Geopolitical tensions are rising – and so is global defence spending, despite the impact of COVID-19 on state purses. Nicholas Neveling explores why M&A will be a key strategic lever as the sector adapts to increased requirements for cyber, digital and space capabilities, and relations cool between the West, China and Russia
A track record of earnings stability through economic cycles has supported M&A activity in the resilient defence sector. According to data in White & Case’s ‘M&A Explorer’ tool, global deal value in the defence industry totalled $3.65bn over the first half of 2021 – an enormous year-on-year rise. A paltry $130m of deals were announced for the same period in 2020.
This year, private equity firms have been particularly active. The value of defence sector buy-out deals in the first half of 2021 was $1.88bn – more than half of the overall aggregate – and was already up threefold on the total of $510m completed in 2020.
A rally in defence stocks following the COVID-19 downturn and the conclusion of the US presidential election in 2020 have supported the M&A resurgence. In the UK, the FTSE 350 Aerospace and Defence stock market index is showing gains of 31% over the past 12 months. In the US, which is the largest customer for private sector defence businesses, President Joe Biden’s administration has signalled its commitment to investment in defence modernisation and research. The UK government published a major review of defence, security and foreign policy in March 2021.
Sam McGarey, a director in the deals value creation team at PwC, says: “The defence industry is resilient across economic cycles, and downturns don’t typically have an impact on defence spending. This has supported ongoing M&A activity in the sector, including from private equity firms, with dealmakers taking comfort in the industry’s long-term contracts and visible cash flows.”
In June, investment group Lone Star finally called off its pursuit of UK-listed aerospace and defence group Senior after the company rejected the US buy-out house’s fifth bid, which would have valued Senior at £840m.
In August, the board of Ultra Electronics, a major supplier to the Royal Navy, accepted a £2.6bn offer from Cobham. A major UK aerospace and defence group, Cobham was itself acquired by US private equity firm Advent International for £4bn in January 2020. This was a protracted process (see ‘Cobham and the UK government’s new priorities’, page 23), so only time will tell if the Ultra Electronics deal progresses smoothly.
Meanwhile, Coventry-based aerospace and defence group Meggitt has been the subject of a bidding war. US engineering group Parker-Hannifin made a takeover offer of £6.3bn for the group, while TransDigm Group, another US player, put forward a counter-offer. The UK’s Takeover Panel gave TransDigm a deadline of 14 September to formalise its offer or retreat from the deal. A week before that deadline Transdigm pulled out, leaving the way clear, or at least clearer, for Parker-Hannifin.
In September, Rolls-Royce and Babcock announced that they would sell their respective stakes in AirTanker (which owns the RAF’s fleet of refuelling planes) to financial buyer Equitix for a combined total of £315m.
KPMG corporate finance director Alastair Horrocks says UK targets have appealed to US private equity firms and strategic buyers, which see valuations as attractive. “The pound is cheaper relative to the dollar, and there could also be a perceived conglomerate discount for some assets.”
Several UK targets also derive a significant portion of their earnings outside of defence, in areas such as commercial aerospace, which has been heavily affected by COVID-19 lockdowns and travel restrictions. According to analysis by Deloitte, passenger traffic on commercial airlines may not return to pre-pandemic levels until 2024. Global commercial aircraft deliveries for 2021 are expected to decline by 41% from its peak level in 2018. These headwinds in the civil arena have adversely affected overall revenues, as well as profitability up and down the aerospace and defence supply chain.
Senior, for example, was in the process of restructuring when Lone Star made its first bid, navigating a slowdown in civil aviation and reduced demand from aircraft and engine makers.
Sheffield Forgemasters, meanwhile, which manufactures steel forgings and castings used in nuclear submarines, was nationalised by the UK government as earnings from steel processing and work in the oil and gas sector declined through the pandemic downturn.
Horrocks says: “Falling earnings from business lines such as commercial aerospace have dampened valuations for aerospace and defence groups, which has presented attractive pricing opportunities for buyers who can take a long-term view.”
