The Chair offers you a summary of the second edition of the “Les entretiens de l'ECODEF” webinar series, which focused on the financing of defence companies.
In order to give its audience a better understanding of the economic challenges of defence activities, the Chair regularly organises webinars: «The ECODEF talks». These webinars provide an opportunity to present the results of the Chair's work in the form of an interview, together with a testimonial from a recognised «practitioner» on the subject in question.
This note summarises the main findings of the second issue entitled «The financing of defence companies»,which took place on Wednesday 13 October from 8.30am to 9.30am, and the answers to the most pertinent questions raised during the webinar. Hosted by Olivier Martin (Chairman of the Steering Committee of the Defence Economics Chair - IHEDN), this issue received Jean Belin (Holder of the Chair in Defence Economics - IHEDN) and Victor Raffour (Arquus).
Companies need to finance their investments, their innovation and R&D activities, and their production cycle. Several parliamentary reports have highlighted the growing financing difficulties facing defence companies. This webinar provides an opportunity to take stock of the Chair's work on this subject and to discuss the growing financing difficulties in this area.
Q. Q. : What is the current state of economic research into the financing of companies and defence contractors?
JB : Economic literature on corporate finance has developed significantly in recent years and highlighted a number of results interesting :
Generally speaking, the cost of and access to finance depend on the characteristics of the sector, the company and the project. Some companies may be financially constrained, i.e. they may not receive the funding they want or may receive it on very restrictive terms. Certain companies (SMEs, young, innovative or R&D-intensive companies) or certain activities (R&D, exports) are more strongly affected by these financial constraints, which can have major consequences for the choices made by companies and their performance.
In defence, Since the end of the 1980s, we have seen a change in funding methods. The use of private finance in the defence sector has grown and the influence of financial markets has intensified. (Belin, Malizard and Masson 2019)[1]. One example is the 1998 privatisation of Thomson-CSF (now Thales). In 1998, after privatisation, the French State held 42.9% of the capital. This share is now 25.68%. SAFRAN was also created in 2005 with the merger of SAGEM and SNECMA (privatised in June 2004). The French State is still the largest shareholder, but now holds only 11.2% of the capital.
We have also shown that defence activity generates significant financing requirements for companies, with substantial investment in R&D[2], more qualified staff (particularly researchers)[3] and an often longer production cycle[4].
- Defence activities may be more difficult to finance due to special characteristics in terms of risk and profitability. R&D projects improve performance by[5] but are more difficult to finance because of their high risk characteristics[6] and duration.
- Financing through the financial market has encouraged the development of foreign financing in Europe. Based on a statistical analysis of the capital links between major European and American defence companies (Belin, Masson, Fawaz 2018), we have shown that the national link, at shareholder level, is strong for Sweden (84.1%), Spain (78.2%) and France (63,4%) but less so for Germany (45,5%) and Italy (38,4%) and particularly low for the United Kingdom (9,7%)[7].
On the other hand, we note a strong asymmetry between Europe and the USA in terms of the capital of defence companies, with a greater direct presence of American companies (GD, Sikorsky, Raytheon, etc.) or American investment funds.[8] in the capital of European defence companies. Based on the available data, we have shown that US ownership ranks second in Spain (7.5%), Italy (5.9%), the UK (5%) and France (4%). In Germany, it is in third place behind national and British ownership. In contrast, the American defence companies on our panel have a very low presence of shareholders from the European countries studied (between 0.1 and 2%). The situation is clearly asymmetrical.
Q. As an industry insider, can you tell us about the financing needs of defence companies?
VR : Whether small or large, public or private, multinational or cooperative, start-up or operating in a traditional sector, a company is like any other project: it needs to be financed. Financing and business strategy are linked, because depending on the needs and the strategy defined, financing methods need to be adapted.
These needs can be divided into 2 main categories:
- Operating cycle requirements (working capital requirements). This is the amount needed to finance the company's normal activities, the purchase of goods or raw materials, and deferred payments from customers (particularly for exports). This is generally a short, regular cycle, but not in the defence sector.
