Innovative funding for Defence

Jan Wind, October 20151                                                                                                                            Download PDF 



Summary


Innovation for defence usually involves new technologies or new capabilities and sometimes it concerns improvements in the organization or leadership. Funding is almost never subject of innovation, particularly not in relation to capability development. However, funding is an important aspect of incorporating defence activities in the economy. An important reason for innovation in the area of funding is the continued decline of government budgets, which affects technology and capability development programmes in particular.


Private investors and banks are certainly interested in participating in defence and security related projects, just like they are in other sectors of the economy. There are vast amounts of money available in the financial market and fund managers are searching continuously for investment opportunities. The need for a reasonable return on investment and a limited risk are however important factors in addition to military needs and technical merit. This can be made possible when dual use and export opportunities are included as key elements in a proposition.


Not all banks and investors are willing to participate in defence and security projects. Concerns about perceived image damage when participating in defence-related activities sometimes can be mitigated by a strict code of conduct against controversial weapons.


A privately funded project should be useful for the armed forces, profitable for the investors and provide opportunities for the entrepreneur: “It should be beneficial in all respects”.



Introduction


Innovation for defence usually involves new technologies or new capabilities and sometimes it concerns improvements in the organization or leadership. Funding is almost never subject of innovation, particularly not in relation to capability development. However, funding is an important aspect of incorporating defence activities in the economy. An important reason for innovation in the area of funding is the continued decline of government budgets, which affects technology and capability development programmes in particular. Could other players in the economy contribute? And if so, how?


For the past three years my team2  has conducted research into opportunities for innovation in defence related finance, and explored comparable issues in other sectors of the economy. In particular we have determined under which conditions private investors could be persuaded to invest in defence technology and capability development.


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Second Coen tunnel in Amsterdam – funded by private investors.

Photo Marion Golsteijn 2014 (CC BY-SA- 3.0)



Increase in Defence budgets unlikely in most of Europe


Due to the financial instability of the past few years and the increasing need to direct funds to many other areas of the overall budget, it is unlikely that European governments will significantly increase their defence budgets, and certainly not to the NATO standard of 2% of their national GDP. Recent conflicts are changing this attitude slightly, but political parties are still influenced by popular phrases such as “defence industry is economically inefficient”, “defence does not attract voters” and “defence expenditures create global instability rather than solve conflicts”. For that reason politicians do not intend to commit political suicide by proposing an increase in defence budgets.


In contrast to the USA, Russia and China it is therefore unlikely that investments in capabilities and developments of new technologies by European nations will return to a level that match the ambition to maintain powerful, high-quality and flexible armed forces.



Financial innovation in other economic sectors


Government budgets have also declined in other sectors traditionally perceived as public responsibility, such as infrastructure and healthcare. In these sectors alternative financing options have been developed to overcome the budgetary constraints.


An interesting example is the building of motorways and tunnels funded by private investors. The government specifies its needs and private companies fund, build and maintain the infrastructure. The investment is refunded either by revenue derived from charging a toll, by government repayment over a 30-year period, or by a combination of the two. Most of the motorways and tunnels in the Netherlands are now funded by banks and other investors. In France and Italy a major part of the motorway network consists of privately funded toll roads.


In healthcare technology and pharmacy it is customary for companies to develop their products funded by private investors. Finalised products are purchased or paid for by hospitals and insurance companies. These institutions and national governments have strong economic ties. In many nations almost as strong as in the defence sector. A complex network of SMEs, large OEMs, insurance companies and governments make innovation in the healthcare sector effective.


These types of Public Private Partnership (PPS) have proven to be successful in many European nations. Large government investments have been modified into services to the government.


Of course, the examples cannot simply be translated to the Defence sector. Primarily because private investors require a financial return for their contribution. This is how they fulfil their role in the economy. Interest or profit requirements are strongly related to the level of risk. When governments and private investors cooperate effectively it is possible to find smart solutions with minor risks and, hence, limited profit requirements.