As governments around the world unwind their COVID-19 support measures, more aerospace and defence companies could face financial stress as revenues from non-defence divisions take time to recover ground lost during lockdowns.
PwC’s McGarey believes that this could lead to further M&A activity in the sector. “Wider supply chain resilience is likely to be a continued focus area in the coming months,” he says. “Many businesses in the sector are not pure play defence groups and carry exposure to civil aerospace and wider industrials, so they may be facing challenges. This could be a driver of M&A as original equipment manufacturers invest to secure supply chains and financial buyers see opportunities to inject capital.”
According to Deloitte, global defence spending is expected to grow by 2.8% this year, surpassing $2trn, as geopolitical tensions increase and countries invest in defence and security. The US, China, France, India, Japan and the UK have committed to maintain or increase their defence spending, despite the impact of the pandemic on state finances.
Visibility on defence spending will provide private equity with the confidence to continue investing in businesses with defence exposure, while trade buyers will keep turning to M&A to build the scale required to meet rising demand because of increasing state defence spending.
M&A is also expected to play a crucial role as the defence sector adapts to the rapidly changing defence and national security field. The UK government, for example, has recently committed to increase its defence budget, investing in artificial intelligence, drones and sensor-linked military hardware, as well as building a Royal Air Force space command centre and creating a National Cyber Force to run cyber operations against organised crime, terrorism and hostile nation states.
A new category of defence company will have to emerge to supply these capabilities, or industry incumbents focused on the development and manufacture of aircraft, ships, vehicles and weapons will have to pivot, developing digital, cyber security and space expertise in addition to existing core competencies.
“Defence is in a period of transition,” McGarey says. “Traditionally, it’s an industry focused on land, sea and air. These domains will remain important, but the industry is moving into the new domains of cyber and information. It’s early in the process and it remains to be seen how the industry players will transition to these new capabilities, but it’s likely that M&A will play a role, whether through venture capital investing in start-ups or incumbents acquiring additional capabilities.”
Understanding the national security regimes of governments that have become ever more hawkish about the risks of cross-border M&A targeting key defence suppliers has become part-and-parcel of dealmaking in the sector. It’s a global trend, and several governments have already put tighter regimes in place for foreign-backed deals in any industry deemed to be of strategic importance.
Cooling relations between the West, China and Russia have meant that any inbound investment in a defence asset from outside the Nato alliance is now effectively a non-starter. Even deals involving bidders from Nato countries are coming under closer scrutiny, as governments take steps to ensure that they can continue to supply themselves domestically. In 2019, for example, Advent International’s bid for Cobham was subject to ministerial intervention before being cleared. More recently, the UK’s secretary of state for Business, Energy and Industrial Strategy, Kwasi Kwarteng, announced a review of Advent-backed Cobham’s move for Ultra Electronics, and ordered Ultra not to share sensitive details of its work for the UK government and armed forces with Advent.
Government reviews of defence deals can prolong deal timetables and increase completion risk. The introduction of the UK’s new National Security and Investment Act (NSIA), which formally takes effect from January 2022, will see a broader range of deals, such as minority transactions, purchases of voting rights and acquisitions of assets, including land and intellectual property, eligible for review. Failure to comply when deals are called in for review may lead to void deals, turnover-based fines, and criminal liability.
At the beginning of September, Kwarteng ordered a national security review of the proposed takeover of graphene maker Perpetuus Group by Taurus International, or any companies associated with Dr Zhongfu Zhou, chief nanotechnology scientist at Perpetuus. He reportedly has business interests in China and studied as an undergraduate at the University of Science & Technology in Beijing, before spending years working on the wonder material. He is a research professor in Aberystwyth University’s department of physics. The directors of Perpetuus are said to be planning a legal challenge to the decision for a review.
KPMG’s Horrocks says that a broadly similar review process from the Committee on Foreign Investment in the US has been in effect for years, and there is visibility on whether a deal will pass muster. Buyers and vendors are thus able to ‘filter down’ bidders and deals with relative certainty.
