge its exposure to defence and shift in government supply chains or policy. The aforementioned Triumph and Chemring, for example, supply commercial companies as well as the military while newer technological or product areas such as drones are also already ubiquitous in civilian life.
Dual-use businesses, however, will not necessarily allow investors a way around their own environmental, social and governance (ESG) policies, wider regulation restricting investment in military technology or both. This has led some to wonder whether the more recent apparent political shift away from ESG, particularly in the US, could help prod institutions such as pension funds more into defence investment. But Edmondson says that if there has been a change in how ESG criteria affects institutional investment, it has been developing for longer than that.
“There have been a lot of public statements by various national bodies from different countries in relation to how ESG assessment of defence-related investments is more nuanced, in fact, than people historically might have assumed, and that it is possible to make investments in the defence sector which are compliant with sustainable finance initiatives and so on,” he explains says. “From our experience and conversations with clients, I don’t know that that is necessarily driving activity, it is more a clarification that ESG requirements shouldn’t automatically act as an absolute barrier.”
Private equity investors who have already made the decision to cross that line are more likely to have already positioned themselves to benefit. Others should consider whether they and their investments can and should go in that direction and what it will mean if they do.
Stay in touch with all of our latest updates and articles. Sign up now.