Defence investments as a service


Defence investments and defence related capability developments could be turned into a service as well. The government does not need to own satellites, training systems and ordinary means of transportation. The armed forces should have unrestricted access to these services when necessary. This is not synonymous with ownership and can be arranged differently.


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Free green energy for Defence in the EDA Go-Green project.

Photo Armin Kübelbeck (CC BY-SA- 3.0)


An example of this type of service was developed by the European Defence Agency (EDA) in 2013. In their Go-Green3 project companies are invited to generate green energy on military camps and bases. They have to supply the base or camp with energy but do not receive any payment from the government. The companies can recover their investments and operating costs by selling the surplus of generated energy on the market. The result is a double benefit for the government: free energy and a substantial contribution to the environmental policy of the European Union. The properties required were already owned by the Ministries of Defence and often not heavily used.


Privately funded services for defence could also be utilised by third parties when temporarily not needed by the military. This could be done in an adapted or limited manner. All users pay on the basis of actual utilisation and their drawing rights. This would be conceivable for the ground and the space segments of satellite communication, for advanced simulation and training systems, for various means of transportation and many other semi-military systems.


A good example is the Desdemona motion simulator4. This advanced six degrees of freedom simulator was specified by the Netherlands MoD and developed by TNO (Netherlands Applied Research Organisation) and AMST Systemtechnik GmbH (Austria). The initial purpose of this simulator was research and training of complex movements of military aircraft and pilots in flight. Since its completion the simulator has turned out to be very useful for motion simulation of ships, military tanks, civilian driving and also for space flight simulation. The simulator was privatised and is now contracted by Ferrari for Formula 1 simulations and by XCOR Space Expeditions to train for short trips into space.



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Helicopter pilots train disorientation in the Desdemona simulator during a brown-out landing in a dusty environment, like in the Mali desert. A great example of a training system with many dual-use opportunities. Privately funded and owned. Photo: Desdemona Inc.



Technology and capability development


Development of defence and security applications also provides opportunities for private funding. Defence technology is still perceived as an important source of innovation5. The best of high-tech! When presented a solid business case investors are certainly interested to invest their money in smart ideas for defence technology and capabilities that also have non-military (dual use) applications or export opportunities. This could be attractive for investors even if more money is needed to develop the additional applications.



Experience in the United Kingdom


The Ministry of Defence in the United Kingdom (MoD UK) has gained a great deal of experience in private funding over the past years, particularly in naval ship maintenance and in technology and capability development.

A naval ship maintenance contract structure was developed resulting the contractors gaining more profit (in absolute terms) when working more efficiently. The resulting parallel interests for companies, investors and government supports cooperation and efficiency.

In order to encourage development of defence technology, the MoD provides guidelines for the desired products, coordinates activities and supports tests. The Private Finance Unit of MoD UK has proven6 that this methodology results in considerably less expensive products compared to development projects funded by government. However the MoD UK and participating companies have experienced many pitfalls along the way. The learning curve has been steep. According to several of their representatives, it has not been easy to find the right structure of joint ventures and contracts.



Costs of private funding


In the example of the Go-Green project of EDA there is no out-of-pocket costs for the government at all. Of course providing a location represents a value too. The property could have been sold or rented out.


When only funding is required and all other variables remain unchanged the cost of capital will be somewhat higher than the interest rate on a government bond. The more risks are moved to the investors the more their profit requirements will increase. This linear relationship should be carefully considered when developing agreements.


To balance cooperation in an effective manner and safeguard the interests of all parties it is customary in the financial industry to use independent brokerage companies. The cost of this type of mediation is limited to a small percentage of the invested amount.



Funding sources


Potential investors can be categorised into several general types as described below. Within these categories each investor has its own area of interest and portfolio. The most suitable combination of investors for defence related infrastructure, capabilities or technological innovation strongly depends on the goals of the investment, the business plan and the location.


