Opinion: Institutional Investors Need Pentagon Action

As aerospace investment banker Stephen Perry’s recent column noted here, initial public offering activity in defense and aerospace has been burgeoning (AW&ST May 18-31, p. 10). The U.S. Defense Department’s strong support for efforts to attract private capital to build competitiveness, resilience and innovation in the industrial base, coupled with expectations for sustained growth in defense spending, has opened a window to institutional investor capital that is flowing to defense contractors.

The Pentagon’s engagement is mostly with venture capital and private equity investors. While there is no data on this, more sophisticated venture and private equity firms are likely to have people involved in defense deals who served in government or still serve in the military as reservists and therefore might have security clearances. Such clearances provide insights not available to most investors.

But the Defense Department must think beyond engagement with venture and equity investors in defense contractors. Investors might be patriotic, but they are in business to earn a return on capital. They often want to exit an investment after 2-5 years.

Such investors have three exit choices. They could sell to a larger company owned by venture capital or private equity. Anduril’s acquisitions of multiple enterprises are examples of this. They could sell to a larger, established defense, aerospace or multisector company. Kongsberg’s acquisition of Zone 5, which makes lower-cost strike weapons, is an example. Or, to Perry’s point, they could sell in a public offering.

It is very important that the Defense Department recognize the difference in information available to institutional investors versus the venture and private equity ones with which it has been working. For instance, venture capital or private equity analysts and portfolio managers will not have security clearances, likely will not have served in the military—or will have served in a single branch—and are likely to be generalists.

This does not mean they would disclose information that could compromise national security. Classified programs have long been a factor that public companies cannot discuss in detail. Investors in Northrop Grumman dealt with this when the company was developing and producing the B-2 bomber. And KeyW, which had multiple classified programs with the National Security Agency, made up names for large programs that had no relation to the names their customer used. The company was therefore able to discuss the financial impact of these with investors. Analysts and institutional investors can take cues from bookings and backlog changes as well as from financial guidance.

Still, the Pentagon could take steps to improve information flows that would provide institutional investors with more confidence about the outlook for defense contractors. Of course, not all such information is happy talk. These are businesses in a capitalist system, which should be seen as a strength.

The first step is for the Office of Management and Budget and the Pentagon to publish outlay estimates, not just estimates of budget authority. These were missing from the last two budgets the Trump administration sent to Congress. Outlay projections can help frame sales growth estimates.

The second step is for the Defense Department to resume publication of the Green Book, which contained historic defense data in current and constant dollars and future spending estimates. It also included data such as the percentage of procurement budget authority that was expected to be converted into outlays each year. This data was invaluable in framing where U.S. spending had been and where it was headed.

The reliance on mandatory spending to be provided by reconciliation has also reduced transparency. This could change if and when the Pentagon resumes submitting discretionary spending requests, but the lack of detail in the mandatory request has lessened confidence in out-year growth expectations.

The Defense Department has to be mindful of risk allocation between itself and its contractors. A recent executive order promoting greater use of fixed-price contracts suggests the risk pendulum is swinging back toward contractors. Earnings blowups from charges on fixed-price contracts are an easy way to scare institutional investors away from the sector. There might not be one right answer on fixed-price versus cost-plus, but the implications of an imbalance should be considered.