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Aerospace & Defense M&A: A Shifting Global Landscape [Virtual Roundtable]

M&A activity in the aerospace and defense industry reached new heights in 2021. Recent data from PwC revealed that there was a 16% year-over-year increase in total annual deal volume, and a $26.8B increase in deal value in the second half of the year alone.

Earlier this week, we sat down with three A&D focused-members of the Axial platform to discuss whether the pace of deals will continue throughout 2022, given the radically different geopolitical environment that we now find ourselves in. Other topics of discussion included how global defense policies are changing and the impact that could have on the industry, the sophistication of cyber attacks and how LMM businesses are playing a role in countermeasures, and the specific types of buyers A&D business owners prefer to partner with and why.

Thank you to the following Axial members who participated in the discussion:

Video

Audio

Introductions: 00:00 – 03:43

Implications of the Russian invasion of Ukraine: 03:43 – 21:20

  • Peter Lehrman, Axial: What’s changing in the Aerospace and Defense sectors as a result of the invasion of Ukraine?
  • Robert Peterson, Peakstone Group: The biggest change overall is the mindset of defense spending in Europe, which has historically been below mandates set by NATO. Robert has already seen movement in spending in Germany. 
  • Barry Calogero, Focus Investment Banking: Not only spending, but deployment of US troops in Germany over the last 10 years has reduced dramatically from 250,000 to 40,000. Troops will start to shift back into Europe which will impact companies who focus on deployment, logistics, and equipment. 
  • Claudio Ochoa, Donovan Capital: 70% of Donovan’s portfolio companies are services businesses with the CIA, DIA, and NSA being their main customers. A lot of portfolio companies and customers were beginning to rethink their strategy and move to their domestic capabilities, but the invasion has shifted their focus back to international issues.  
  • Peter Lehrman: Is the increase in demand in the industry still speculative or is it becoming tangible even after only a month?
  • Barry Calogero: It is very tangible. One of the companies that Focus is working with is a logistics company and their phone started ringing non-stop two weeks ago. They are struggling to keep up with demand because of the complicated logistics of moving US troops over to Europe. 
  • Peter Lehrman: How many of those capabilities make their way into lower middle market businesses vs. multinational corporations? 
  • Barry Calogero: All US bases have local support contractors, which means there is a huge number of small businesses involved in operations and logistics. 
  • Claudio Ochoa: Exactly. A lot of the businesses in Donovan’s area are doing a very niche type of work, and these are the types of companies that larger corporations are looking to purchase. 
  • Peter Lehrman: Germany re-authorized 2% of GDP to be spent on national defense, how might that capital be deployed? 
  • Robert Peterson: Right off the bat, Peakstone is seeing increased demand for the F35. In terms of where the spending will occur, it’s within the supply chain of fighter jets and other military equipment and vehicles, and that’s where lower middle market businesses can really have an impact.
  • Peter Lehrman: Barry, what makes you think that size and duration of the shift back to Europe will be so large?
  • Barry Calogero: There is no easy off ramp for Vladamir Putin and so we have to decide if we want to increase our defense in Europe because we can’t respond fast enough from the United States. We are also seeing the use of weapons that we haven’t seen before and this will fundamentally shift the way we view defense planning in the future. 
  • Peter Lehrman: Are troops being re-deployed to Germany specifically, or Europe as a whole? 
  • Barry Calogero: Multiple locations, but mostly Germany because the US already has a strong military infrastructure there.
  • Peter Lehrman: Military spending as a percent of GDP has been steadily declining for the last 40 years and is holding steady right now. Will that number increase in the near future?
  • Robert Peterson: Some people believe that defense spending is increasing every year, however due to inflation it is actually compressing. There is agreement in the house and senate to increase the spending a little bit. This whole conflict is causing a bit of a re-set in terms of our perceived value in investing in the military.

Information Intelligence in the Aerospace and Defense Industry: 21:20 – 30:00

  • Peter Lehrman: Claudio, what were your businesses doing in the world of intelligence services before the invasion of Ukraine? 
  • Claudio Ochoa: We are now at 18 or 19 organizations that make up the intelligence community. Like Barry said, if you deploy human intelligence officers or signal intelligence capabilities there is a long supply chain that goes along with that. Not only in terms of how you collect information but also what you do with the information and how you analyze it, which has been one of the biggest growth areas Donovan Capital has seen and focused their investing on. The other category of businesses Donovan invests in are operationally focused in places such as Syria, Afghanistan, and Africa. Some of these companies have now begun to focus their resources towards Ukraine. 
  • Peter Lehrman: Because those businesses are carrying so much sensitive information, are they vertically integrating or can they integrate horizontally as well in terms of contracting with third parties? 
  • Claudio Ochoa: There are some businesses that have classified contracts that can work with other businesses but where Donovan has traditionally invested is in businesses that operate covertly and work solely for the US government. They focus there because other investment companies may shy away from the work that some of these companies are doing. 
  • Peter Lehrman: Why do they shy away? Is it ESG considerations or any regulatory barriers that some more traditional firms may face? 
  • Claudio Ochoa: Yes sometimes is is ESG concerns, for example one company that Donovan Capital worked with received loans from Bank of America, and some of their activities created an FCPA (Foreign Corrupt Practice Act) risk and because of that BoA recalled its loan to the company and Donovan was able to step in. 
  • Barry Calogero: On the topic of intelligence, Focus is working with a client that uses AI machine learning and neural networks to develop software for classified agencies. Like Claudio mentioned, this company is transforming both the collection of classified information and the analysis and use of that information so these types of businesses are usually two pronged. Focus finds that the best buyers for those types of companies are companies that have those same types of capabilities already, otherwise, there will be a disconnect. 