European and regional investment banks

The European Investment (EIB) bank, owned by all EU member states and the European Bank for Reconstruction and Development (EBRD) are important examples on a supra national level.

Unfortunately these two important investment banks are not permitted to participate in defence related activities. This policy of exclusion of the EU owned banks is contradictory to the official European Security and Defence Policy (ESDP). In the ESDP the importance of a strong defence related industry is highly emphasized and industry is dependent on the type of financial instruments as provided by the EIB and EBRD. Activities are ongoing in Brussels to change the EIB policy, but the formal exclusion is currently still in force.

On a national level more flexibility exists. For example the regional development bank in the Dutch Province of North-Brabant (BOM) participates in several defence related activities. This bank particularly focuses on in service support in the regional “maintenance valley”. The Innovation Quarter (IQ) in The Hague focuses on security solutions. The share in the activities of these regional banks is, however, limited to revolving funds7 of a few tens of millions euro.


Commercial banks

Many commercial banks are worried about the risk of image damage when participating in defence related activities. They often use a strict code of conduct related to granting credit. Many of these codes of conduct are more stringent than the Wassenaar-arrangement8 on export controls of nations.

A bank’s code of conduct usually excludes funding for the development and production of controversial weapons, and for export of sensitive military equipment to certain nations. Among the list of controversial weapons are anti-personnel mines, cluster munitions, chemical, biological and nuclear weapons. Sometimes European Union nations are also excluded for export when the bank recognises a risk of corruption or is worried about human rights. Major banks have whole departments guarding their code of conduct. Companies without a formal code of conduct requesting credit are immediately suspect.


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Lots of money available in the market!


Mutual Funds

Mutual funds managed by investment companies like Blackrock and JP Morgan could be relevant for very large projects. Worldwide more than 20.000 funds exist, with average assets of over 1 billion euro per fund, totalling an astronomical amount of money. However, these funds usually only invest in companies listed on the stock exchange. It will therefore be quite complex to develop an attractive proposition for a specific defence project.


Equity investment funds, informal investors and business angels

These categories of investors may be an easier match. They search continuously for attractive propositions, usually in companies or projects with a value between 1 and 20 million euros. The European private equity and venture capital association “Invest Europe” (formerly EVCA) reported a total of over 40 billion euro of investments in 5.550 European companies in 20149.


Not all of these funds however are interested in investing in defence related activities. The European Union coordinated European Investment Fund (EIF) has the most stringent limitation, similar to the EIB: defence and important areas of the security sector are “excluded areas”. Several other funds follow the policies of the EIF to avoid perceived image damage.


Crowdfunding

This type of funding is currently very popular worldwide. Due to the short investment horizon and small amounts involved crowdfunding is not very attractive for defence related projects. Defence capability development projects usually involve more than 0.5 million euros. Moreover crowdfunding is not as easy as putting a funding request on-line. Effective and fair contracts that avoid unmanageable risks for the investors and the company are of utmost importance. National authorities for the financial markets and the central banks apply a strict licensing system for crowdfunding platforms.


This overview shows that there is an incredible amount of money in the market. Managers of funds are continuously searching for favourable investments. A number of these funds are certainly interested to invest in defence and security related technology and capability development, just like they are in other sectors of the economy.

Each individual investor, however, has its own area of interest and its own financial objectives. Anywhere between high and low risk; short or long term; green technology or real estate. Sometimes a defence or security-related investment is acceptable or even desired, particularly when an effective dual use opportunity is available in another economic sector.



European perspective


An advantage compared to traditional government funding is that private funds are not as strictly bound to national borders as government money often is. Project arrangements and consortia will be established using companies providing high quality products for a reasonable price and risk, regardless of their location in the EU. This could also stimulate cross border cooperation and involvement of SMEs throughout Europe as is desired by the European Commission in their policies.



What is important for proper funding?


