Defence is becoming an asset class – Part II: in a class of its own

This is the second in our series examining the development of defence as an increasingly distinct private capital investment strategy.

In our first article, published in July, we explored the growing amounts of private capital flowing into defence and dual-use businesses, the emergence of dedicated defence funds and the gradual dismantling of some of the historic barriers to institutional investment in the sector.¹

Recent developments have reinforced that direction of travel. Dedicated defence funds are raising substantial institutional capital, while private equity and credit investors are taking an increasingly active interest in the defence industrial base.

But as the market matures, a second and equally important theme is becoming clear: defence may be emerging as an asset class in its own right, but not a conventional one.

Unlike most private capital strategies, government policy, procurement, industrial policy and national security are not merely external influences on the investment case. They are an integral part of it.

From specialist capital to institutional capital

The scale and nature of the capital entering the sector continue to change.

In September, DTCP announced a EUR455 million first close for its first dedicated defence fund. Its investors include Deutsche Telekom and Porsche SE, Danish pension and insurance investor Danica, and state-backed investors EIFO and SmartCap. The fund will principally invest in European and NATO-aligned growth-stage businesses across autonomous systems, artificial intelligence, cyber defence, secure communications and space.²

At company level, the amounts being raised are also becoming increasingly significant. TEKEVER announced the first close of a USD580 million Series D financing at a USD6.4 billion valuation, led by UC Investments and Baillie Gifford. The company said the financing would support its international expansion, industrial and technological capabilities, strategic acquisitions and future growth.³ 

These developments matter not simply because more capital is flowing into defence, but because of the nature of that capital. Pension capital, strategic corporates, sovereign and state-backed investors and mainstream institutional managers are increasingly sitting alongside specialist defence investors.

That should help bring defence closer to the mainstream of private markets. It also raises new questions about how defence investments are sourced, diligenced, structured and ultimately realised.

Procurement and investability

The role of government is particularly important.

Defence companies are unusual because their principal customer is often also responsible for the policy framework within which the market operates. Government decisions can determine which technologies are prioritised, which businesses receive contracts, where manufacturing capacity must be located and, in some cases, who may own strategically important assets.

There is an obvious difference between an innovative defence technology and an investable defence business. Moving from one to the other will often depend on public procurement. Government contracts can validate technology, demonstrate demand and provide visibility over future cashflows. That can support investment in manufacturing capacity, working capital and international expansion, while making businesses better able to support debt as well as equity capital. 

Defence and dual-use businesses are increasingly attracting valuations more commonly associated with technology companies. Yet their underlying economics may remain closer to infrastructure or government-contracted businesses. Investors therefore need to understand not only the technology, but the durability of procurement relationships, barriers to entry and strategic importance of the underlying capability. In some cases, those factors may matter more than the technology itself.

The connection between public procurement and private capital is increasingly being recognised by policymakers.

In June, the UK Government published its Defence Investment Plan, which addresses the UK as a destination for defence investment, the defence investment ecosystem and the mobilisation of public and private capital. The Government describes the plan as being backed by GBP298 billion of investment over four years.⁴

The Government has also placed the Defence Investors' Advisory Group on a permanent footing and announced a programme under which finance-industry secondees will join the Ministry of Defence. It has said these measures are intended to deepen the relationship between government and the UK financial sector and explore how private investment can support defence readiness, innovation and growth.⁵

Europe's defence industrial base will require considerable debt, working capital and supply-chain finance if increased procurement commitments are to translate into increased production.

For lenders, longer-term procurement visibility may be just as important as government encouragement to lend.

A business with strategically important technology but uncertain revenues may remain difficult to finance. A business with substantial, long-term government orders presents a different credit proposition. Public procurement is therefore becoming part of the investment infrastructure surrounding the sector.

Government as investor as well as customer

Governments and public institutions are also moving further into the capital stack.

Public capital is increasingly being deployed alongside private capital through direct investment, fund commitments, lending programmes and guarantees.

