Investing in defence: A guide

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“Change brings about opportunity,” says Manish Thakur, Managing Partner of boutique Private Equity (PE) firm Hudson Fairfax Group. “The decline in the defence budget is masking spending reallocation and new technologies that offer new opportunities, especially in the PE space.”

Hudson Fairfax, which invests in mid-market defence and security companies, was founded last year by Thakur, a 20-year defence industry investment veteran. In an interview with Defence IQ, Thakur discusses how the industry is evolving, what the budget cuts mean for companies and how the status quo will be affected, as well as identifying the key technologies and markets from an investment perspective.

Consolidation and reorganization

“The defence industry has seen strong spending for so long that it supported a large supply chain of small and medium size enterprises. In the new world, we will start to see some real winners and losers,” Thakur began by asserting.

Over the last decade in particular, the defence industry went through a boom with defence departments writing so many cheques it likely put a strain on the pen and paper industry. Times have changed. As a result, Thakur expects to see a significant increase in merger and acquisition (M&A) activity over the next few years.

“Over the next five years there will be a lot more M&A taking place in the sector as well as much more PE money going into the space as firms get rolled up into the primes,” Thakur said.

In November General Dynamics announced the acquisition of Force Protection Inc. (NASDAQ: FRPT) for around $360 million. The Summerville, South Carolina firm flourished throughout the Bush era but with the outlook for armour and survivability products bleak, it's little wonder the mid-market leader was brought into the General Dynamics family. I said at the time that the market cannot remain in limbo for much longer as there simply aren't enough contracts to sustain the number of firms vying for them. Mid-market consolidation is inevitable.

It’s a sentiment shared by Hudson Fairfax too.

“The industry is already beginning to witness a renewed level of mergers & acquisitions activity, a trend we expect to increase greatly over the coming years. While mergers among the large prime contractors are politically untenable, we expect to see major consolidation in the highly fragmented traditional subcontractor supply chains.”

But Thakur is also quick to point out that even though this consolidation is an upshot of a sluggish economy, “don’t forget the (U.S.) defence budget will still grow in nominal terms.” Indeed, at the unveiling of the U.S.’s “new era” defence strategy in January President Obama made a point of highlighting this.

“Over the past ten years, since 9/11, our defence budget grew at an extraordinary pace,” the President said. “Over the next 10 years, growth will slow, but the fact of the matter is, it will still grow.”

“There will be a fundamental reorganisation of the industry,” Thakur said, “but change brings about opportunity.”

The next generation

Government investment in the sector is being curtailed. That is true for many facets of the military, but by no means for all. Thakur explained that the U.S. Army and Marine Corps are suffering from cutbacks, but new technology is now driving job creation and economic stimulus in the sector. For example, in June last year the National Security Agency (NSA) announced it was hiring in excess of 1,500 cyber experts each and every year.

Cyber is elbowing its way to becoming the fourth defence domain after Land, Sea and Air, but that’s not to say it’s at the expense of all three. Thakur conceded that Land forces may suffer, but was very optimistic about the opportunities and emerging technologies in the Air and Sea domains, and especially those for the Navy.

“So the industry is not so much contracting but changing,” Thakur explained. “The budget is effectively being redistributed and we need to learn fast how to adapt and make the most of the opportunities as they present themselves.”

The key question for investors then becomes: Where are the funds being redistributed to?

Thakur said that he sees lots of growth in sectors including cyber security, C4ISR (but specifically communications, intelligence and surveillance), unmanned systems, biometrics, and satellites. Hudson Fairfax expects to see the “transformation of the U.S. military to a lighter, more mobile and network-centric force.” Any technology that will hasten that transformation is where you will find the PE money heading.

“Anything that sits on the network, that’s where our heart is,” Thakur said, indicating where he believes the most attractive investment opportunities to lie.

Emerging markets

“We’ll see a reallocation of global spending on defence as regions like Asia and the Middle East continue to emerge,” said Thakur.

“India represents a particularly promising new area of growth for the U.S. defence sector,” as Hudson Fairfax sees it. “The country is the world’s largest democracy, has the second fastest growing economy, and operates the third largest military. India is undertaking a major defence modernization program, and last year was the world’s largest importer of defence equipment.”

This analysis is supported by Defence IQ’s recent Armoured Vehicle 2012 – 2022 industry report, which identified India as the (clear!) target market for OEM’s over the next decade, with 57% of respondents underscoring the opportunities in the region.

“The moment has arrived when India is on the threshold of economic and technological surge,” said Lieutenant General J.P. Singh (Rtd.), former Deputy Chief of Staff, Indian Army.

Thakur said that India will spend an enormous amount on building up its security and defence infrastructure over the coming years because “India has a level of obsolescence that means it needs a whole new generation of technology, equipment and infrastructure.”

As for Hudson itself, the firm sees the greatest opportunity with “small and medium sized enterprises with proven products and referenceable government customers.” Growth capital is the firm's sweet-spot.

The New York-based investor summarizes as follows, with a keen focus on the opportunities available in a changing defence sector: “Consolidation in the traditional military supply chain, company creation in new sectors such as cyber, divestitures of non-core businesses, and increased trade with emerging markets, offer an opportunity to both unlock and create shareholder value. We believe that few sectors in America, or globally, offer investors as much opportunity over the next decade.”

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Contributor:   Andrew Elwell

Andrew graduated from The University of Nottingham with an MA in History in 2003. After graduating Andrew started his career with a niche armour systems manufacturer, which provided ballisitic and blast armour products for the international defence market. His first major undertaking was to project manage a UOR up-armour programme for an in-theatre MoD vehicle. After completion of the contract, Andrew headed up the research and development department at the company. This involved designing, developing, testing and presenting new armour solutions to defeat customer specific threats to all major European and International ballistic and blast standards.

Following this Andrew moved behind the desk and became Senior Editor at a news and data provider, offering proprietary analysis, intelligence, market research and data on the global security and defence industry. The role offered the chance to write widely on the industry, exploring new technologies and getting to grips with corporate finance, mergers and acquisitions and debt and equity fundraisings.