In the past five years or so Private and Venture Capital (VC) have become a feature of Australia’s defence industry landscape. This is despite a down-turn (in real terms) in defence expenditure as Australia’s relatively static defence budget tries to cover more and more capabilities, including a nuclear-powered submarine.
Defence ministers and officials keep saying we’re faced by the most challenging strategic environment since the Second World War. To meet this the Australian Defence Force (ADF) is trying to reinvent itself as it adopts long-range fires, the means to target these weapons and a new generation of Group 1 and 2 UASs and Counter-UAS capabilities, among other things.
This all takes money, of course, and Defence hasn’t got much. Which is where the private sector comes in, sometimes: where the returns exist, there is private money available to complete development, commercialise and ramp up to full production. But only where the returns exist.
Defence needs three things from Australia’s defence industry: advanced capabilities, and the quicker the better; ‘hot’ production lines so that it doesn’t have to wait if it decides it needs more of something; and it needs secure supply chains. Those advanced capabilities could range from something software-based which can be delivered quickly but will need upgrading constantly, to something very complex such as the Nulka anti-ship missile decoy which protects billion-dollar assets and needs several years and lots of testing before it’s ready for service.
A hot production line and a secure supply chain belong in the same basket, to a degree: ramping up production can be slow and expensive so an established production line with the ability to manufacture something quickly is prized; that ability depends on the availability of components and services - if they are interdicted for some reason then a hot production line goes ‘cold’ very quickly.
“Often the discussion on why private capital is important in defence focusses on government budget constraints rather than focusing on the potential for attractive returns,” Anthony Lazzoppina, the former CEO of Australian Bondi Partners and former investment director for the 1941 Fund, told ADM.
Private and VC funding of Australia’s defence industry is in part a response to Defence’s own perceived budgetary shortfalls, agree several VC funders.
Firstly, most agree there’s not enough money going into Defence as a percentage of Gross Domestic Product (GDP), so private capital is needed to supplement government funding.
Another VC source says: “Our holiday from history is over - we need to get real again.”
That means investing to build capability and capacity quickly. However, private capital, at its core, is returns focused so may not see a long-term Defence need as a commercial opportunity. Government might encourage private capital to invest in a long-term prospect with little chance of even a medium-term pay-off, but it can’t make it do so.
The funding challenges facing the Australian defence industry are mostly well-known. However, one that isn’t well known, say a number of VC sources, is Environmental, Social and Governance (ESG) issues, which mean that as much as 80 per cent of available investment capital, including much of the National Reconstruction Fund, is not actually available to the Australian defence industry.
Secondly, there is too much red tape in government as a whole and between different defence organisations, such as ASCA, CASG and GWEO - this seriously inhibits investment. And there are too many bureaucrats and processes involved, which slows decision-making down significantly - Defence has acknowledged this and is trying to simplify considerably its acquisition process.
And Defence doesn’t always seem to understand that funding an innovation, through ASCA or ADSUN for example, is not the same as awarding a company a production contract. That contract is what gives the ADF useable capability and where industry capability and capacity is actually built, point out both industry and VC sources.
And according to one source contacted by ADM, Integrated Investment Program (IIP) pressures mean we cannot even begin innovation investment, let alone sustain it, as industry has no confidence that, regardless of funding, an attractive but low TRL innovation could transit the so-called Valley of Death to an ADF production program in any case.
“Nothing drains confidence like giving small federal grants to entrepreneurs, knowing there is zero chance it will be picked up by a major program. That’s why the US and (increasingly) European route has been the preferred path to scale and success for the Australian defence industry,” this source said.
There are some sources of funding that target start-ups and take equity in those businesses, partly because they want to be part of a rapidly growing and successful business and partly because those start-ups need less cash, at least to begin with.
Then there are more established businesses which need investment capital to get over the Valley of Death or to ramp up manufacturing capacity with an eye on the domestic defence market, the export defence market and even civilian markets for the technology concerned. That technology could be a material, or a sensor, or even a manufacturing process that’s unique. The more complex the technology, generally, the longer it takes to get it into service and therefore the deeper the pockets needed by industry and its funding sources.
So, what do sources of Private or VC funding look for when they’re planning their investments? There are probably five things, according to sources contacted by ADM:
- Good technology with a point of difference
- Intellectual Property (IP) protection
- A very competent, enthusiastic but realistic management team
- Solid export prospects
- Dual-use technology
The first three are essential parts of any technology start-up and apply also to Small and Medium Enterprises (SMEs) and Primes. The latter two can generate sales volume: strong export and civilian demand for a new technology can generate rapid profits and therefore returns to sources of funding.
For example, says one VC source, Ukraine has shown GPS is now virtually unusable near the front line in any serious conflict, so there’s a lot of deep science into alternatives now under way. Australian researchers are very strong in this field but aren’t the only ones.