The UK's National Security Strategic Investment Fund describes itself as the Government's deep-tech venture capital fund for national security and defence. It invests directly in dual-use technology businesses and indirectly through venture capital funds, and seeks to connect portfolio companies with government customers.⁶

The NATO Innovation Fund, supported by participating NATO nations, invests in deep technologies addressing defence, security and resilience challenges. Its published portfolio includes companies and fund investments focused on a range of defence, security and resilience technologies.⁷

The European Investment Bank has also expanded its support for security and defence, including financing and guarantees intended to support investment and working-capital requirements for businesses in European defence supply chains. Weapons and ammunition remain excluded from the EIB Group's eligible activities under its published framework.⁸

The relationship is therefore becoming more complex than the traditional one between government customer and defence contractor.Government can now be the customer for a business's products, an investor in the business or its fund, a provider of debt or guarantees, and the regulator responsible for determining whether a future investor or purchaser is acceptable from a national-security perspective.

This further distinguishes defence from strategies where public policy may shape the market but public institutions do not routinely participate alongside private investors.

Beyond venture capital

The private capital opportunity is also expanding beyond defence venture capital.

Much recent attention has focused on emerging defence technology businesses, particularly in drones, autonomy, artificial intelligence, cybersecurity and space. But Europe also needs to increase production across a much broader industrial base.

That creates potential opportunities for conventional private equity in precision engineering, advanced materials, electronics, propulsion, thermal imaging, aerospace components and other businesses serving the defence supply chain.Their financing requirements are also broader. Manufacturing expansion requires capital expenditure. Larger order books create working-capital requirements. Fragmented industrial sectors create opportunities for acquisition finance and consolidation. Defence infrastructure may require long-duration capital.

The market is therefore likely to involve venture and growth capital, private equity, credit, infrastructure and specialist financing.

That breadth matters because an established asset class requires more than primary equity investment. It also requires mechanisms through which businesses can be financed, consolidated and ultimately realised.

National security remains part of the investment analysis

The growth of private capital in defence does not remove the sensitivities associated with the sector. Those issues are likely to become more important as mainstream investors increase their exposure.

Foreign investment screening, export controls, sanctions, security requirements and restrictions on access to sensitive technologies can all affect an investment. For example, the UK's defence export-control framework continues to require licence applications to be assessed against the Strategic Export Licensing Criteria.⁹

National-security considerations may also restrict the universe of potential purchasers of a portfolio company, with consequences for entry valuation and exit planning. Investors therefore need to understand a defence business's activities with considerably more precision than a simple sector classification might suggest. What products does the business manufacture? Is its technology conventional defence or dual-use? Who are its customers? To which countries can it sell? Where is its intellectual property located? What restrictions might arise if its ownership changes? Could a future buyer trigger foreign investment scrutiny?

Those questions increasingly feed into fund terms.

Institutional investors continue to take differing approaches to defence. Some have revised historic restrictions as government and regulatory attitudes have changed. Others continue to distinguish between different categories of weapons, activities or customers, or retain broader investment restrictions.

The question for a fund is therefore not simply whether it can invest in "defence". Increasingly, it is which defence activities it can invest in, which products are involved, where they are sold and what controls apply.

An unusual asset class

Defence is attracting larger pools of institutional capital. Dedicated managers are raising larger funds, and private equity, private credit and infrastructure investors are examining the sector with growing interest. Yet defence remains distinct from almost every other private markets strategy. Public procurement underpins revenues. Industrial policy influences where capabilities are developed and scaled. Public capital increasingly sits alongside private capital. National-security considerations can shape ownership, financing structures and exit opportunities.

Those factors are not peripheral to the investment thesis; they are part of it.

Defence is emerging as a distinct investment ecosystem, shaped as much by government demand, strategic policy and national security objectives as by conventional commercial forces.

Defence may be becoming an asset class, but it remains an unusual one. For sponsors and institutional investors alike, understanding the interaction between capital, public procurement, government policy and national security may ultimately prove just as important as identifying the technologies and businesses themselves. As defence continues to attract larger pools of institutional and private capital, investors, fund managers and defence businesses will need to navigate an increasingly complex intersection of finance, procurement, regulation and national security.

DLA Piper advises investors, fund sponsors, lenders and defence businesses across the full investment lifecycle. If you would like to discuss the issues raised in this article, please get in touch with Sam Whittaker, Maria Perreira or your usual DLA Piper contact.