WISER Consultancy’s own research has shown six factors of primary importance for successful private funding of defence and security-related activities: (1) dual-use and export opportunities, (2) sound contracts, (3) an effective combination of investors, (4) a clear code of conduct against controversial weapons, (5) financial guarantees and (6) the innovative power and creativity of the armed forces.


Clear dual-use and/or export opportunities10, in one or more other economic sectors are very important, especially to reduce the risk perception of the investors. When risks are relatively small, an investor is inclined to settle for less profit.

An additional opportunity to create sales and profit with the same technology or product limits the investment risk. Even if more money is needed to develop a dual use or export opportunity this may still be attractive, particularly if an opportunity exists in another economic sector.



A second contributor to successful private funding is a sound consortium structure with effective contracts. Terms and conditions must be favourable for all parties involved, not just for the government or a major player. Currently governments often impose strict requirements on PPS agreements based on improbable assumptions. This regularly leads to unexpected and often high additional costs, pointless contractual restrictions and a great deal of annoyance. A regular tender does not work for PPS. Cooperation should be developed jointly with all interested parties.

Arrangements, terms and conditions should be carefully formulated and properly agreed on.


As a third factor, it is of major importance to combine various types of financing in an intelligent manner. A bank usually does not want to take any risks, particularly when no suitable security is available. Investment funds are reluctant to take all risks alone. Therefore, a combination of several banks and investors is often the best solution to accommodate the particular investment strategy of each investor. Sometimes a (small) additional government contribution may convince parties to close a deal.


To avoid image damage by unethical investments the fourth factor to take into account is a strict code of conduct against controversial weapons11 as discussed earlier in this article.


As fifth factor for proper funding financial guarantees by the government should be considered. Under certain conditions governments are willing to guarantee bank credit when a project fails, in particular when dealing with a high technological risk. This concept is counterintuitive for most non- financial people, but has proven to be an effective means to mobilise private investments in many nations.

In addition to existing national arrangements the European Union recently established the European Fund for Strategic Investments (EFSI), also referred to as the “Juncker Fund”. The EFSI is a 16 billion euro guarantee fund from the EU budget, complemented by 5 billion euros from the European Investment Bank (EIB). This should unlock private investments of at least 315 billion euros between 2015 and 2017.


As discussed earlier in this article it is uncertain if the EIB will ever be allowed to use its budget for defence technology projects. If this is the case, European Ministries of Defence or EDA could consider setting up their own guarantee fund. This would be an important contribution to the ESDP. A guarantee for failed projects is often more effective than grants for all projects.


The market should bear risks, but governments can help where the market fails. This is also in the interest of government, because support and guarantees as described in this article keep profit requirements relatively low for high-risk technology development projects.


The sixth contributor to successful private funding is the innovative power and creativity of the armed forces. There is a significant amount of knowledge, experience and creativity present in most MoDs and military organisations in order to stimulate and support development of products suited to their needs. To provide functional or technical specifications, generate ideas for new functionality, test products in an operational environment and/or act as launching customer helps to develop products to near perfection and stimulate export. In several EU nations one or more of these support activities are already part of formal or informal government policies. This relatively inexpensive model of government support decreases technical and market risks. It also increases profit opportunities for companies and helps to increase the appetite of private investors to participate. This is useful for the company and the investor, but also for the MoD and military users.



Downsides of private funding


Traditional funding of defence technology and capability development by government provides a quite strong degree of security for the companies involved. These companies are paid for their work and may expect additional payments when unforeseen delays or technological difficulties occur.

Resulting Intellectual Property Rights (IPR) usually reside in industry. Sometimes returns on these government investments flow to industry when governments waive royalty requirements. Private investors are usually less generous as their role in the economy is to make a profit.


Technology and capability development funded by a bank or private investor cause additional costs. The investor will require interest or profit and repayment of the invested capital. Arrangements for the investments have to be set up properly, which is sometimes more complex than a government contract. This cost of capital limit the entrepreneur’s profit margin.


