The defence industry: same as it ever was?

As COVID-19 spread in 2020 and national lockdowns bludgeoned the global economy, many feared the worst for state finances. Jittery economists expected treasuries to react in a manner similar to the financial meltdown of 2008-2009, by slashing government budgets and implementing a raft of austerity measures.

Quite the opposite transpired. As zealous central banks hoovered up bonds and flooded markets with liquidity, governments loosened their spending taps. While cuts fell hard on defence budgets from 2009 to 2014, they gingerly benefited from government windfalls this time around.

Such is the largesse that even traditional laggards like Germany have committed to increased spending over the next five years. Global defence spending reached a dizzying $1.98 trillion in 2020 according to the Stockholm International Peace Research Institute. This was the highest annual level since 1988 and spending is expected to increase steadily in the coming decade.

The main force keeping defence budgets flush seems to be an ever-worsening security environment. The world is a far more fraught place than in 2008 as China moves from putative partner to foe, and a resurgent Russia retools its forces.

International terror remains a persistent, if now secondary, worry; while simmering conflicts in Syria, Libya and sub-Saharan Africa threaten to spill over.

The demands and requirements of emerging ‘Great Power Competition’ are consuming much of that fresh budgetary pie among the NATO states. Speaking to Shephard in September 2021 during the DSEI exhibition, Ross Elliott, MD for aerospace and defence at Accenture, noted that ‘we're probably seeing the biggest change in services and capabilities and value propositions needed from the industry of all time’.

Many Western militaries are funnelling new investments towards a digitalised era of warfare. Discussions at DSEI centred on multi-domain integration, data fusion and AI, with many experts seeing in this ‘tech-heavy’ vision of future war a gamble to maintain parity with numerically superior peer-rivals like China and Russia.

However, Elliott said: ‘Those things haven't traditionally been the way that the industry has been organised.’

In continental Europe, the impetus for increased defence spending might also be explained by another factor: industrial-nationalism. David Black, a partner at Renaissance Strategic Advisors, noted that while the US and UK seemed intent on acquiring strategic capabilities, ‘the French and the Germans are slightly different’.

‘There is absolutely sovereign capability that we need to protect in the UK’ — Ross Elliott, Accenture

Although France and Germany are also moving funds towards the acquisition of next-generation capabilities, ‘in my mind it’s more about keeping industry alive’, mused Black.

Many European states had tentatively reconfigured their armed forces following the Russian annexation of Ukraine in 2014. COVID-19 has accelerated that shift in a big way. The jolt of the pandemic seems to have delivered a shot into the arms of governments wary about shedding jobs and capability in such a strategic industry.

‘It’s more an industrial-nationalistic side than anything else,’ explained Black. In the blurry confusion of the pandemic’s first wave, many European governments fretted about ‘losing jobs, or the potential that the whole economy be geared towards supporting healthcare, [there was a fear] of losing critical industrial capability in manufacturing and all the technologies that we need for defence’.

Yet a look around the show floor at DSEI gave a different impression. Many of the prime OEMs, such as BAE Systems, Lockheed Martin and Raytheon, seemed to have rebranded themselves as sleek software companies.

Gone was the emphasis on brawny mechanical manufacturing. In its place, a focus on developing state of the art R&D centres, niche high-tech capabilities like hypersonics and AI algorithms. Many seemed to hint at a desire to become nimble system integrators tasked with cobbling together groups of specialised contractors and subcontractors to deliver complex platforms, rather than building from start to finish.

That shift seems the latest in an industry that has slowly, but surely, changed over the past 20 years. At DSEI in London, the demands of peer competition, lingering industrial-nationalism and rapidly evolving technology all indicated things could change further.

You may ask yourself, ‘how did I get here?’

The 20th anniversary of the 9/11 terrorist attacks (and the withdrawal of US forces from Afghanistan in August) weighed heavily at DSEI. Keynote US and UK speakers charted the trials and tribulation of their counterinsurgency campaigns, before lamenting the erosion of conventional and industrial capabilities engendered by 20 years of COIN whack-a-mole.

There was little reflection, however, as to how the industry changed over the last two decades. When in 2001 the US and its allies embarked on the War on Terror, the defence industry was ill-equipped to meet those demands, suggested Elliott.

The war in Afghanistan followed a frenzied period of M&A consolidation in the US defence sector, unlike in Europe which remains fragmented to this day.  As the end of the Cold War slashed defence budgets, prime contractors found themselves with little choice but to consolidate. In 1993 then-Deputy Secretary of Defense William Perry infamously hosted a ‘Last Supper’ with executives from top defence firms and warned them of the writing on the wall. By the end of the 1990s, 107 top-tier firms had become five.