However, it will take time for enough cases to be reviewed under the NSIA regime to form a picture of what will be required to clear the review process. The convergence between defence and sectors such as technology will make cases where a deal target serves both civil and defence end users challenging.
“There are deals that fall into a grey area, where it’ll be tricky to predict whether they’ll be subject to review or not,” Horrocks says. “Presently, if you’re running a process for an asset with any kind of defence exposure, you’ll ideally want to be taking a UK bidder into the final round of an auction in case any overseas buyers are ruled out.”
Changing geopolitical priorities can also have a rapid impact. Last month, the US, UK and Australia announced the ‘Aukus’ alliance - which would include building a new fleet of nuclear subs for Australia. But this scuppered a A$90bn deal the country made with France in 2016.’
Buyers interested in defence assets are also having to gate defence prospects on environmental, social and governance (ESG) grounds. It has become a priority for retail and institutional investors when allocating capital, with many ruling out investments into areas such as weapons. In both the Meggitt and Ultra deals, bidders have made ESG commitments.
“Private equity is ultra-cautious when it comes to defence and a firm will only pursue an asset if it has total conviction. It tends to be self-selecting in terms of the firms that go beyond the first round of auction processes,” Horrocks says.
However, defence assets will continue to appeal to bidders who have the experience and patience to navigate national security and ESG gating issues.
Steadily rising global defence budgets provide a solid foundation for long-term investment. The evolution of defence into new areas such as information, cyber and space will stimulate demand for assets and opportunities for vendors. In the UK, these long-term drivers have been supercharged by a weaker pound and demand for deals in the sector from cash-rich buyers.
The large UK defence deals in the market at present – such as Meggitt and Ultra Electronics – could precede many others.
This year, private equity firms have been particularly active. The value of defence sector buy-out deals in the first half of 2021 was $1.88bn – more than half of the overall aggregate – and was already up threefold on the total of $510m completed in 2020.
A rally in defence stocks following the COVID-19 downturn and the conclusion of the US presidential election in 2020 have supported the M&A resurgence. In the UK, the FTSE 350 Aerospace and Defence stock market index is showing gains of 31% over the past 12 months. In the US, which is the largest customer for private sector defence businesses, President Joe Biden’s administration has signalled its commitment to investment in defence modernisation and research. The UK government published a major review of defence, security and foreign policy in March 2021.
Sam McGarey, a director in the deals value creation team at PwC, says: “The defence industry is resilient across economic cycles, and downturns don’t typically have an impact on defence spending. This has supported ongoing M&A activity in the sector, including from private equity firms, with dealmakers taking comfort in the industry’s long-term contracts and visible cash flows.”
Multinational interests
In the UK, defence M&A has been dominated by cross-border activity, with cash-rich US trade buyers and private equity firms actively pursuing opportunities to buy up UK defence contractors.In June, investment group Lone Star finally called off its pursuit of UK-listed aerospace and defence group Senior after the company rejected the US buy-out house’s fifth bid, which would have valued Senior at £840m.
In August, the board of Ultra Electronics, a major supplier to the Royal Navy, accepted a £2.6bn offer from Cobham. A major UK aerospace and defence group, Cobham was itself acquired by US private equity firm Advent International for £4bn in January 2020. This was a protracted process (see ‘Cobham and the UK government’s new priorities’, page 23), so only time will tell if the Ultra Electronics deal progresses smoothly.
Meanwhile, Coventry-based aerospace and defence group Meggitt has been the subject of a bidding war. US engineering group Parker-Hannifin made a takeover offer of £6.3bn for the group, while TransDigm Group, another US player, put forward a counter-offer. The UK’s Takeover Panel gave TransDigm a deadline of 14 September to formalise its offer or retreat from the deal. A week before that deadline Transdigm pulled out, leaving the way clear, or at least clearer, for Parker-Hannifin.
