“Why are you not convinced by trillions of dollars? What has happened to your business instinct? Are you stupid?” — Admiral Rob Bauer, Chair of NATO’s Military Committee, 2024 (via Financial Times)
This was addressed to Western financial institutions during a NATO industry forum in Washington, where Bauer expressed frustration at the persistent reluctance of institutional investors to fund defense companies, despite surging geopolitical demand. He went on to criticize ESG frameworks and pension funds for applying outdated exclusions to defense investments, suggesting they fail to recognize defense as essential to “the foundation of peace and freedom.”
Well, all fine and good. And perhaps necessary to shake up the banks. And I do share his frustration in getting credit funding for defense startups (or even a bank for a checkings account to make payroll – jeez!). But our job description per AIFM or CSSF says we “direct capital” (we don’t “invest”!) and we “manage risks”.
Investing in defense and security related sectors through private equity presents distinct challenges and heightened risks compared to traditional equity investments.
1. Regulatory and Compliance Hurdles
International Traffic in Arms Regulations (ITAR) and Export Controls: Defense investments are subject to stringent regulations like ITAR, which govern the export of defense-related articles and services. Compliance is mandatory and can limit market opportunities.
Committee on Foreign Investment in the United States (CFIUS): CFIUS reviews foreign investments for potential national security risks, potentially imposing restrictions or blocking transactions involving defense assets.
European Defense Sovereignty: Investors must navigate policies aimed at maintaining domestic control over defense industries, which can restrict foreign investment and complicate cross-border deals.
2. Financial Constraints and Credit Challenges
Capital Intensity: Defense projects often require substantial upfront investment with long development cycles before realizing returns, posing liquidity challenges for private equity firms. This is especially true when hardware is involved; or DeepTech, where productization of groundbreaking scientific discoveries for mass adoption is significantly more difficult than an iterative software problem.
Financing Limitations: We found it incredibly difficult to find lenders financing defense-related ventures due to perceived risks, regulatory scrutiny, ethical considerations, and fear of image impact — all leading to higher borrowing costs or limited access to capital.
3. Talent Acquisition, Security Clearances, Trust & Discourse
Specialized Workforce: The defense related sectors demands personnel with specialized skills and experience, creating competition for a limited talent pool. And a company might not qualify for certain government contracts if, for example, U.S. citizenship would be required to handle confidential communications.
Rigorous Vetting Processes: Positions often require security clearances, necessitating thorough background checks and potentially leading to delays in staffing critical roles.
Trust and Discourse: All employees must trust their leaders and their processes that “see something, say something” will not be retaliated nor seen as biased witch hunting, whether it comes to employees or service providers or consultants or vendors in the supply chain and even customers. Most reported cases will not be simple, black-and-white, open-and-shut: There needs to be active discourse on potential threat vectors, confidentiality, and moral compass. You want people to reach out and discuss concerns and observations, so that policies can evolve quickly and reduce contract risks, RFP risks, and supplier risks.
4. Intricacies of Hardware Development
Complex Supply Chains: Developing defense hardware involves intricate supply chains with dependencies on specialized suppliers, including startups whose instability can pose risks to project timelines and success.
Extended Development Timelines: Unlike software, hardware development in defense is often prolonged due to rigorous testing, compliance requirements, and the necessity for durability and reliability in extreme conditions.
5. Prolonged Acquisition Processes
Government Procurement Cycles: Defense contracts are subject to lengthy government procurement processes, where decisions sometimes unfold over years. This contrasts sharply with the faster-paced decision-making typical in the private sector, affecting investment liquidity and strategic planning. That’s not to say that acquisition and procurement isn’t a hot topic by all outgoing and incoming US Under Secretaries of Defense and Assistant Secretaries of Defense. But if contracts are not scalable or remain in the hands of the usual primes to coordinate, then startups face heightened risks of macro changes.
6. Political and Policy Volatility
Shifts in Defense Priorities: Changes in administration or legislative focus can lead to abrupt shifts in defense spending and priorities, impacting the viability of existing and prospective investments.
Policy Reversals: Investments may be jeopardized by sudden policy changes or cancellations of defense programs, which can occur due to political dynamics or budgetary constraints.
Political Career Risks: We have encountered more empty promises and 180 degree changes and flip flopping senior government officials than early-stage venture investors and crypto currencies. And that says something. It’s important to understand that most political appointees’ actions are based on political capital, their careers are not driven bei revenue or shareholder value. If you look at this from an enterprise software or life sciences perspective of “what motivates a buyer” or “what motivates an investor” you’ll be wrong in 90% of the times.
7. Investors’ Blissful Ignorance
Because the renaissance of venture capital investments in Defense and Security related sectors and industries has been rekindled relatively recently; and because many sectors and industries are actually quite relevant for defense / security / resilience, we will see a lot of investors with limited previous exposure in DeepTech or Defense. Here, success and performance and value creation and adoption rates are measured very differently than in, say, enterprise software startups. In absence of hands-on previous experience, investors might fall back to things they know and things they are used to measure and things they are getting asked from investors or stakeholders unfamiliar with Defense. And in effect, they will push startups to track metrics that are irrelevant at best, and fatal at worst.
Yes. Of course we are part of the problem. Was it ever different?