Strategic Reasons and Regulatory Hurdles
Carve-outs - meaning the spin-off and possible sale of a part of a company - are becoming increasingly important in the aerospace and defence (A&D) sector. Established aerospace and defence companies are faced with the question of how they can optimise their portfolio and focus on core areas. Investors (such as private equity firms or industrial groups) are also increasingly interested in spun-off divisions from corporate groups. In our three-part specialist article, we highlight the typical legal and practical challenges that arise in carve-out transactions in the A&D sector. The focus is on regulatory hurdles and strategic success factors that are decisive for the successful preparation and implementation of such transactions.
Strategic reasons and drivers for carve-outs in the A&D sector
The decision in favour of a carve-out is usually driven by strategic considerations. Large corporations often want to sharpen their focus on their core business. In the face of increasing competitive pressure, regulatory requirements and high shareholder expectations, companies must continuously review which business areas create sustainable value and which merely tie up resources without being strategically essential. A carve-out can make it possible to separate out non-core business areas and in doing so, concentrate management capacities and capital on the most important business areas.
At the same time, carve-outs can have financial reasons. The sale of a division can generate capital for investments or debt reduction and increase the value of the company. In some cases, groups also aim to float a divested division on the stock market or bring in a strategic partner. In this way, value potential can be realised that remains hidden within the diversified large corporation (unlocking hidden value).
In the A&D sector, there are also specific drivers: technological upheavals or market changes often require a reorientation. For example, a defence group could decide to spin off civilian business areas (or vice versa) to be able to operate in both areas in a more focused way. The development of defence budgets also plays a role - in times of falling budgets, some businesses have been spun off in the past, while in phases of high demand for armaments (as is currently the case in Europe), companies spin off divisions to enter into partnerships or obtain additional financing for growth. One prominent example is Airbus: in 2017, the aerospace group spun off its defence electronics business (now Hensoldt) and sold it to an investor to streamline its own portfolio and focus on other areas of defence. This step was justified as a strategic rationalisation of the defence activities and provided Airbus with greater financial flexibility and a clearer focus on core products.
Regulatory hurdles: export controls, security clearances and investment controls
The A&D sector is subject to particularly strict regulation. Three areas need to be considered at an early stage: Export control law, secrecy/security clearances and foreign direct investment (FDI) screening.
1. Export control requirements
Weapons, defence equipment and even many aerospace products are subject to national and international export controls. A carve-out in this sector therefore requires close examination of all export licences and requirements. Companies must ensure that the divested entity continues to have all the necessary export licences to export its products - regardless of whether it receives a new owner as part of the transaction. In the case of an asset deal, there is a risk that export licences will have to be reapplied for, as these are not usually automatically transferred to the acquirer. In the case of a share deal, existing licences initially remain with the company, but a change in the ownership structure may also be subject to notification or approval.
Furthermore, with carve-out projects, there is often an extensive transfer of technology and data. For example, confidential technical documents must be shown to potential buyers as part of the due diligence process. Great care must be taken here to ensure that no export control offences are committed. Contacts with the authorities may be necessary, for example to obtain authorisations for the transfer of defence equipment information to foreign bidders or to temporarily exclude certain technologies. In cases where US technology (ITAR-regulated goods) is involved, the consent of the US authorities may even be required for the change of ownership. Early involvement of export control officers and the creation of a clean transfer plan (including possible new licences for the future company) are therefore essential to be able to continue operations seamlessly.
2. Secret protection and security clearances
Many defence projects require secrecy - the companies and employees involved need security clearances in accordance with the German Security Clearance Act (SÜG) or comparable regulations in other countries. A carve-out must not jeopardise these confidentiality requirements. Changes in the ownership or control structure of a defence company must often be reported to the relevant security authorities. For example, it may be necessary for new shareholders, managing directors or supervisory board members to undergo a personal security check before they are given access to information classified as VS Confidential or higher. In extreme cases, foreign investors must be excluded from access to certain top-secret projects or complex trust structures must be implemented to protect confidentiality (e.g. setting up a trust solution or black box, as known from the USA as FOCI mitigation).
Even in the due diligence phase, the question may arise as to how secret information or information only intended for “German eyes” is presented to potential buyers (keyword: clean team or diluted data). Once the transaction has been completed, it must be ensured that the operational confidentiality requirements (e.g. appointed security officers, secure IT systems, sealed-off areas) are also fulfilled in the new setup. It is important to bear in mind that security clearances are time-consuming - background checks on individuals or parts of the organisation often take many weeks or even months in practice. This can become a real bottleneck if, for example, additional personnel are urgently needed or new shareholders are only allowed to exercise comprehensive information rights after a positive check. The Federal Association of the German Security and Defence Industry (BDSV) explicitly points out that such background checks currently take too long and need to be accelerated for the growing defence production. As a result, companies should contact the security authorities at an early stage for carve-outs in the defence sector to avoid delays in approvals. In terms of transaction security, it is advisable to provide for contractual closing conditions that clearly regulate which official security approvals must be obtained before the transfer becomes effective.
3. Investment control (FDI-Screening)
A third critical factor is investment screening for foreign investments. Almost all EU states - and Germany in particular - have significantly tightened their FDI screening procedures in the security and defence sector in recent years. If an investor from outside the EU/EFTA acquires more than 10% of the shares in a German defence company (or in an outsourced defence division), this must be reported to the Federal Ministry of Economics and approved. In some cases, the review already takes place at lower thresholds if certain critical technologies are affected. In 2021/2022, Germany significantly expanded the catalogue of security-related activities - since then, all military equipment on the export list (Part I A) has been subject to sector-specific controls. Previously, only the acquisition of individual particularly sensitive military equipment was covered; now, practically any involvement in defence technology requires a licence. In addition, the standard of scrutiny has been lowered: the probable impairment of public security (instead of concrete evidence of a threat) is sufficient as a reason for prohibition. These stricter rules give the authorities more leeway to stop transactions with potentially critical security implications or to impose conditions on them.
In practice, this means that in the case of a planned carve-out sale to foreign investors, an investment review process must be scheduled at an early stage. This can take several months, especially if an in-depth review (phase 2) is initiated. To minimise risks, companies in the defence sector often prefer to choose European (or NATO) investors as buyers. Alternatively, structuring measures are taken, e.g. participation of a state or domestic partner as a minority, to allay concerns. Hensoldt AG (resulting from the Airbus carve-out mentioned above) provided an impressive example in 2021: Here, the federally owned KfW Bank acquired 25.1% of the shares, which secured a blocking minority for the German government. The government decided to take this step to prevent “unfriendly powers” from gaining access to sensitive technologies (such as sensors and encryption). This example shows that the state will intervene directly if it considers national security to be jeopardised. For those involved in transactions, this means that they should communicate openly with the authorities in advance, present transparent ownership structures and, if necessary, provide assurances (e.g. to maintain German sites or technologies) to obtain authorisation. Conditions such as long-term site security, restrictions on access to information for certain shareholders or the composition of management can be possible requirements that should be expected in the signing/closing process.
In Part II of Carve-outs in the Aerospace & Defence Sector we will deal with the structuring of the transaction and operational unbundling. In Part III of Carve-outs in the Aerospace & Defence Sector we consider the success factors in the preparation and implementation of carve-outs.
