Even before European governments ramped up their focus on defense funding this year, with many LPs and GPs following suit, family offices were making hay from investing in defense-related technology. The sector is shaping up for a boom, while posing unique challenges for investors and managers, with venture capital seen as a key channel for accessing such assets.
“Recently, European defense tech funding has undergone a transformation, unlocking hundreds of billions of euros for modernization efforts in the coming decade,” says Garvan McCarthy, chief investment officer for EMEA and Asia at investment consultancy Mercer. “In addition, the US is working on removing regulatory burdens for tech investing in general.”
Such activity is ramping up in Europe in response to waning military support from the US under President Donald Trump and the growing threat from Russia, exemplified by its invasion of Ukraine.
The UK government has been actively courting venture capital investment for its defense sector this year, while the French financial regulator in March introduced an accelerated approval process for investment funds targeting the defense sector.
Nordic countries like Finland and Sweden had already made similar moves. Defense Innovation Network Finland (Define), a defense start-up accelerator, was launched in October. In June this year, Sweden adopted a new strategy for its defense industry aimed at fostering innovative emerging and disruptive technologies, following the launch of a defense innovation initiative in early 2023.
This activity is taking place as NATO members in June committed to invest at least 3.5 percent of GDP on defense spending by 2035. That followed a call under the Munich Declaration in February for a greater European focus on defense. In addition, the NATO Innovation Fund launched in 2023 as a €1 billion multi-sovereign VC fund to invest in deep-tech and defense start-ups, as well as venture funds, and announced its first investments in June last year. Among the VC funds NIF has committed to are Alpine Space Ventures Fund, Baltic Sandbox Ventures Fund II, Faber Tech III, OTB Fund II and Vsquared Ventures Fund II.
Just getting started
It is still early days for many allocators to be committing capital to the sector.
Danish retirement funds AkademikerPension and PenSam, and Finnish pension insurance firm Varma all eased restrictions on defense investment in June. The State Pension Fund of Finland did so in 2022, chief executive Timo Löyttyniemi tells Venture Capital Journal.
Others look set to follow suit, if they haven’t already. The full range of institutions is now investing in or evaluating defense tech, says David Kelnar, who leads equity private placement for EMEA at investment bank Houlihan Lokey. “There are numerous conversations occurring between GPs and LPs regarding LPs’ greater willingness to support investment into defense technology. But those conversations take longer than many might expect.”
Kelnar expects to see “more material quantums of capital flowing into defense tech” over the next 24 months as LPs and GPs work through deployment strategies, he tells VCJ.
Yet even when the institutional capital really starts to flow into the sector, a good chunk of it is likely to go into private equity rather than VC funds. PenSam, for instance, does not make venture investments as it finds it difficult to source the best managers, says chief investment officer Claus Jørgensen.
Family office involvement
Large family offices are playing an important role in the early growth or late-stage venture phases of the market, Kelnar says. For one thing, they have greater autonomy and agility regarding decision-making than most institutional investors. “If the principal of a family office wants to invest in defense tech… they don’t need months of conversations and modifications to their [limited partner agreement].”
They also don’t face the degree of public scrutiny that public pension funds do, Kelnar notes. In addition, “given the war in Ukraine, a growing number of family offices, particularly those in Eastern Europe, feel urgency and alignment around the importance of defense technology now for the protection of values and assets,” he says.
The sector has also proved attractive for family offices outside Europe. “Aerospace and defense is a key area where we’ve made successful investments through economic cycles,” says Vishnu Amble, founder, director and head of investments at single-family office GreenBear Group, which is co-located in Miami and Singapore. “We continue to be bullish on the sector across stages.”
GreenBear focuses on tech that is critical to the industry, where there are barriers to entry, which include areas such as reg tech and space tech, he tells VCJ. The LP makes allocations to funds and alongside those will make co-investments.
Amble sees benefits in having been an early mover in defense tech. “You are seeing this increasing flood of capital into the defense theme, but a struggle to access it in the early stages. So that is pushing up valuations in the later-stage assets. We like buying in at the early stage and selling into the later stages. That has worked quite well for us.”
Defense tech companies often start out as venture-backed and are now receiving later-stage investment, Amble adds, because more dollars are now available to deploy into this area.
Investment challenges
Defense tech has indeed seen a surge in VC interest, with most investors looking to gain exposure through managers, as direct investing requires significant sector knowledge and rigorous due diligence, says Mercer’s McCarthy.
Nonetheless, there has been a big rise in the amount of defense deal opportunities in the venture segment, says Dylan Doran Kennett, a partner at law firm Herbert Smith Freehills Kramer. “I’ve not seen anything like it in the defense sector before, frankly.”
In Europe, funding for defense and dual-use tech – the latter serving both civilian and defense purposes – reached more than €1.5 billion in 2023, up 70 percent year-on-year, McCarthy says.
There is a growing number of specialist defense-focused VCs, alongside increased participation from generalist funds and corporate VC arms, McCarthy adds. “Much of this new capital targets dual-use technologies applicable to both military and commercial markets, offering outsized opportunities in sectors traditionally dominated by government primes.”
Specialist venture managers are targeting areas like autonomous systems, secure AI, advanced communications and cyber-defense, McCarthy says. “These funds remain relatively concentrated and selective, often accessible only to existing relationships.”
One example is Dutch manager Keen Venture Partners, which is looking to raise €125 million to invest in defense and security technology start-ups in Europe from seed to Series B. The fund, which claims to be the first of its kind in the Benelux region, received a €40 million commitment from the European Investment Fund in May.
As for US generalist funds deploying capital in the sector, law firm Taylor Wessing cites Andreessen Horowitz, a backer of Shield AI, which makes AI-powered fighter pilots and drones, and Anduril Industries, a provider of defense hardware and software; Founders Fund, also an Anduril backer; and General Catalyst, an investor in Germany’s Helsing, which makes drones and underwater surveillance systems.
LP concerns
GPs, particularly generalist managers, should be aware that investments in defense assets may deter some existing or prospective LPs. After all, the fundamental sustainability risks and negative impact of the arms sector remain unresolved, investor network Shareholders for Change said in June. The issues include exports to countries with human rights violations, autonomous weapons systems, the sector’s carbon footprint and failings in product governance.
For instance, UK charity Barrow Cadbury Trust has divested from companies that supply components for military equipment, says Mark O’Kelly, director of finance and administration, who also oversees the trust’s £90 million ($121 million; €104 million) investment portfolio.
“You have to be confident that the manager you use aligns your investments with your mission,” he tells VCJ. “Obviously they have to react to the markets, but I would be very surprised if our investment manager started investing into arms companies, for example.”
Barrow Cadbury is even reviewing its exposure to tech companies in general, given its concerns over the use of AI in military applications, says O’Kelly. “We’re invested in Google, for example, which has recently dropped its ban on AI being used in developing weapon systems, so we need to find out more about that.”
Similarly, PenSam’s Jørgensen says: “Even though we are more open to investments in the defense sector now, it’s still a focus area for our board and our members, and we need to be a bit careful here about the activities of these underlying companies.” As a result, he says: “We would probably prefer to have a smaller group of investors with us in these funds,” such as other Scandinavian pensions, to make it easier to have an aligned approach.
Strong collaboration is likely to be necessary, given the complexities that will be involved.