Cybersecurity: 30:00 – 36:45

  • Peter Lehrman: When it comes to cybersecurity, specifically in defense, what are the backgrounds of the companies and people and what are the unique capabilities of winning companies in the sector? 
  • Claudio Ochoa: It varies depending on how you define cyber. Donovan has one company that does training in cyber defense and analytic skills. An example is being able to monitor what’s happening on social media in a particular area that you’re operating in. There are other companies that are ensuring that our cloud systems are secure. Most of the businesses they deal with focus on how to use and disperse information effectively. 
  • Peter Lehrman: What are the talents of the people in those organizations?
  • Claudio Ochoa: They have talents in a broad range of fields. One in particular has experience doing base support services in Iraq. 
  • Robert Peterson: Exactly what Claudio said. Peakstone is seeing a lot of mid to level senior folks coming out of the intelligence community or special services within government contractors and forming their own company using the expertise they acquired throughout their careers. A good example of this happening is Booz Allen Hamilton in the cyber sector, where they’ve acquired a large pool of talent from other contractors. 

Nature of private equity firms in aerospace and defense: 36:45 – 46:00

  • Peter Lehrman: What resonates with company owners in terms of the Private Equity firms? Which are putting together the most compelling partnership opportunity?   
  • Barry Calogero: As a PE firm, coming into this space with no experience is really difficult in terms of not only the language but the procurement process of the industry. For smaller companies, SBICs (Small Business Investment Corporation) are usually most attractive due to their focus on helping maintain growth for small businesses. For other larger businesses, the experience and expertise of the private equity firm is the most important because they often want to stay on and help run the company so they have to be able to work with the firm in the future. 
  • Robert Peterson: Barry is exactly right. However, one way in which generalist funds can compete is in being able to identify their weaknesses and work with an experienced advisor or consultant within the industry to fill those gaps. 
  • Claudio Ochoa: Donovan has tried to set themselves up as the go to call for businesses in the sector. The other firms that are most attractive to businesses looking for capital are firms that have security clearance. Some companies simply can’t give any information to firms without clearance and so the deal would be unattractive to those types of firms. The expertise of the PE firms can be important to businesses, but Donovan saw an equal amount of importance in the terms of the deal. Lots of PE firms including Donovan were offering minority equity and debt in the past year and beginning to compete with Donovan on deals.  
  • Peter: Why the focus on minority equity and debt?
  • Claudio Ochoa: Donovan is only three and a half years old and so when they entered the market they didn’t want to step on any toes. They began offering minority equity to stay competitive. 

Implications of China, Taiwan, and politics on the industry: 46:00 – 59:56

  • Peter Lehrman: How will the Russian invasion impact military decision making and political calculus as it relates to Taiwan and China?
  • Barry Calogero: The Chinese leadership is not happy with Xi Jinping in terms of how the Russian invasion is exposing their global positioning. They were trying to move to a more neutral setting where they were becoming an economic power as opposed to being aligned with Russia. China needs to decide what they want to be over the following decades as right now they are highly dependent on their export market which relies on relationships with other countries, and so isolation could damage them to a large extent.
  • Claudio Ochoa: One of the things that the focus on China and Russia has done is bring forward the discussion of security and highlighted the importance of having not only a strong military but a defense and industrial base as well. An example is one of Donovan’s companies, which is one of the last wool mills in the United States. The US government has a law that says they must buy all fabrics for their military equipment from US suppliers and there are only two wool mills in the US. Certain laws had to be changed due to the lack of supply of some fabric dyes and processes so that the equipment could actually be manufactured. 
  • Robert Peterson: Exactly, the military supply chain is so complex that defense touches every single industry in the United States. Over the last few years we have focused deeply on outsourcing especially in the earlier stages of the supply chain but the invasion has made us realize that we really need a, “just in case,” strategy if defense becomes an issue in the future. An example is all the energy that Russia supplies which makes it difficult to produce anything even if you have the capability to do so otherwise due to lack of energy. 
  • Peter Lehrman: What is the staying power of these influences? Will the theme of defense continue and will it be bipartisan over multiple political cycles? 
  • Robert Peterson: Robert believes Americans have a very short term memory and don’t often react how we should unless we are truly forced to. There is a large force in the western capital markets to invest in growing areas and so capital will continue to be pulled into countries like China to set up that market. 
  • Barry Calogero: Barry does not believe the conflict will end any time soon. Although Americans will become numb to the conflict, congress and military leaders will continue to keep the conflict on their radar. Similarly to this conflict, we were in Afghanistan for 20 years.
  • Claudio Ochoa: Agreed. This invasion has fundamentally changed us and brought back to light the indirect tension between the US and Russia and so the staying power of the influences will be large.

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