In September, Rolls-Royce and Babcock announced that they would sell their respective stakes in AirTanker (which owns the RAF’s fleet of refuelling planes) to financial buyer Equitix for a combined total of £315m.
KPMG corporate finance director Alastair Horrocks says UK targets have appealed to US private equity firms and strategic buyers, which see valuations as attractive. “The pound is cheaper relative to the dollar, and there could also be a perceived conglomerate discount for some assets.”
Several UK targets also derive a significant portion of their earnings outside of defence, in areas such as commercial aerospace, which has been heavily affected by COVID-19 lockdowns and travel restrictions. According to analysis by Deloitte, passenger traffic on commercial airlines may not return to pre-pandemic levels until 2024. Global commercial aircraft deliveries for 2021 are expected to decline by 41% from its peak level in 2018. These headwinds in the civil arena have adversely affected overall revenues, as well as profitability up and down the aerospace and defence supply chain.
Senior, for example, was in the process of restructuring when Lone Star made its first bid, navigating a slowdown in civil aviation and reduced demand from aircraft and engine makers.
Sheffield Forgemasters, meanwhile, which manufactures steel forgings and castings used in nuclear submarines, was nationalised by the UK government as earnings from steel processing and work in the oil and gas sector declined through the pandemic downturn.
Horrocks says: “Falling earnings from business lines such as commercial aerospace have dampened valuations for aerospace and defence groups, which has presented attractive pricing opportunities for buyers who can take a long-term view.”
As governments around the world unwind their COVID-19 support measures, more aerospace and defence companies could face financial stress as revenues from non-defence divisions take time to recover ground lost during lockdowns.
PwC’s McGarey believes that this could lead to further M&A activity in the sector. “Wider supply chain resilience is likely to be a continued focus area in the coming months,” he says. “Many businesses in the sector are not pure play defence groups and carry exposure to civil aerospace and wider industrials, so they may be facing challenges. This could be a driver of M&A as original equipment manufacturers invest to secure supply chains and financial buyers see opportunities to inject capital.”
Long haul
In addition to the UK deal opportunities linked to the COVID-19 fallout and softer pound over the past five years, long-term defence sector fundamentals provide a favourable backdrop for sustained defence dealmaking beyond the pandemic.According to Deloitte, global defence spending is expected to grow by 2.8% this year, surpassing $2trn, as geopolitical tensions increase and countries invest in defence and security. The US, China, France, India, Japan and the UK have committed to maintain or increase their defence spending, despite the impact of the pandemic on state finances.
Visibility on defence spending will provide private equity with the confidence to continue investing in businesses with defence exposure, while trade buyers will keep turning to M&A to build the scale required to meet rising demand because of increasing state defence spending.
M&A is also expected to play a crucial role as the defence sector adapts to the rapidly changing defence and national security field. The UK government, for example, has recently committed to increase its defence budget, investing in artificial intelligence, drones and sensor-linked military hardware, as well as building a Royal Air Force space command centre and creating a National Cyber Force to run cyber operations against organised crime, terrorism and hostile nation states.
A new category of defence company will have to emerge to supply these capabilities, or industry incumbents focused on the development and manufacture of aircraft, ships, vehicles and weapons will have to pivot, developing digital, cyber security and space expertise in addition to existing core competencies.
“Defence is in a period of transition,” McGarey says. “Traditionally, it’s an industry focused on land, sea and air. These domains will remain important, but the industry is moving into the new domains of cyber and information. It’s early in the process and it remains to be seen how the industry players will transition to these new capabilities, but it’s likely that M&A will play a role, whether through venture capital investing in start-ups or incumbents acquiring additional capabilities.”
Special protection
However, as positive as the outlook for defence M&A may be, deal execution in the sector is complex, and it increasingly requires specific expertise, especially from private equity buyers.Understanding the national security regimes of governments that have become ever more hawkish about the risks of cross-border M&A targeting key defence suppliers has become part-and-parcel of dealmaking in the sector. It’s a global trend, and several governments have already put tighter regimes in place for foreign-backed deals in any industry deemed to be of strategic importance.