- Lnvestment cycle requirements. This involves financing the acquisition of a tangible asset (machine, vehicle, etc.), intangible asset (innovation, patent, software, etc.) or financial asset (shareholding, etc.) with the aim of making a profit in the future.
In the defence sector, there is a high risk of not making a profit in the future, and the return on investment may be 10, 20 or even 30 years away. What's more, in the face of financing difficulties, operating cycle financing tools are very often used to finance de facto investment cycles, which poses specific problems for VSEs/SMEs that are often undercapitalised.
Q. What are the different methods of financing for defence companies?
JB: As Victor pointed out, a company, whether civil or defence, can use several sources of finance: self-financing generated by its activity, recourse to external private finance (through short-term or long-term debt or equity) and public funding.
Because of the characteristics of the market and the companies involved, defence companies have less recourse to external private financing than civilian companies. As a result, they have a specific financial structure with structurally fewer capital providers[9]. Defence companies therefore rely more on self-financing or public funding.[10].
Self-financing depends directly on the activity and performance of companies at home and abroad. Olivier Martin points out that the level of self-financing in defence is closely linked to export activity, In other words, the closer the domestic need is to the export need, the more the manufacturer may be inclined to self-finance part of its development costs. So, the closer the domestic need is to the export need, the more the manufacturer may be inclined to self-finance part of its development costs.
Defence companies also use national or European public funding. The IDA finances defence companies through Defence Technology Projects (formerly upstream research programmes), Rapid or Astrid funding and, more recently, through the creation of the Defence Innovation Fund.[11]. At European level, the launch of the European Defence Fund (EDF) will provide EU funding for collaborative defence research and development projects. Despite the difficulties involved in bringing it to fruition, the EDF has finally been approved for €7.9 billion over the period 2021-2027. Olivier Martin points out that this is ultimately a large sum of money, of which we are not always aware: in fact, the statistics produced by the European Defence Agency, even if they have methodological limitations, show that annual funding from the European Defence Fund represents around 10% of defence R&D budgets as recorded by the EDA.[12].
Q. Defence budgets have been rising in France and Europe for some years now. Yet there is increasing talk of funding problems in the defence sector. So what are the main risks in this area today?
VR : Manufacturers in the defence sector are currently observing a sharp contraction in financing from French banks to the defence industry, particularly SMEs, for reasons of image risk, over-compliance and new standards (taxonomy), but also for reasons specific to the DTIB, with a problem of under-capitalisation of companies in the sector (particularly SMEs) and also a de facto demand for SMEs to comply with new standards to which they are not really subject (e.g. SAPIN 2).
Dialogue is underway to find solutions that will enable banks and the DTIB to find the right solutions. The «flash» mission on the financing of the defence industry has made some very pertinent proposals, such as :
- transparency on the part of the banks, which should be able to give the reasons for their refusal to finance and provide reassurance in the management of sensitive information transmitted.
- decision times to be reduced, because in highly competitive export markets, financial terms and conditions must not be allowed to block bids.
- trust between players, as defence manufacturers are responsible companies, equally exposed to image risk, and respectful of international agreements, European standards and national laws.
Questions and answers from webinar participants
Q. Do you think that French banks are aware of these difficulties in financing defence companies?
VR : There are no statistics on refusals and they are often undocumented, but we have to find solutions. Funding is refused because of image risks, but we need to make our funders understand that we too bear this image risk and that we take it into account in our decisions. So manufacturers need to communicate more about their practices.
Q. Q. : What is the current status of taxonomy at European level?
R. : This issue is still under discussion in Brussels. Europe must take into account the importance of the need for security and the associated defence industry. Ultimately, it would be highly paradoxical to see the EU funding defence via the EDF and putting in place rules to the contrary via the taxonomy.
Q. Do insurance companies have the same aversion as banks?
VR : Today we have strong export support from BPI and many insurers, mainly Anglo-Saxon, regularly support the defence industry. These insurers are no more of a problem than before.
