Interview: Why capital is still not flowing to Europe’s defence SMEs

Nordic and other European states are seeking to significantly expand their defence production capacity.

As a result, the defence industry requires additional capital to fund investment. However, as reported in recent days, many small and medium-sized enterprises (SMEs) and start-ups continue to face difficulties accessing finance.

But how significant is the problem?

- This question is very difficult to pin down, says Linus Terhorst, a research fellow in the Military Sciences team at the Royal United Services Institute (RUSI), a London-based defence and security think tank.

- It depends on who you ask.

Many struggle

Many European SMEs do at times struggle to secure investment for expansion or research and development, he said, stressing that he is referring to the bread-and-butter supply-chain SME rather than the high-profile start-up backed by a major venture capital fund.

According to Terhorst, banks often present a different picture, arguing that they are willing to engage with defence companies and dual-use businesses.

- Many large banks maintain that there is no problem.

Terhorst, whose research focuses on defence procurement, industrial strategy and defence innovation management, recently published a report examining whether environmental, social and governance (ESG) requirements are constraining defence sector growth.

In the report, he argues that the main limitations to growth in the defence industry are much wider structural issues that limit its ability to attract investment:

"These limitations include dependence on politically driven procurement decisions, export controls, the long-term cyclical nature of many defence products, late payments, and legal challenges affecting services and products in the monopsonistic defence market," the report states.

Against this backdrop, Terhorst does not view the issue primarily as a regulatory challenge. 

It is more a question of banks fully aligning their behaviour with new policy priorities, while SMEs often lack the capacity to make effective use of de-risking mechanisms, he explains.

- That takes time, which many companies do not have, and it is then labelled as a financing problem.

Terhorst notes that the defence sector carries several risks that lenders frequently highlight, including lengthy procurement cycles and highly concentrated markets, often with a single dominant customer.

- It is not an easy market to enter, he says.

- If you are a lender, you need to think carefully about whether a company is capable of repaying a loan, particularly in the case of a start-up.

Not always attractive

As mentioned, Terhorst agrees that parts of the industry face a liquidity challenge, but he argues that the more important question is where the problem originates.

He points to post-financial-crisis capitalisation regulations, which govern how much capital banks must hold and how much they can lend against their balance sheets.

Commercial lending has generally declined since the financial crisis, increasing competition for available loans and giving banks greater discretion over where capital is allocated.

- This means that higher-risk industries such as defence are not always especially attractive, he says.

He also points to sustainability-related restrictions, with some institutions either maintaining or having previously maintained reservations about investing in defence companies.

- That creates challenges, but they are not necessarily the largest ones.

A workaround

Terhorst noted that new financing instruments are emerging, including the proposed Defence, Security and Resilience Bank (DSRB), a multilateral financial institution intended to mobilise capital for NATO members and partner nations.

The objective is to provide capital that commercial banks can lend against.

- It is something of a workaround, he said. 

- By increasing the leverage available to commercial banks, you can expand the amount of capital available to the defence industry.