Private credit poised to fill defence sector funding gap as geo-political risk intensifies
Private credit funds could be well placed to fill the funding gap in the European defence sector, as alarm bells are raised around the availability of defence financing on the continent.
Global geo-political tensions have fuelled the need for more defence spending, particularly in Europe, where the sector has been underfunded for decades. Amid a shortage of bank funding, private credit has been touted as a viable alternative. An executive director focused on credit at an investment bank said that it was “very plausible” that private credit would capitalise on the opportunity.
“Private credit is good in filling the gaps and providing funding to the under-funded sectors or companies that would otherwise struggle to get bank funding,” he said, speaking on the condition of anonymity.
“This would of course come at a price (and would be more expensive than corporate debt or syndicated lending), but this is the exact unique selling point for private credit. It can pick up good quality credit that for whatever reason does not neatly fit into the bank lending investment criteria.”
According to a study from the European Commission, there is an equity financing gap of approximately €2bn (£1.68bn) and a debt financing gap of between €1bn and €2bn for small- and medium-sized enterprises (SMEs) in the defence sector.
The same study found that SMEs operating within the defence sector find it much more difficult to access finance than others.
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“For private credit firms, there is an opportunity there,” said Arnaud Journois, vice president at Morningstar DBRS.
“There is a financing gap for European SMEs in the defence sector. They have difficulties not only accessing funding, but also having bank accounts.”
A recent report from Morningstar DBRS said that banks are expected to play a pivotal role in financing the defence sector, as public spending is not sufficient to fund the growing needs. However, banks appear to be reluctant to lend to the defence sector due to the sector’s incompatibility with environmental, social and governance (ESG) guidelines.
This has created an opportunity for both private equity and private debt firms to step in and support the 2,500-odd defence SMEs which play a central role in the complex defence supply chains in Europe.
“I think the real opportunity is in the SME sector,” said Journois. “The lack of funding will have to be filled by external funding.”
The need for more SME defence financing has led the European Investment Bank (EIB) to implement a rule change which allows it to invest more easily in defence firms; as well as creating a fund to buy into defence SMEs, as well as non-defence SMEs.
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Earlier this year, the EIB announced that it would invest another €6bn in European defence and security. However, Journois said that this is “very marginal compared to the total needs of the sector.”
“We’ve seen a changing trend in Europe since the invasion of Crimea in 2014, and this has really accelerated since February 2022 with the invasion of Ukraine,” Journois added.
“This is a very quickly evolving situation. The European Union has been built on a social contract of peace being there on the continent, and this is the first direct war since the end of World War II. In that context, there is a need for Europeans to be ready on an industrial level.”
Many private credit firms have already stepped in to meet the demand for funding, albeit with certain limitations. There is little appetite to fund controversial weaponry such as cluster bombs or landmines, and as a result some investment houses have implemented internal policies regarding defence investments. For instance, Rothschild & Co has a policy of not investing in companies involved in the production of weapons prohibited by the Oslo Convention on Cluster Munitions (2008) and the Ottawa Anti-Personnel Mine Ban Treaty (1999).
Meanwhile, in the equity markets, defence investments have been top performers over the past year. Weapons manufacturer BAE Systems has seen its stock price rise by almost 40 per cent, while military tech provider QinetiQ Group shares have risen in by more than 38 per cent.
Dual purpose companies have witnessed an even more pronounced bump. Jet engine manufacturer and car maker Rolls Royce has seen its stock jump by more than 206 per cent over the past year.
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