What LPs are looking for in defence-related PE strategies

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Speaker B: Welcome to the latest episode of Private Equity Spotlight, a P.E.I. group podcast that delves into the very latest in private markets investing. I'm Adam Lay, senior editor for emea, and today we are talking all about defense investing. No, I'm not referring to investing in a defensive way. I'm talking about private equity firms investing in the sector or the concept of investing in defense and security. And to discuss this, I'm sitting down with my very dear colleague, Joe Marsh. Joe, you are EMEA editor for Investor Intelligence. Joe, welcome to Spotlight.

Speaker C: Thanks Adam. Thanks for the intro and uh, great to be here today.

Speaker B: It's great to have you. Um, Joe, what a fascinating time to be talking about investing in defence. It's, uh, fair to say that 2026 so far has been a, uh, pretty volatile and somewhat scary time on the geopolitical front. Um, Joe, we're going to set the scene in a second in terms of how private equity fits into this concept of investing in defence. But, um, I first listeners to know that the reason we've brought you specifically on today is that you are probably PEI Group's most authoritative editorial voice on defence investing. Um, you wrote a cover story on the topic which listeners can find@privateequityinternational.com and I get the impression that you're speaking almost every day to as many LPs as you can to stay on top of how the institutional investor community is thinking about exposure to defence. Um, Carlyle wrote a white paper about this topic last year that Europe could spend around 9 trillion doll euros, I believe, on defense spending over the next decade. So there is a lot to play for. Let's start with why we're talking about this. It's been such a hot topic over the past year. Who are the main kind of actors and why is this a hot topic for them?

Speaker C: Um, yeah, let's take a step back here, I think, and really just very quickly. Clearly the European pivot by governments towards ramping up defence investments was definitely sparked by Russia's invasion of Ukraine back in February, uh, 2022, and then somewhat reinforced by the waning military support from the us Basically President Trump telling Europe they had to stand on their own two feet when it comes to defence spending. So I mean I suppose the key players if anything are European governments and state budgets. But that has obviously encouraged or really fueled um, investment, uh, or private investment into the sector or at least interest into the sector initially. Now there's as a result that's led to a lot of talk, particularly the closer uh, uh, institutions are to Russia. Clearly for them it's a lot more real. So you know, you're talking about the Baltic states, Poland, uh, Sweden, Denmark, Norway here. In many ways they're already somewhat, I don't know if prepared is the right word, but certainly uh, ready to respond perhaps quicker than some others have been. But that's definitely changing now. And as we'll go on to see, you know, other countries that might have perhaps have been reluctant or other investors even in Europe that might have been reluctant to discuss this or talk about this before of now, it's definitely not a subject that people are avoiding anymore. And that goes from you know, pension funds to insurers to other investors as well.

Speaker B: Of course that was going to be my next question. So you mentioned pension funds and insurers. Are they really the main types of LPs that are really thinking about this or is it you know, family offices as well?

Speaker C: Uh, yeah, I mean it seems that the starting point, uh, and even before the Ukraine war, family offices I think both in Europe and probably particularly in the US were already uh, investing in uh, defence tech, things like that, um, defense related assets partially because I don't think they faced the same sort of ethical issues perhaps around the topic. Um, and they clearly saw opportunities there. So certainly that's been going on for some years before uh, Russia invaded Ukraine. But that has definitely now moved on to include for instance Finnish, Swedish, Danish pension funds are certainly the earlier uh, movers when it comes to interest in doing something in this sector now. Mhm.

Speaker B: And is this part of a uh, wider push amongst these investors, amongst their whole portfolio? Are they thinking about investing in defense from all sort of asset class pockets or is this really quite specifically a private markets and, or a private equity push?

Speaker C: Certainly if you look at defence sector stocks in Europe or the US they just really uh, rocketed since 2022. And private markets now, uh, people see that as definitely perhaps the way to have a more direct and more controlling ability over your assets in this space, a more uh, specific impact in the areas you want to be in. And private equity has definitely been the focus so far above all. Um, but as we'll go on to Discuss. I mean clearly this has implications across asset classes, from private equity to infrastructure to real estate, even private debt as well. But private equity does seem to be the way most people are looking at accessing it, at least currently.

Speaker B: And before we delve more into sort of what specific LPs or even GPS are doing, let's take a step back. What do we mean when we talk about the concept of defence? What types of companies and what types of assets are uh, investors looking to invest in to ride this growth?