A bank requires securities in order to avoid all possible risks of losing the funds invested. For the same reason a private investor often requires a level of control over the company or project. Both risk reduction measures are not always in the interest of the entrepreneur. For this reason investment contracts should be carefully balanced to serve the interest of all parties involved.


In recent years subsidies and development contracts by the government have often been replaced by a “revolving fund”. These loans bear regular interest and need to be repaid within a few years. This drastically reduces the historical advantages of government funding. Companies should compare the terms and conditions contained in a “revolving fund” with private investment opportunities and develop investment strategies suitable for their particular goals


Examples

A few fictional examples make opportunities clearer. The first example (1) concerns shared use of training facilities, the second (2) is about technology development; the third example (3) concerns international cooperation within the European Defence Agency EDA and the last example (4) describes an alternative for government owned satellites.


Training systems 
These often large and complex systems provide an excellent opportunity for shared use between military and civilian operators. Visit the Ship Handling Simulator (SHS) of the Royal Netherlands Naval Academy in Den Helder, Netherlands. This facility is capable of providing very realistic simulation of complex navigational situations thus removing the need for high risk on-board training of the past. Examples are mooring in bad weather conditions, search and rescue operations in bad weather and anti-piracy training. More realistic than real life. The simulator is wholly owned by the Netherlands Navy, but is not used to its maximum capacity. Civilian use is prohibited as it may be perceived as unwanted competition by the government.


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Ship Handling Simulator at the Royal Netherlands Naval Academy. A great example of a training system having many dual-use opportunities. Private funding definitely would have been an option.

Photo: LT Vanessa Strijbosch


If this system had been privately funded, or privatised like the aforementioned Desdemona simulator, it could have been available for use by maritime schools and academies, shipping companies and the offshore industry as a perfect example of dual-use. Similar to the Go-Green project of EDA, revenues from use by third parties could have covered a significant part of the investment and operating costs, even if the initial investment to develop the dual-use capability would have been higher.


Sulphur in diesel fuel
In Europe and the USA diesel fuel with a very low sulphur content has been mandatory since 2006 (Ultra low sulphur diesel – ULSD12). Oil companies now remove most of the sulphur in very large plants and diesel engines have been adapted to function on sulphur reduced fuel. In many African and Asiatic nations the rules are still less strict and the sulphur content in their fuel is higher. A modern engine using this diesel fuel wears out within 30.000 km. Consequently low sulphur fuel necessary for out-of-area military operations is often transported at high cost over long distances.


Considerable cost savings would be possible if sulphur is removed locally on a small scale. If this technology were available armed forces could purchase fuel locally. Small scale desulphurisation would also have excellent dual use opportunities in many other applications, like shipping. In addition an application like this would contribute significantly to the European Union’s environmental policies.




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Small scale desulphurisation plant. Drawing: Toeps Energy


It is however hard to find a knowledgeable and reliable user-organisation interested in small scale desulphurisation, capable of defining requirements and testing the results. If the armed forces of a European nation could provide this type of non-financial support, it would very likely be possible to find private investors interested to fund this development.


Cooperative projects by the European Defence Agency (EDA)

Cooperative projects by EDA are complicated by the need for detailed alignment of many aspects between participating member states (pMS) and industries. Research, development, industry schedules and budgets of pMS all have to be matched to a painstaking level of detail. This is particularly true for so-called category B projects. Usually negotiations take at least a year, even for quite small projects of a few million euros. Often industrial work has to be adapted to a nation’s budget in a manner unsuited to the technological and industrial needs of the project.

Banks could easily overcome the scheduling alignment and funding gaps by short term credit. Of course within the applicable laws and rules. Much higher efficiency in industry could easily compensate for the interest banks would charge for this kind of budget shift.


