Investments in defence companies are experiencing high demand in light of geopolitical developments. At the same time, start-ups in the defence sector are actively seeking new investors. One way of financing is through venture capital (VC) or private equity (PE) funds.
In the first article of our Aerospace & Defence Bulletin [New market, new opportunities: What companies should consider when entering the defence sector], we outlined in detail the challenges companies have to overcome to successfully gain a foothold in the defence sector. For those interested in getting involved with start-ups in the defence sector, investing in such companies—rather than establishing a fully operational enterprise—can be a viable alternative. To efficiently pool and allocate capital from various investors, the establishment of a specialised fund focused on investments in defence companies presents an attractive option.
What needs to be considered?
Funds are subject to regulatory requirements, as not everyone is permitted to collect capital from a broad investor base for the purpose of joint investment under a defined investment strategy. As a result, such funds are typically managed by a licensed alternative investment fund manager (Kapitalverwaltungsgesellschaft) authorised by the German Federal Financial Supervisory Authority (BaFin). Obtaining such a license is complex and entails meeting many regulatory requirements. Therefore, existing alternative investment fund managers are often used in the market.
However, if experts from a specific industry want to join forces and set up their own smaller fund, a ‘regulatory light’ option has gained popularity and is also suitable for the defence sector. Provided that the value of the fund's investments does not exceed EUR 500 million (without the use of debt capital) or EUR 100 million (including debt capital) at any time, the fund may be managed by an alternative investment fund manager that is only registered with BaFin, rather than fully licensed. The hurdle to becoming a registered alternative investment fund manager that is then permitted to manage a lightly regulated fund is not high. Nonetheless, certain requirements still apply— such as money laundering checks of investors, risk management and sector-specific expertise of the management. Such a fund could then acquire and hold stakes in start-ups in the defence sector on behalf of its investors and sell them again at a later date for a profit.
Who can invest?
The investor base is not open to all potential investors, but only to so-called professional and semi-professional investors. Professional investors are self-regulated companies or large commercial enterprises, while semi-professional investors are those who, among other things, commit to investing at least EUR 200,000 and already have prior investment experience.
If foreign investors wish to participate in the fund, certain additional considerations apply. For instance, a foreign direct investment review procedure may be triggered if a foreign investor directly or indirectly (e.g., through fund participation) reaches or exceeds the threshold of 10% of the voting rights in a defence company. The voting rights of affiliated companies or companies that are deemed to exercise voting rights jointly based on an agreement are aggregated for this purpose.
And what about ESG?
Fund investments are also subject to the EU Sustainable Finance Disclosure Regulation (SFDR), which aims to steer capital flows towards sustainable investments and economic activities. The main purpose of the regulation is to create transparency for investors in terms of sustainability. Funds are therefore required to disclose whether they pursue environmental or social objectives or even sustainable objectives with their investments. If they do not pursue such objectives, funds must disclose this explicitly.
While a few years ago it was a matter of course that funds wishing to invest sustainably would exclude any investments in the arms industry and weapons, there is currently a lively debate about the incorporation of ESG criteria in defence companies. This debate is complex and multifaceted. On the one hand, weapons can play a role in defending democratic values and protecting civilian populations. On the other hand, concerns remain about the ethical implications and social responsibility associated with the manufacture and use of weapons. The EU Taxonomy Regulation, which defines sustainable economic activities and mandates corporate disclosure of environmental and social impacts, currently does not consider defence investments sustainable. However, as a political compromise, the EU Taxonomy Regulation may evolve to reflect the ongoing ESG-defence discussion in the next revision.
The market is also currently discussing whether companies in the defence industry that place particular emphasis on social aspects in their corporate policy and governance—such as high occupational safety, equal pay, diversity in the workforce, etc.—can be deemed at least partially sustainable. For now, however, this has no impact on their classification under the current EU Taxonomy Regulation.
Conclusion
The defence sector is currently an attractive investment field. The establishment of specialised funds in the venture capital or private equity space opens up new opportunities for investing in defence companies. “Regulatory-light” fund structures allow for the launch of smaller funds under simplified conditions—offering a pragmatic, low-threshold solution. In addition to regulatory compliance, ESG criteria continue to play an important role in fund structuring. While defence investments are not currently recognised as ESG-compliant under the EU Taxonomy Regulation, there are growing calls for the integration of ESG criteria in defence companies. It is therefore quite conceivable that the discussion will find its way into the next amendment to the Taxonomy Regulation. Ultimately, careful structuring of the funds is crucial to operate successfully in this market in the long term and in compliance with legal requirements.