Speaker C: You can look directly at arms manufacturers and things like that, but these are not really the areas that most people are starting to look at. It is more around what is called dual use, which uh, means companies with both civilian and military applications. I mean that could be any number of things, but uh, one example example might be night vision goggles, so usable by civilian, like fire brigades, things like that. But more recently a lot more demand coming from armies in Ukraine for instance. And there could be medical, mobile medical testing stations, things like that that are obviously useful both, uh, near or in battlefields and lots of other places too that don't involve defensive applications. So definitely people are more comfortable around making those sorts of investments, whether GPs or LPs or at least talking about making those sorts of investments. Now I don't think that's just because of the ethical aspect. There's also an aspect here which is do we want to be concentrated in pure defence investments or would we rather be focusing on areas which, let's say a certain war ends tomorrow. Uh, we're not going to be stuck with assets which are going to be going down in value, uh, very quickly, potentially because they're only related to a military conflict going on or that's what's particularly driving their value.

Speaker B: So investors are uh, I mean they're keen to kind of ride this wave, but they're also wary of the fact that they don't want to invest in something that might sort of lose its sales channels or clients or underlying customers overnight because a war ends.

Speaker C: Yeah, I mean I think that's definitely something that people are thinking about. Um, I mean that's one of a number of challenges which we can, we can go on to. But I mean, yeah, I mean we stick around on that one for the time being is that governments are ah, the most obvious buyers of defence assets, be it weapons, munitions, uh, so on and so forth. So yes, defence budgets are being increased, which is obviously creates an opportunity in theory for private investors to exit down the line. But it also does mean that um, you've got to be confident that those governments are a going to be the same buyers that they were five or seven years before when you come to exit and that they have the money to uh, continue to buy all the assets they want to and the inclination to do so. And that is not a given. If you see how fast, you know, things are moving even today and you have to think about that five or seven or even longer years down the line, uh, it's a tough one. Uh, so if you're a little bit more flexible and diverse, diversified in terms of how you invest in defence, then that's obviously could work out better and is a more comfortable way of doing it for most investors.

Speaker B: So it sounds like a strategy or a sector, you might say, that isn't necessarily straightforward, that has a few different push pull dynamics going on that investors uh, looking to get exposure to need to navigate. Um, one of those uh, dynamics is esg. Joe, um, talk to us about how big uh, a blockade this is for investors who might want to invest in the defence strategy, but maybe it might be restrained because of internal policies around investing in certain types of assets.

Speaker C: Yeah, um, look, this is something that was or would have been an issue in the past, but that's very quickly gone away it seems because, you know, quite quickly and it's ranged from, you know, maybe family offices and private banks starting out, um, changing their ESG policies with a view to allowing them more flexibly to invest in areas of defence that they might have been perhaps, if not prohibited, perhaps certainly slightly constrained on in the past. Now that very quickly spread to some of the investors with more ethical outlooks if you like, or ESG focused outlooks. And that would be Scandinavian pension funds for instance. And the irony is that they've been the quickest movers on this in many ways, even though they arguably they're some of the most ethically minded investors on the planet simply because that's mainly for

Speaker B: the geographic sort of reason, as you mentioned before.

Speaker C: It seems that way certainly. But uh, m. Uh, while they might have been the quickest moves, I think for example, the state pension fund of Finland changed its ESG policies as early as 2022. Now I don't think most people moved quite that quickly, but that is probably an indicator that proximity was a factor there. Certainly it sounds to me from what I hear very widely that there are very few investors that are now prohibited or constrained by ESG policy, um, from investing in, even directly into arms companies and things like that. Controversial weapons I think will always remain an issue. But when it comes to even arms companies, a lot of people are now fine with that because they, you know, we can go on to why they've decided that, but, um, it's another issue. Uh, it's interesting to hear that ironically, perhaps defence as a theme has almost fallen in the laps, I think one almost described me is almost accidentally of the ESG specialist or sustainable investment specialists at certain pension funds or other investors. Um, they are now arguing the point that actually, if anything, it's gone from being a taboo because of ESG to being something which is very much a topic, which is, put it this way, some people are saying that ESG should add a D to it for democracy or defense. Right. It's now become almost something, uh, that's got to be done even from a fiduciary standpoint, because companies the world over are going to be affected by this, if, uh, so, and have the potential risk from this, from not being prepared for things from cybersecurity, national, uh, grid resilience, all these sorts of things which all fall under the defense umbrella. So that's one thing I would say. Um, another thing is that quite a few investors I speak to, even if they are wary of investing directly into defence assets, they are certainly looking more closely at the wider themes that include defence. So, three words I would say security, sovereignty, resilience. These are specific themes that are being focused on more than before, with defence as a clear part of those topics, if you like. So, um, that's how a lot of people are looking at it now, I think. And so the momentum is definitely moving.

