by Victoria Rakitin, Isaac Resca, and Louis Paget
In the defense sector, the government usually stands out as the sole customer, characterized by strong rigidity and risk aversion. This unique feature of the industry creates both opportunities and risks for private equity firms interested in investing in the industry.
When it needs equipment, the government lists specific requirements, evaluates the different proposals from vendors, and selects a supplier. The risk for tier-1 vendors of not winning the contract after heavy spending on Research and Development and Capex is therefore high and can discourage investors. The sector is also characterized by the long-term nature of contracts, usually longer than 5 years. This can be seen as a source of stable revenue streams and predictable cash flows, a desired feature for private equity firms relying on debt to fund their acquisitions but can also deter PE firms wishing to operate major changes in cash flows in a 5-to-7-year period of time before exiting.
Moreover, the proactive role of the government is a double-edged sword for potential investors. On the one hand, governments can choose to boost their national military capacities by increasing defense spending or even encouraging private funding. This position is exemplified by Macron’s “war economy” policy in France, setting a goal of a 40% increase in the military budget by 2030 and supporting the implementation of defense investment funds.
However, the heavy regulation brought by governments in the defense industry can also pose difficulties. Indeed, some companies developing unique weapons and technologies are considered national strategic assets by their government. The state, therefore, has power over the bidding process of their exit, and can go as far as to refuse the selling to rival states’ acquirers in order to protect their interest. For instance, in 2021, France refused to approve the selling of Photonis, an electro-optic company. Limiting bidders to particular regions or countries leads to lower exit multiples and hurts the return on investment.
Understanding the role of the government and its impact is, therefore, crucial to navigate this highly regulated industry and make informed investment decisions.
Deglobalization Trends: Geopolitics and the Defense Industry
While the defense industry has always been a massive point of opportunity for investment, recent trends in the past several years have made the sector much more attractive for Private Equity investors. In the past, many Venture Capital and Private Equity firms have often been reluctant to invest in defense-focused companies, yet recent shifts in geopolitics have impacted the structure of the industry, as government needs and demands change according to the ever-evolving threats to the current world order.
Most notably, the escalation of the Russia-Ukraine conflict has had a very real effect on the defense industry, as Putin’s decision to formally invade Ukraine in early 2022 led to overt
military support by the West to Ukrainian capabilities. War in Ukraine has had the very real effect of depleting both European and American arsenals of munitions and other needed logistical capabilities beyond a sustainable rate of replenishment. Moreover, governments specifically in Europe have dramatically increased military expenditure as a protective move against certain indirect conflicts with Russia and the potential for new conflicts in areas like the Baltic states and Moldova. In 2022, the year Russia invaded Ukraine, European governments increased their military expenditure by over 13%, the highest increase since the Cold War.
In addition, escalating tensions in Southeast Asia have Western powers planning for the possibility of armed conflict with China. Aside from simple increases in government expenditure fueling opportunity in the defense space, the global trend of increased protectionism due to geopolitical conflict as well as COVID-19 contributing to the reshoring of supply chains has incentivized governments to increase spending in sectors like microelectronics, which previously relied on extended supply chains across countries like China.
The Future of Warfare: Shifts in Military Technology
With such recent changes in global trends, governments now see the need for revamping their conventional warfare capabilities and therefore have begun to focus less on main weapons platforms contractors and direct more funding on electronics and automated systems. The use of cheap drones and disposable anti-air weapons in conflicts such as the Nagorno-Karabakh and even more strikingly the Ukraine has proven that capital-intensive capabilities such as large, armored tanks have pushed militaries around the world to focus on smart weapons capabilities. Many of the existing companies in this subsector are small due to the need for large amounts of research and a relatively light need for physical capital expenditures. This presents a great opportunity for PE investors, who can incorporate many smaller synergetic companies in their portfolio while benefiting from the stability of multi-year government contracts.
The fact that small unique technology companies have suddenly gained importance in the eyes of militaries and their governments have pushed the investment timeline earlier, allowing for Private Equity investors to benefit from larger returns and higher growth potential. As an added benefit, many technology-heavy firms have applications for defense and civilian markets, increasing a company’s probability of future success.
A By-Product of These Trends: Consolidation
Industry dynamics spearheaded by these geopolitical and technological trends are triggering a spate of consolidation activity in the defense sector, which finds a perfect fit in private equity playbooks. As strategic investors, private equity firms can acquire a few small companies across the supply chain – for aero electronics, this could be acquiring a parts and materials supplier, a board assembler, an avionics original equipment manufacturer, and a logistics supplier –, and can then improve their operations, create synergies, and achieve economies of scale. The
product is a single firm with wider-encompassing capabilities, technologies, and essential industrial know-how. Such a process is what investors often refer to as a “roll-up.”
More than this, private equity firms have the opportunity to invest in large companies with high value-added potential who, as a group, share one central concern: securing a solid supply chain. As Serge Weinberg, Chairman of the private investment firm Weinberg Capital Partners, puts it, “there is a need for additional production capacity, ability to build up stocks, and therefore there is a need to strengthen the financial structures of these groups.” A fragmented supply chain threatens the profitability of businesses in the defense sector, and consolidation is a natural step toward hedging this risk. The importance of size at the prime and subcontractor level is also evident as a source of competitive advantage, as primes are progressively demanding for their suppliers to provide complex assemblies rather than components.
Eiréné, Weinberg Capital Partners’ newest LBO fund with more than 100 million euros in commitments, is a prime example of how this vision towards consolidation manifests itself in the private equity world. According to a recent press release by Weinberg Capital Partners, the target companies for Eiréné address all areas of activity in the defense sector (i.e. land, naval, aeronautics, space, electronics, security, cyber, etc.) and the entire value chain (i.e. design and manufacture of components, equipment, systems, service provision, etc.). The objective is to support SMEs and mid-caps in France in their growth strategies and consolidate the relatively fragmented French security and defense industry. Supported by the French government, the fund has been referenced in last month’s National Assembly as an opportunity to keep France’s strategic companies under French capital during the transition to a war economy, but also as a lever to transform French SMEs into Economically Targeted Investments (ETIs)—investments that will generate societal benefits in addition to the investment return.
While consolidation poses opportunities for private equity firms to profit, concerns have risen nonetheless among governments. In the United States, a dramatic reduction in the number of companies within the defense industrial base has alarmed the Department of Defense. In fact, a recent report by the DoD states that over the last 30 years, the defense sector has consolidated substantially, transitioning from 51 to 5 aerospace and defense prime contractors. This highlights the dangerous supply-chain dependencies on a limited group of primes that the DoD may uncover and, with lacking competition, the strains to the essential innovation for the products and services needed to support national defense.
Sources:
https://www.ft.com/content/d70982dc-ffec-4055-847b-49ab0b2dd843
https://www.nationaldefensemagazine.org/articles/2023/2/27/private-equity-fueling-growth-of-def ense-mergers
https://www.weinbergcapital.com/en/all-news/weinberg-capital-partners-cree-le-fonds-eirene-de die-aux-pme-et-aux-eti-francaises-du-secteur-de-la-securite-et-de-la-defense/
https://www.defense.gov/News/News-Stories/Article/Article/2937898/dod-report-consolidation-of
-defense-industrial-base-poses-risks-to-national-sec/
https://www.realcleardefense.com/articles/2023/03/04/defense_innovation_and_venture_capital
https://www.assemblee-nationale.fr/dyn/16/rapports/cion_fin/l16b1023_rapport-information.pdf
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