Cooling relations between the West, China and Russia have meant that any inbound investment in a defence asset from outside the Nato alliance is now effectively a non-starter. Even deals involving bidders from Nato countries are coming under closer scrutiny, as governments take steps to ensure that they can continue to supply themselves domestically. In 2019, for example, Advent International’s bid for Cobham was subject to ministerial intervention before being cleared. More recently, the UK’s secretary of state for Business, Energy and Industrial Strategy, Kwasi Kwarteng, announced a review of Advent-backed Cobham’s move for Ultra Electronics, and ordered Ultra not to share sensitive details of its work for the UK government and armed forces with Advent.
Government reviews of defence deals can prolong deal timetables and increase completion risk. The introduction of the UK’s new National Security and Investment Act (NSIA), which formally takes effect from January 2022, will see a broader range of deals, such as minority transactions, purchases of voting rights and acquisitions of assets, including land and intellectual property, eligible for review. Failure to comply when deals are called in for review may lead to void deals, turnover-based fines, and criminal liability.
At the beginning of September, Kwarteng ordered a national security review of the proposed takeover of graphene maker Perpetuus Group by Taurus International, or any companies associated with Dr Zhongfu Zhou, chief nanotechnology scientist at Perpetuus. He reportedly has business interests in China and studied as an undergraduate at the University of Science & Technology in Beijing, before spending years working on the wonder material. He is a research professor in Aberystwyth University’s department of physics. The directors of Perpetuus are said to be planning a legal challenge to the decision for a review.
KPMG’s Horrocks says that a broadly similar review process from the Committee on Foreign Investment in the US has been in effect for years, and there is visibility on whether a deal will pass muster. Buyers and vendors are thus able to ‘filter down’ bidders and deals with relative certainty.
However, it will take time for enough cases to be reviewed under the NSIA regime to form a picture of what will be required to clear the review process. The convergence between defence and sectors such as technology will make cases where a deal target serves both civil and defence end users challenging.
“There are deals that fall into a grey area, where it’ll be tricky to predict whether they’ll be subject to review or not,” Horrocks says. “Presently, if you’re running a process for an asset with any kind of defence exposure, you’ll ideally want to be taking a UK bidder into the final round of an auction in case any overseas buyers are ruled out.”
Changing geopolitical priorities can also have a rapid impact. Last month, the US, UK and Australia announced the ‘Aukus’ alliance - which would include building a new fleet of nuclear subs for Australia. But this scuppered a A$90bn deal the country made with France in 2016.’
Buyers interested in defence assets are also having to gate defence prospects on environmental, social and governance (ESG) grounds. It has become a priority for retail and institutional investors when allocating capital, with many ruling out investments into areas such as weapons. In both the Meggitt and Ultra deals, bidders have made ESG commitments.
Defence, not attack
According to Sustainalytics, a provider of ESG metrics to investors, the ESG score for aerospace and defence ranks 37 out of 42 industries, with 62% of companies in the sector considered a high ESG risk and 21% a severe risk. Buy-out firms have thus tended to focus on companies providing radar, cyber security, reconnaissance or similar services, although even assets in these areas can exceed risk appetites.“Private equity is ultra-cautious when it comes to defence and a firm will only pursue an asset if it has total conviction. It tends to be self-selecting in terms of the firms that go beyond the first round of auction processes,” Horrocks says.
However, defence assets will continue to appeal to bidders who have the experience and patience to navigate national security and ESG gating issues.
Steadily rising global defence budgets provide a solid foundation for long-term investment. The evolution of defence into new areas such as information, cyber and space will stimulate demand for assets and opportunities for vendors. In the UK, these long-term drivers have been supercharged by a weaker pound and demand for deals in the sector from cash-rich buyers.
The large UK defence deals in the market at present – such as Meggitt and Ultra Electronics – could precede many others.