Government owned and operated satellite communication
In December 2013 the European Council adopted a proposal to develop a major satellite system for military communication and image processing13, similar to the Galileo system for European navigation. It is the intention to invest heavily in this plan and the system should be operational by 2025.




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Current (US) AEHF communication satellite. Does the EU need to own a SATCOM system?

Photo: USAF


This may not be the best way to spend European taxpayers’ money. Solutions used in other sectors of the economy could be more budget efficient. A government does not need to own and be the sole operator of a military satellite system: the military just needs to have unrestricted access when necessary in times of war and tension. When owned by private industry a major satellite system like this could be shared with commercial users in peacetime. Every user pays in proportion to their particular drawing rights and actual use of the system. This type of modern balance between ownership and use could easily be adopted in many other cases14.



Conclusion


Private investors and banks are certainly interested in participating in defence and security related projects, just like they are in other sectors of the economy. There are vast amounts of money available in the financial market and fund managers are searching continuously for investment opportunities. The need for a reasonable return on investment and a limited risk are however important factors in addition to military needs and technical merit. This can be made possible when dual use and export opportunities are included as key elements in a proposition.


Not all banks and investors are willing to participate in defence and security projects. Concerns about perceived image damage when participating in defence-related activities can sometimes be mitigated by a strict code of conduct against controversial weapons.


A privately funded project should be useful for the armed forces, profitable for the investors and provide opportunities for the entrepreneur: “It should be beneficial in all respects”.






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1 Earlier versions published in the Dutch language in Marineblad (Sept 2014), APA magazine (Dec 2014) and Militaire Spectator (Jan 2015)

2 See www.wisernl.com/team

3 Factsheet EDA GO GREEN version 3 dated 22 March 2012

4 See www.desdemona.eu

5 Conclusions European Council 19/20 December 2013 (EUCO 217/13) par. I-2, I-18

6 Mike Charlton (MoD UK - Private Finance Unit) at the Future Forces Conference 2013 (FFC2013) in Amsterdam. See FFC2013 Conference report page 83.

7 A revolving fund is established by a one-time only investment of the participants. Users of the fund receive a loan for a limited period of time. This loan has to be repaid – with interest or royalties - when the company or project is successful. The repaid money then can be re-invested by the fund for another project.

8 The “Wassenaar arrangement on Export Controls for Conventional Arms and Dual-Use Goods and Technologies” is now used by 42 nations. See www.wassenaar.org

9 Invest Europe association (formerly EVCA) website: www.investeurope.eu (annual statistics 2014)

10 Dual use is defined as: primarily for defense purposes and secondary suitable for other economic sectors.

11 See for example www.wisernl.com/about/code-of-conduct

12 See http://en.wikipedia.org/wiki/Ultra-low-sulfur_diesel

13 See European Commission communication “Towards a more competitive and efficient defence and security sector” of 24 July 2013 (EC COM(2013) 542 final) par. 6.2 – action 2 last line; Conclusions European Council 19/20 December 2013 (EUCO 217/13) par. I-11; EDA fact sheet Governmental Satellite Communications of 24 March 2014.

14 A satellite for military communications will be launched in 2017 for the Luxemburg based company LuxGovSat SA, a joint venture of SES and the Luxemburg government. Almost 80% privately funded, this satellite will provide military grade communications just as proposed in the example. For more information see: http://www.ses.com/4233325/news/2015/20635031



About the author


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CAPT RNLN (rtd) Jan Wind (1953) served almost 35 years as officer in the Netherlands Navy. The major part of his career he managed development of advanced technology programs for the armed forces. After his retirement he established WISER Consultancy, serving government and industry on strategy, complex funding & investment solutions and legal issues. Activities focus on support of defence and security technology and capability development. Additionally Jan Wind is chairman of the Royal Netherlands Society of Engineers for Defence and Security (KIVI DV) and President of the Federation of European Defence Technology Associations (EDTA).



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Jan Wind,
15 Jul 2017, 12:17