However, if that technology gets to market, Australian firms can probably export it to no more than 50 countries that are both acceptable to Australia’s Defence Exports Control regime and that can actually use some of our high-technology equipment. Assuming the US International Trade in Arms Regulations (ITAR) regime allows it, of course.
Between them those 50 countries represent a market that’s worth about US$1.7 trillion a year, according to one estimate, or about 2.1 per cent of their combined Gross Domestic Product, which is significant. By contrast, the Australian market is very narrow and small.
Dual-use technology matters, points out Anthony Lazzoppina: “This dynamic, coupled with global alliances such as AUKUS and the Quad, will drive very good returns for private investors. Hence, I believe the discussion will evolve to a returns-based lens for investing, and private capital will continue to grow in the sector given the great potential returns.” So, something like a non-GPS navigation system could find applications in mining, in the civilian offshore market and even in space and civil aviation.
Steven Baxter from Beaten Zone Venture Partners, which focusses on early-stage ventures, talks about Tailwinds, Latent Opportunities and Future Opportunities. The Tailwinds in the current defence environment are the general security situation: we’re seeing bigger defence budgets (except in Australia) and the US defence budget alone is growing from about US$864 billion ($1.31 trillion) to about US$1 trillion ($1.52 trillion) by 2026. There is reduced reliance on traditional suppliers as new technologies and business models come into play - in the United States new, cashed-up companies like Anduril, Skydio, Palantir and Shield AI have emerged in the past few years to challenge entrenched technologies and business models that are in some cases decades old.
Latent Opportunities include the much higher level of innovation funding in Australian defence: ASCA, for example, will spend around $3.5 billion over 10 years; the Guided Weapons and Explosive Ordnance (GWEO) Enterprise aims to spend about $4.1 billion in total; and the defence industry will get a small share of the National Reconstruction Fund’s $15 billion. Non-dilutive grants to start-ups, which allow founders to maintain control and ownership of their companies, have also resulted in impressive capabilities, he considers.
Baxter points out that getting equity in an Australian start-up is fairly cheap at present: despite recent interest from Private and VC funders there’s still not very much capital in the Australian defence market at present compared with the United States.
Future Opportunities, in his view, are things like the AUKUS agreement and the liberalisation of ITAR and export controls for the three AUKUS signatories. He also highlights Russia: at one point it was providing 18.6 per cent of the global defence equipment market but this has fallen to about 10.5 per cent - this is due partly to the poor performance of Russian equipment on the battlefield and partly also to Russia rebuilding its domestic stocks and so exporting less. That shortfall has left a hole which others are now rushing to fill.
Some complex technologies can take several years to come good and be marketable. That timescale can be compounded by Defence’s own sclerotic and risk-averse processes, agree multiple private funding sources: it can take a decade or more before a new product enters production and starts to make a profit.
So, investors and industry need to be aware of the working capital cycle in the defence sector, warns Ryan Whitelegg, Managing Director of Melbourne-based independent adviser Henslow. If companies and VC funding sources aren’t aware of this when investing in the defence industry they could come a cropper: “Industry is littered with great ideas that never got to acquisition,” he points out.
And as welcome as it is, Defence’s focus on its own innovation needs can be a two-edged sword, warns Mike Kalms of KordaMentha: “Defence is rightly focused on its own innovation agenda – but sovereign innovators need global market scale to succeed,” he says. “If we want enduring sovereign innovators, we need to start with a focus on serving global allies, not just our domestic Defence needs.
“I feel innovative defence business can access small federal and private capital markets more readily than ever,” he adds, but believes Australian companies need to focus on exports and even overseas production in order to win the really significant funding many of them need: “Our Department of Defence hasn’t the budget capacity, and the US and Europe are demanding local production more than ever.”
Markets in Europe and the Middle East are also increasingly asking for ITAR-free goods, which means that some Australian companies are having to pursue two separate routes to market, with some clear but often uncomfortable interfaces between markets.
Some sources believe that the US and Five Eyes market is so big that Australian companies have no choice but go there, anyway, either as exporters or as manufacturers, and bite the ITAR bullet.
So, what does an Australian company with investment potential actually look like?
- It probably (though not necessarily) works in a high-demand sector like ISR, underwater, cyber security, space or Counter-UAS - basically all of the Defence and AUKUS Pillar II technology priority sectors
- Its technology works, has a point of difference and its IP is protected
- It has a strong management team that’s capable of lateral thinking
- There is strong export demand - and any ITAR implications need to have been thought through
- The technology is dual-use which, with export demand, means greater volume, quicker returns and faster growth
And finally, adds Beaten Zone Ventures’ Steve Baxter, “You’ve got to invest in something that people actually want to buy.” And that is the bottom line: intent and money.