Speaker B: And how does that then translate into exit strategies? I appreciate that a, uh, Nordic pension fund might tweak its internal policies to be able to invest in a drone manufacturer or something even maybe closer to defense, um, products and manufacturers or something like that. But then five, seven years down the line, if they then try to sell an asset, or one of their GPS tries to sell an asset and they sell it to a defense company, is that then something that might cause a problem? How are investors, uh, dealing with that aspect of it?

Speaker C: If ESG was one issue before, that's not an issue anymore. Now it's a question of how do you invest in defence and what the problems are if you do, or what the challenges are if you do. Defence is very highly regulated and very specialist. I mean, for good reason. So not everyone is allowed to acquire these assets. Even governments that would be obvious buyers, or big defence companies that are usually very clearly linked to governments. In certain countries, there are major rules over uh, what they're allowed to buy and who's allowed to buy these uh, direct defence assets, uh, for fairly obvious reasons. So again, if you're trying to think about exiting five or seven years down the line and trust has, for example, gone away between the EU and the U.S. let's say there's no guarantee that governments that you assumed would be able to buy your, you'd be able to exit to are now in the same boat and the rules apply the same way. So yeah, there's no question that this could be an issue. And I mean one lawyer even said he does definitely see people getting burned as a result of, you know, thinking they've got a potential exit route when actually maybe they don't.

Speaker B: Joe. I mean it seems like there was a period when uh, as journalists we were receiving press releases sort of every week about a new, new GP launching a defense fund. I feel that that's kind of dropped off a little bit, um, as we speak here in June, in 2026. But talk to us about sort of what the push pull dynamics are at the moment. Um, how often are you seeing GPS launching funds and what are uh, the sort of LP appetites like for those strategies?

Speaker C: GPS are clearly finding that there is a very high barrier to investing here and it's not that simple. And you have to have, you know, specialists and we're not just talking about special, you know, a bit about defense, we're talking about military specialists who have long established track records in, in the M military. Right. You've got, uh, you know, I think KKR, you know, David Petraeus is former U.S. general. Right. I mean they've got him as an advisor. They've got, you need people who have credibility in this area. Um, and most of the gps that are doing anything directly related defence assets do have those people. But I also think probably they're also recognizing that there is talk, but the money is not as easy to raise as perhaps some people might think it should be given the talk around the topic. So I don't know how much the funds that are uh, already raising have raised, but they certainly haven't set huge targets. I mean we're talking sort of 2,300 million. Right. So they're, they recognize the billions. Yeah, not in, at least not, not the ones I've seen or heard about so far. So, um, and this is in Europe now, I think it's a different matter in the U.S. as we know, because there's more of a history of investing in defense. But, but in Europe it's certainly still a relative niche. So I think they're recognizing that and they're recognizing that your investors are, you know, still cautious. I think one quote I heard last week for the conference is, um, from an expert in the space was cautious and very selective, despite all the talk about investors looking at defence.

Speaker B: So, yeah, cautious and very selective. So a potentially 9 trillion euro opportunity according to Carlyle over the next 10 years. But LPs, at least that you're speaking to, are, uh, being cautious and, um, very selective. Fascinating. Joe, um, as we sit here in the middle of the year, what's your outlook for this space over the course of 2026? What will you have your eyes on?

Speaker C: A few things do seem clear to me. One, investors will continue to monitor and seek transparency, data, track record from gps that are looking at this sector and starting to invest, uh, in the sector directly. I think, given that this isn't an area which in Europe at least, really has any track record at all in a sort of direct investment kind of way. Um, yes, in the US perhaps, but not in Europe. That's something that, you know, people will be very curious to see. And there's probably another thing maybe holding them back at the moment. Um, ethical issues around the ultimate end use of weapons and munitions, however, are never going to go away, for obvious reasons. You know, you never know whose hands they're going to end up in or whether they're going to be used for the right quote, unquote purposes. So, uh, there will always be probably wariness of investing for some in core defense. But the momentum, as I say, is definitely shifting. I mean, I think the key point here is that defence is no longer taboo, and it was, say, five years ago, as recently as five years ago. So more investment capital is inevitably going to flow into the sector, whether indirectly or directly through wider themes. The question is how much and how quickly, obviously. But, uh, we'll see that, I'm sure.

Speaker B: Well, a fascinating space to watch and I'm sure, Joe, you will be continuing your conversations with the institutional investors who are looking to ramp up their exposure in this space. Joe, it's been absolutely fascinating speaking with you. Thank you for coming on Spotlight, and we look forward to hearing from you again.

Speaker C: Thanks, Adam. Nice to be here. Cheers.