Nixon Peabody’s Hot Topics in the Middle-Market series welcomed a panel of national defense, military, cybersecurity, and AI experts to discuss current trends in their vital and evolving industries. Our panelists dove into the current state of defense spending, dual-use technology, cybersecurity/AI, and the current geopolitical landscape, as well as how these dynamic environments impact middle-market M&A. The panel featured Tess Oxenstierna of Capstone Partners, Adam Nahari of Pinegrove Capital Partners, Jeremy Hitchcock of New North Ventures, Bill Alderman of Alderman & Company, and Steve Gilmer of CohnReznick LLP.
The current state of the US Defense Industry
Our panel first discussed the current US defense budget. The country’s base defense budget has steadily increased from 2001 to date (save for a handful of years in the mid-2010s in light of the Budget Control Act of 2011), exclusive of supplemental dollars for matters like the ongoing war in Ukraine and Operation Allies Welcome. For context, the Department of Defense budget for fiscal year 2023 totaled $816 billion (which increases to $851.8 billion when including supplementals) and is expected to reach at least $842 billion for fiscal year 2024. Typically, the DoD’s budget increases 5% or so annually, with additional increases in times of war. Current Department of Defense (DoD) budget priorities include technology (cybersecurity, cloud computing, technical debt), climate change analysis, space initiatives (enhanced space command and control, missile systems, satellite innovation, GPS), infrastructure, supply chain improvements, and expansive research and development initiatives.
Like many industries, the defense industry has seen significant consolidation of defense contractors over the years. Each of the five largest defense contractors in the United States (Lockheed Martin, Raytheon, Boeing, Northrop Grumman, and General Dynamics) have been extremely acquisitive, particularly over the last two decades. Consolidation in any segment invites scrutiny, which has resulted in a significant uptick in antitrust and CFIUS focus in Washington, scrutiny that our panel expects to continue into 2024.
The influence of private innovation
Private innovation has become a core component of the broader US defense strategy. Technical and mechanical sophistication from private companies like Microsoft and SpaceX now rival—or even exceed—the capabilities of entire nations. The DoD recognizes that private sector input and innovation in data aggregation and analysis, cybersecurity, and AI will be vital for the United States to protect its citizens and preserve stability worldwide. In particular, the need to protect the massive amount of data generated by the DoD and intelligence agencies is paramount; that information cannot simply be loaded into the cloud. Moreover, the extreme speed of tech innovation—particularly in times of war—is not always matched by the speed of development and implementation of cybersecurity solutions, making vulnerabilities easier to exploit by the day (and by less sophisticated actors). Given the prevalence and increased complexity of phishing, malware, and ransomware attacks—and the advanced age of much of the DoD’s existing technology—the defense industry is particularly focused on developing and implementing the next generation of data protection with assistance from its private counterparts.
Over time, US military and budget spending has declined when measured as a percentage of GDP. For example, current defense spending is approximately 3% of US GDP, down from nearly 10% in 1960. To further illustrate the point, military spending was over 35% of US GDP during World War II. Many reasons may explain the contraction, but our panelists observe that a declining market garners fewer suitors. Smaller companies have a much lower survival rate when their sole client is spending proportionately less on defense needs than ever before. Fewer market entrants means less capability to adapt to changing needs. Even worse, a declining market creates increased backlogs and inevitable delays: outcomes that foster dire consequences when the market is national defense.
A focus on the future
Some of the defense categories our panelists are focused on for the future include cybersecurity, satellite technology, autonomous vehicles/drones, surveillance and target identification systems, and language processing. Space innovation, spurred in part by the creation of the United States Space Force in 2019, as well as significant leaps in private-sector space innovation over the past 15 years, is front and center. Increasing scale and efficiency in propulsion advancement and NanoSat and CubeSat technology command lofty multiples for savvy manufacturers and innovators. Our panelists also foresee increased research and development funding flowing into satellite (and antisatellite) technology, which will accelerate this segment of the M&A market and introduce new government/commercial partnerships in the coming years.