That restructuring produced the ‘top-heavy’ industry of today, Black told Shephard. Referring to the UK, he warned 'you have a lot of SMEs and then the big guys – but not a whole lot in the middle'.

At the time of the 9/11 attacks, the major projects under development by prime OEMs were the F-22, experimental ground-based missile defence systems, and the announcement of the mammoth F-35 programme. None of those platforms would prove particularly suited to counterterror efforts.

Following 9/11, ‘[defence] spending in the US, and in Europe, created this frenzy of money [...] if you had something -- an idea or a capability -- you basically got a contract” added Black.

Many of the prime OEMs, hitherto geared towards large platforms, found themselves funnelling newfound cash towards specialised suppliers and building less in-house. A cottage industry of defence service companies emerged to support the logistical footprint of US operations in the Middle East, covering everything from the maintenance of platforms to mess hall potato peeling.

Elliott noted that industry had to rapidly react to meet vastly different government requirements in the post-9/11 operational landscape.

How is an ever-changing strategic environment (illustrated here by the US withdrawal from Afghanistan in August 2021) influencing the direction of the defence industry in the US and Europe? (Photo: US Army/Master Sgt Alexander Burnett)

In the US and Europe, many companies soon found their fortunes tied to yearly budgetary wrangling, especially after 2008. ‘We saw companies grow massively and in some cases then crash to earth as those contracts ended,’ noted Black. As austerity measures coincided with drawdowns in Iraq and Afghanistan, certain mid-tier companies found themselves smarting for income.

Black noted the effect has partly caused a surge in private equity activity over the last 10 years. Private equity funds are ‘helping companies rough-ride those contracts. It’s fuelled large Tier one consolidation’. He added that recent M&A activity, such as the L3 and Harris merger, reflects a trend towards greater scaling in Tier 1/Tier 2.

The aim of private equity firms in scaling mid-tier defence companies is to create a new Tier 1/Tier 2 layer that can ‘either go public or sell them on to a prime. We’ll see more of that especially as the big defence primes continue to shed [subsidiaries] they don’t need anymore’, said Black.

He explained that as prime contractors continue to opt for expansive systems integrator roles, they are likely to jettison their unwieldy manufacturing operations. ‘They don’t really want to make EW modules anymore. They don’t want to make big radars anymore. They want to do all the processing and the software and [platform] integration.’

With primes shedding their analogue-style subsidiaries, a new gap could open for lower-tier defence companies to move up the value chain propelled by a wave of private equity funds.

Although not immune from the attentions of private equity, the industrial picture looks different in continental Europe. Whereas the US and even the UK saw large consolidation among OEMs, Black said that ‘European consolidation has been a discussion point for years’.

Overcapacity in multiple weapons systems is hardly a question of debate among the national security commentariat in Brussels, Paris or Berlin. An industry siloed along national lines has produced 178 different weapons systems, compared to just 30 in use in the US.

Consolidating industry would make eminent economic and geopolitical sense, especially as calls for ‘European strategic autonomy’ intensify.

Yet industrial-nationalism hobbles most efforts to pool prestigious national industry, share sensitive technology, or trade domestic jobs for a still nebulous conception of ‘strategic autonomy’.

Though some consolidation is happening in lower tiers, that too is increasingly happening along national lines according to Black. French and German governments have blocked foreign takeovers of smaller companies, preferring their own state support or reserving it exclusively for national rather than foreign takeovers.

And you may ask yourself, ‘how do I work this?’

The emergence of private equity has met defiant political bluster in the West. In the UK especially, private equity has come under sustained fire by the press and certain politicians as an erosion of ‘sovereign capability’. Cobham’s purchase by the US firm Advent produced the most visceral reaction so far. Just over the last six months a flurry of UK defence assets, worth a combined £10 billion, have been subject to takeover bids: Ultra Electronics, Meggitt and Enterprise Control Systems.

Beyond mere political point-scoring against corporate financialism, both Black and Elliott suggest the issue is more nuanced. ‘There is absolutely sovereign capability that we need to protect in the UK [...] but that doesn't necessarily mean it'll be owned by a UK firm,’ explained Elliott.

Governments must ensure that despite foreign ownership, such capabilities remain protected and accessible. Given the expenses involved in defence, ‘everybody wants to see savings [...] with venture capitalists coming in and providing infrastructure investment to deliver better quality of services at a reduced cost, there’s always a certain trade-off’, he added.

Indeed, the issue might not necessarily be one of private capital flooding in, but rather its source. Using the example of France, Black posits that private equity investment could follow national lines.

For instance, iXblue, which specialises in building resilient navigation systems for naval vessels and the French nuclear deterrent, is looking for investors. However, this investment opportunity will probably remain focused on the French capital markets.

