Private equity investments in the US and European defense sectors in 2023 were at their lowest level since 2018, though longer-term trends show private funds are driving more deals in the defense contractor industry.
Peter Manos, a managing partner at defense-focused private equity firm Arlington Capital Partners, portrayed 2023 as a blip, noting that a strong outlook for investment is drawing more private equity firms, including generalist investors, into the defense sector.
A 4% compound annual growth rate for the US defense budget is forecast through 2028, Manos said, adding that Russia's 2022 invasion of Ukraine is also spurring a rise in defense spending in Europe, particularly among NATO member states.
"It's a very robust market right now. The macro in defense — the product side and the services side — is as robust as it's been in a long time," Manos said.
Temporary pivot to smaller deals
The size of private equity investments in the sector mostly trended larger between 2017 and 2022, but that trend reversed in 2023.
Announced private equity-backed deals in the US and European defense sectors totaled $1.62 billion in 2023, down nearly 86% year over year from $11.44 billion in 2022. With the 2023 total spread across 34 deals, average deal value was at its lowest since 2018, according to S&P Global Market Intelligence data.
The decline occurred against a backdrop of slower global M&A as higher interest rates made deals more expensive and a forecast of slower growth drove a wedge between buyers and sellers.
Private equity firms pivoted away from large platform investments and pursued smaller add-on deals that may have been easier to complete in a challenging M&A environment, said Meghan Welch, a managing director in KPMG's corporate finance practice with a background in aerospace and defense M&A.
Welch predicted private equity-backed deal size would rebound in 2024 as M&A volume picks up. The year's announced private equity-backed transaction total through Feb. 12 has already exceeded the annual total for 2023, due mainly to Arcline Investment Management LP's roughly $1.90 billion take-private deal for Kaman Corp., which does business in aerospace and defense.
Investor pool grows
As recently as a decade ago, a handful of private equity firms specialized in aerospace and defense investments, but KPMG's Welch said their number is quickly growing, drawn in part by the perceived stability of the sector. Since 2017, 178 different private equity or venture capital firms have made US or European defense sector investments, Market Intelligence data shows.
"Essentially, anyone who's never invested in this space, they are starting to create funds that are specifically focused toward defense or government services. And they're looking at characteristics like long-life contracts or incumbent positions with someone like the [Department of Defense] who is, really, too big to fail from a customer perspective," Welch said.
More private equity firms pursuing more deals in the sector is a trend dating to the early 2000s, when defense spending rose in the wake of the 9/11 terrorist attacks, said Charles Mahoney, a member of the political science department at the University of California, Long Beach, who has researched private equity defense investments.
"In just the past five years it’s really amped up, and the deal size has also increased significantly," Mahoney said.
The US defense sector has absorbed $27.65 billion in private equity investment since 2017, or about 2.5 times the $10.18 billion that flowed to the European defense sector, according to Market Intelligence data.
Mahoney said the Pentagon now encourages investment in the defense sector by US-based private equity and venture capital firms to inspire innovation and diversify the defense supply chain.
"They think that's going to spur these advances in defense technology that are going to help the US outcompete China," Mahoney said.
In Europe, the outlook for government defense spending has been inflected by Russia's ongoing war in Ukraine. The number of NATO member states committed to spending 2% of GDP on defense increased to a record 18 in 2024 from just three a decade ago, NATO Secretary-General Jens Stoltenberg announced in February.
"And guess what? A lot of what they buy is American defense product because we're the gold standard when it comes to technology, equipment and services for the military," Arlington's Manos said.
Appeal for private equity
The Pentagon-led outsourcing trend goes partway toward explaining the flow of private capital to US defense contractors, said Justin Siken, founder of government contracting data platform HigherGov.
"Regardless of what happens with the [US defense] budget over time, more of the budget has gone to contractors versus the government doing it themselves," Siken said.
Siken noted two other aspects that are particularly appealing to private equity. One is high rates of consolidation in the US defense industry creating an opening for private equity fund managers, who often specialize in rolling up multiple small or midtier businesses into a platform that can capture more market share. Another is the very nature of government contracting: Three- to five-year defense contracts align nicely with the five- to seven-year horizon of a typical private equity investment while giving fund managers a good view to future revenues.
While those attributes are drawing a wider array of private equity firms into the defense sector, Manos said it remains a niche that rewards expertise. That includes the ability to navigate complex government contracting rules and, in the case of Arlington, clearances to work in areas that are classified.
"That knowledge base takes years to build up," Manos said.