Private equity and venture capital firms are pouring more capital into funding rounds for defense companies this year, as investors bet on disruptive new technologies and manufacturing models.

At nearly $2.6 billion across 25 funding rounds through Sept. 1, the total invested by private equity and venture capital firms into the defense sector has already exceeded the $2.2 billion full-year total for 2023, according to S&P Global Market Intelligence data.

The investment increase in the defense sector contrasts starkly with the broader decline in all venture capital investment so far in 2024. Between Jan. 1 and Sept. 1, funding rounds across all sectors totaled $181.9 billion globally and were on pace to fall short of the full-year 2023 total of $280.1 billion, according to Market Intelligence data.

The ongoing conflict in Ukraine sparked by Russia's 2022 invasion was a turning point, convincing a wider swath of venture capital firms to invest in weapons of war while also demonstrating how quickly those weapons were evolving, said James Cross, managing director of Franklin Venture Partners LLC and founder of the Silicon Valley Defense Group, a nonprofit focused on growing venture capital's role in the US defense industry.

The success of cheap, off-the-shelf drones in Ukraine highlighted the emergence of weapons that are low-cost, reusable and expendable.

"Silicon Valley believes the future of conflict will be automated, and we'll need a lot of cheap, 'attritable' systems," Cross said.

Defense startups are benefiting from venture capital's search for growth opportunities amid a technology slowdown, said Meghan Welch, a managing director in KPMG's corporate finance practice with a background in aerospace and defense M&A. Outside of hotspots like AI, tech startups have struggled under higher interest rates, increased regulatory scrutiny and declining investor sentiment.

"These VC funds have to put money to work somehow, and they see defense as a really opportunistic area to do that," Welch said, noting that swelling national defense budgets in the US and elsewhere are an enticement.

Disrupting defense

The opportunity to disrupt the US defense industry, which is dominated by a handful of prime contractors, is the "big prize" for venture capital firms, said Shana Marshall, an assistant research professor of international affairs at The George Washington University who studies the arms trade. A pervasive attitude in Silicon Valley is "that the government bureaucracy is slow and it's cumbersome and the weapons are too big and too expensive, and they don't match the wars that we need to fight," Marshall said.

Franklin Venture's Cross said the new approach to defense manufacturing is exemplified by startups like autonomous weapons specialist Anduril Industries Inc., which combines cheap, off-the-shelf hardware and AI-enhanced software in its drones.

Anduril's $1.5 billion series F round was the largest private equity- or venture capital-backed funding round targeting the defense sector between Jan. 1 and Sept. 1. Anduril aims to use the funding to "hyperscale" the manufacturing of its weapons, which include autonomous aircraft and undersea vehicles.

Seeking growth

The spike in the third quarter was driven by the Anduril deal. Nonetheless, venture capital investment in defense is clearly on a quarterly rise this year.

Outlook on exits

Whether defense startups eventually produce the kinds of exits that justify current levels of enthusiasm from venture investors is "the million-dollar question" for the industry, Franklin Venture's Cross said.

"It's probably healthy to be skeptical. I don't know that we'll have a giant IPO boom in defense tech," Cross said.

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KPMG's Welch said a growing issue for defense startups is that they are being valued like tech companies by venture capital investors, even as defense sector M&A multiples tend to run much lower than tech sector multiples.

"They're coming up to a point where the valuations that they're getting in their VC rounds are never going to get validated on the back end if they sell to a strategic. And many of them will never go public," Welch said.