Reports indicate that French private equity outfit HLD and one of the country’s household banks, Crédit Agricole, are poised to invest. ‘The government has clearly made a determination that private equity aren’t the bad guys. Do you want to open it to American or British private equity? That’s maybe a step too far’ mused Black.

Data is the new oil

Much of the private equity and venture capital know-how coming into defence seems to follow a broader trend of ‘digitising’ platforms and companies hitherto branded with such words as ‘legacy system’ or ‘operational obsolescence’.

Black and Elliott remarked on the acute focus on autonomy, AI and data at this year’s DSEI. Nor are such capabilities simply the purview of niche commercial companies anymore, as the bigger primes get in on the action.

On the smorgasbord of unmanned systems on display at DSEI, Black observed ‘we’ve seen that every show for the last 15 years. What’s interesting this time round is it’s a bit of a shift – you’ve still got those advertising small UAVs and ISR platforms, or even big companies like BAE are getting involved with quadcopters. Yet people are taking that concept of unmanned operations and really starting to think a little more outside the box regarding the use of force multipliers’.

The other interconnected trend on display at DSEI is an ever-burgeoning field of data fusion and analytics. In a new era of warfare, ‘we’re going to need data, we’re going to need information. There are more and more sensors available turning that sort of raw data into actionable intelligence and insights’, commented Elliott.

Likewise, Black noted ‘we’re going to see a bigger push into making use of data in a more efficient manner; enabling people to see exactly what’s happening, understand their situation and how to make use of that information’.

He pointed out that Hawkeye 360 had a stand at this year’s DSEI, while Spire Global’s purchase of exactEarth was a flavour of things to come.

‘We can now use these things where the networking or the connectivity wasn’t really there from an autonomous operations perspective [in the past]. It’s still not there yet, but we’re getting much closer,’ added Black.

The Western defence industry’s focus on data and AI at DSEI clearly mirrored the central challenge of how to compete with sophisticated and numerically superior rivals like China or Russia after 20 years of all-spectrum dominance. In a future peer conflict, salvos of Chinese or Russian missiles are likely to pummel NATO C2 nodes, logistics or ISR assets.

The answer seems to be crafting a more dispersed and resilient force, capable of ‘massing’ at the right time through a network of connected sensors and C2 and bulked out with ‘attritable’ unmanned systems of all stripes.

‘People are looking at the force multipliers,’ Black noted.

‘People are taking that concept of unmanned operations and really starting to think a little more outside the box regarding the use of force multipliers’ — David Black, Renaissance Strategic Advisors

This is not the first time the Pentagon or MoD have placed faith in technology as a panacea. Voguish concepts in the 1990s such as ‘Revolution in Military Affairs’, ‘Net-Centric Warfare’ or ‘Transformation’ posited a one-size-fits-all technological answer to winning wars. Yet the 1990s and early 2000s yielded a bevy of failed or expensive platforms, like the Future Combat System or even the F-35, that reached for technological achievements but were not grounded in reality.

Black was cautious when pressed by Shephard as to what makes the current zeal for AI, automation and software connectivity different from such sorry sagas.

‘I’m not convinced it is different this time,’ he said, although ‘there’s arguably been a technological advance in the last 20 years’.

Where once there was nebulous talk about ‘force connectivity’ revolved around bulky radars and spotty networks, technology has made great strides since the 1990s. ‘Echodyne, for instance, now make an AESA smaller than a piece of paper. That advancement in 20 years has also been mirrored in networking, processing speed, and how we think about connectivity.’ said Black.

‘There’s more of a technological baseline that we can build from, and arguably more conservative aspirations in terms of what the end-users are actually looking to do [operationally],’ he added.

Those new operational concepts, along with maturing technologies and a changing industrial landscape, could chart the way forward for smaller businesses to claim a greater stake in the value chain over the coming decades.

As the primes increasingly shift towards a systems integrator role, opportunities for small and midsize companies to fill gaps in the ‘mid-tier’ will increase. Primes will require ‘all sorts of little capabilities in the middle: a networking backbone architecture that someone else is providing, even an IT provider’, noted Black.

He added that the US Army is thinking of evolving their acquisition environment: ‘The concept [still at the theoretical stage] is to bring in a whole lot of small businesses and give them one or two-year contracts and keep re-upping them because those companies drive innovation in a way big primes do not.’

As DSEI showed, the trend seems to be one of nimble ‘primes’ turning to software processing and letting smaller suppliers provide the manufacturing brawn.

But the challenges still facing the industry remained somewhat overshadowed at DSEI 2021. From industrial-nationalism in Europe to pernicious techno-optimism in Washington, the next twenty years will remain just as fraught as the previous two decades.