On February 24th, 2022, Russia launched a full-scale invasion of Ukraine. Longstanding assumptions about the necessity of (or lack thereof) defense spending have been brought into question across the Western Hemisphere. Western countries are now attentively considering what increasing defense spending looks like in practice. Most notably, Germany announced a military spending increase to more than 2% of its GDP. A significant portion of defense spending and investments across the West will be routed to prime and subprime military contractors. As the sector continues to grow, private equity will play an increasingly important role in improving national capabilities to ensure safety and sovereignty.
Investing in the Aerospace & Defense industry has become increasingly complicated with the rise of environmental, social, and governance (ESG) considerations. ESG considerations within Aerospace & Defense are difficult to navigate: security clearances creating information gaps, LP exclusions around kill chains, an investment’s impact on human rights, and polarized political landscapes are a few examples of obstacles faced when factoring ESG into the investment process. Malk Partners, a boutique management consultancy, advises private markets on incorporating ESG and Impact in the investment process and has a long track record of helping private equity firms navigate Aerospace & Defense investments. While the majority of Malk’s work is bespoke to target acquisitions, it has identified best practices for these kinds of investments:
1. Stay clear of red lines:
Strictly avoid producing or distributing controversial weapons governed by international conventions or legal bans. These include, but are not limited to: anti-personnel mines, cluster munitions, biological weapons, chemical weapons, and nuclear weapons.
2. Implement thorough customer stewardship procedures:
Actively consider both the end use of a product and the stakeholders involved through a customer stewardship process. These two components ultimately determine levels of risk and reputational scrutiny. Avoiding the worst actors does not clear an investment of all risk, as risk varies considerably within US allies, NATO countries, and/or countries that receive US military aid. A customer stewardship process may determine which parties should be restricted from purchasing products and services and facilitate reviews of product features, such as facial recognition, that can have latent harmful effects – even in the hands of allied governments.
3. Ensure a member of the investment team or advisors maintain required security clearance:
Understanding a target acquisition is key in any investment process. Gaining a sufficient understanding is challenging when details around specific projects or services are walled behind security clearances. To understand whether sensitive information materially changes an investment’s ESG risk profile, at least one member of the acquiring party should have the appropriate level of security clearance (e.g. secret, top secret) to fully evaluate the investment.
4. The greatest risk often lies in the kill chain:
The “kill chain” describes the structure of a military attack. The chain consists of identifying a target, dispatching forces, deciding to eliminate, ordering to eliminate, and ultimately destroying a target. Aerospace & Defense products and services may fall within the kill chain; the further along the kill chain a company’s product or service is, the greater the ESG risk.
5. Aerospace & Defense is not void of ESG opportunities:
While Aerospace & Defense has material reputational and ESG risks, it also has significant ESG opportunities. An ESG opportunity is an EBITDA-expanding initiative that results from an ESG improvement. These opportunities vary by company and can offer competitive advantages to target acquisitions. For example, programs to transition veterans into civilian roles not only provide a positive societal impact but can also take advantage of available tax credits.