Private equity need not shy away from defence investments
Jussi Lehtinen
As everyone and their dog have noticed by now, the world has changed. One of the unfortunate consequences of that change is that defence spending in Europe is set to boom.
Large shifts in capital flows also create opportunities for the savvy investor. Over the past months I’ve had a number of discussions with Nordic private equity investors on defence as an industry and as an investment opportunity.
In these discussions, it has become clear that there is considerable interest in deploying capital in defence firms. Nonetheless, it is equally evident that certain concerns are impeding these investments. These can be grouped into three main areas: long-term outlook, customer concentration, and lack of recurring revenues.
Long-term outlook – military spending reverting closer to the historical norm
At the moment, European countries are scrambling to raise their defence spending to 3.5% if not more (way to go, Poland!). However, investors are rightly worried about what will happen when the war in Ukraine ends or freezes and the mass attention shifts to other topics – such as public indebtedness, an ageing population, or climate change, to name just a few money sinks.
Will the spending on security (which should be thought of as a broader topic beyond just armed defence) remain at the new increased level or dip back to the levels of the late 90s and early 00s?
While it is, of course, impossible to predict with certainty anything as fickle as the public mood or spending priorities, it should be noted that any upcoming shift in the security environment will be different from any of the three large demobilisation phases of the 20th century: 1918, 1945 or 1989.
In those cases, the conflict was clearly defined and had an easily identifiable ending with Western Europe clearly on the winning side. In the current environment, it is unlikely that the war in Ukraine will end in a way which would lead to such an immediate removal of the threat from adversaries – and even if it did, the shift in US focus means that Europe has no choice but to take more responsibility for its security.
Also, while the current spending levels may seem high, they are actually close to the historical averages. Between 1700 and 2022, the United Kingdom, the country with the best data series available, spent on average 3.2% of GDP on defence. So, as we are now reverting closer to the historical norm, it may be that we’ll look back to the brief period between 1991 and 2014 as an aberration rather than the harbinger of a new era.
Customer concentration: a constraint that favours scale
Defence spending is largely driven by national governments, which typically means a market of one per country. This, combined with long procurement cycles, means that demand even for a successful product can be like a Finnish summer: hard to predict and slow to realise. Another problem is that many of these customers are hesitant to procure from small start-ups, especially if the systems are truly mission critical or have a long lifecycle.
While this can make life difficult for an investor, it also creates an opening. By providing sufficient financial firepower, they can assure customers that the promising start-ups won’t go out of business in 6 months. Moreover, the defence market is currently extremely fragmented with a lot of small suppliers striving to grow. Thus, there is a real opportunity for an investor who is able to consolidate the field by combining some of the interesting point-solution providers into a larger entity before they either go bankrupt or are swallowed by the larger contractors.
Another mitigating action is to target companies with a clear dual-use purpose, whether protecting critical infrastructure, supporting emergency services, or helping in disaster recovery. These end markets are typically larger than the military use cases and offer good diversification. The downside is the need to build a different go-to-market channel as well as smaller account sizes.
Lack of recurring revenues will become less of a concern
Having become used to the steadily growing monthly payments provided by the large and growing software market, many investors have an inbuilt dislike for one-off revenues. A recurring (pun very much intended) concern for investors is that a large part of the defence spend is geared towards hardware and systems with limited continuous revenue or service components. Historically this has indeed been the case, and it is true that a lot of the growth in expenditure is going toward hardware such as planes, tanks and ships. However, there are two trends which are poised to shift this dynamic.
The first one is the increasing role of software in defence. Like any other industry, armies of today rely on a growing library of code which will need updates. Provision of those updates is a natural source of after-sales revenue. Mid-life updates that used to be a decennial exercise may become a monthly if not weekly feature.
Another trend is the lack of manpower affecting several Western armies. As armies face the harsh reality of smaller cohorts, they need to take a critical look at the division of roles between the private and public sector. This means that many service roles that have traditionally been handled by the defence forces themselves will be outsourced – a trend already evident in countries like the US or UK.
Lessons for the private equity investor
My objective is not to dismiss the worries that investors have regarding the defence sector. As with any major shift in capital spending, there are bound to be mistakes and disappointments.
However, with a clear understanding of the industry’s dynamics and careful pre-deal planning it is possible for even a generalist investor to be successful in the field and take advantage of the opportunities this shift will generate.
