Looking Ahead: Defense Spending and Opportunities for the Lower Middle Market
The Russian invasion of Ukraine has set in motion a chain of events unprecedented in the contemporary defense landscape. The West is reassessing its military might, and Europe is accelerating defense spending. The aerospace and defense sector stands to reap the benefits, with a potential flurry of M&A. The spotlight has finally come for this often-overlooked sector. A&D investment banking may soon see a surge.
We predict that increased defense allocations will spur new opportunities in the lower middle market.
In its Private Equity Opportunity in Aerospace and Defense report, KPMG reports that the 2021 DoD budget projected 1.5% annual growth in the coming five years—a very small increase. But in the United Kingdom, defense is accelerating at a rapid clip, with a projected 10-15% beyond its current budget of $58 billion. This occurred before Russian aggression, suggesting that Russia could change everything, leading to a defense spending bonanza.
The United States and Russia: Tough Decisions
Fundamentally, the U.S. will ultimately have to decide whether it intends to engage in Russia, directly or indirectly. New technologies have shifted the defense landscape, and may alter what conflict looks like. Europe’s aging defense infrastructure necessitates the purchase of American-made equipment. Moreover, supply chain delays have revitalized interest in shoring up the American defense supply chain. All of this spells opportunity for the lower middle market—still, though, the nature of that opportunity is heavily dependent on American decisions about the Russian conflict.
New Supply Chain Opportunities
With rising concerns about dependency on foreign manufacturing sites, much of the supply chain has returned to the United States. This spells opportunity for American businesses, offering lower middle market firms a fine opportunity to profit from increased defense spending.
Defense contracts are sensitive, suggesting firms should vertically integrate services. This doesn’t always happen. Lower middle market firms still have much to contribute. Technology is one key example, and cybersecurity continues to be a priority across the industry.
What About the Buy-Side?
Lower middle market businesses aren’t the only potential beneficiaries of new defense changes.TheCOVID cash flow crunch will force reintegration of tier 3 and 4 suppliers. This means more opportunities for private equity. But opportunity isn’t always easy. Generalist PE firms will face significant hurdles. The defense industry is complex and difficult, and the sell-side tends to prioritize industry insiders with real expertise. It’s critical to understand the defense contracting process. PE firms must be willing to obtain the expertise they need.
As governments move swiftly to strengthen their defense capabilities, we expect a rapid influx of cash in the A&D sector. But will these changes last? Russian aggression could spur a new generation of defense competition and building. Or it could be a temporary blip that quickly goes away. Industry insiders don’t know which way the pendulum will swing. For now, though, A&D companies that have the expertise to capitalize on the new surge of cash can serve their countries and their investors. Now is an excellent time to innovate, and an exceptional time to consider A&D M&A.