Q. Do we ever talk about funding for start-ups?
VR : The problem of funding for start-ups is also found in the civil sector. There was almost no funding for start-ups in the 2000s. There has been a recent increase in funding for these companies, but the volume of funding is still much lower than in the United States. We also lack the business angels who not only provide funding but also have knowledge of the sector. Financing through debt or the banking sector is not very suitable (young, small companies with little collateral and a lot of intangible investment). These companies will mainly finance themselves through equity (shares). In France, we have funding available for the early stages of these companies' development, but there is a lack of funding for the later stages, which culminate in the product being brought to market. For example, of the 16 start-ups that raised more than €100 million this year, only one had a French lead investor. It is mainly foreign funds that are driving these success stories.
Q. Q. : Doesn't having a foreign shareholder base in Europe, particularly American, introduce a risk of «vassalage» to the US?
JB: The financier has rights, the shareholder is the owner, he is entitled to information and to participate in decision-making. Nevertheless, in the case of defence, there is a specific legal framework that can prevent this risk: ownership and control are not equivalent here.
Q. Is defence part of the 2030 plan presented by the French President?
JB: Not directly, but the Relance 2030 plan covers a range of technologies that will certainly have an impact on the defence sector (aerospace, nuclear, etc.). For example, In the terrestrial sector, we are interested in innovations linked to the energy transition, and we are taking part in this research.
Q. Is the majority of funding for dual-use technologies provided by defence?
JB: Today, there is much more money outside the defence sector than in it, and each brings its own area of expertise (for example, defence often brings robustness, obsolescence management, etc.).
Civilian research has become important and defence companies have repositioned themselves. They are present at both ends of the research process (fundamental research in areas not covered by the civilian sector and the development of new products).
Q. Given the size of the consortia at European level and the reimbursement of eligible costs, will EDF funding be effective?
VR : In the civil sector at European level, the practice of large consortia already exists. There is a trade-off between the benefits of collaboration, which increases the likelihood of innovation, and the disadvantages, in terms of coordination and efficiency. At Arquus, we're big believers in consortia and partnerships, because we can no longer afford to finance and develop certain products on our own. As far as reimbursements are concerned, we are indeed concerned that part of the costs will not be reimbursed. There is also a trade-off between public funding and intellectual property issues.
OM : Consortia are useful and necessary for the success of the EDF, but it is important to ensure that the funding rules do not lead to a scattering of funds among a large number of industrialists to the detriment of the major objectives of developing new high-performance operational capabilities that meet the EU's needs and creating European champions in the defence field. A subtle balance therefore needs to be struck between these objectives to enable effective cooperation in the interests of Europe.
Q. Q. : With regard to the financing arrangements put in place by the IDA, are we able to assess their impact on the sector?
JB: There is as yet no specific study on IDA, but older studies on funding from the Ministry of the Armed Forces show that public funding has a positive effect on the likelihood of innovating or on the amount of R&D expenditure.
VR : Most of the technologies at Arquus have benefited from Rapid or Astrid funding. They enable us to accelerate our innovation.
[1] Until then, according to Jean-Paul Hébert (1995), the French armaments production system was characterised by an «administered mode of regulation», based on the pre-eminence of the role of the State (both producer and buyer). From the 1990s onwards, the status of private company became the rule, that of public entity the exception (the CEA for example). All the historic industrial players (Thomson CSF, Alcatel, Sagem, DCN, GIAT, Snecma, Aérospatiale, Matra, Dassault Aviation and SNPE) were affected to varying degrees by these privatisations and/or structural mergers.
[2] The defence companies identified thus have a sustained R&D activity. They represent 2 % of the total of French companies performing R&D and carry out 29 % of the internal R&D expenditure of French companies and employ 28 % of researchers (cf. Belin et al. 2018).
[3] An analysis of personnel costs shows that defence companies have higher personnel costs than other companies (37.1 % of sales vs 33.2 %). This difference is mainly due to differences in personnel structure (i.e. more managers and researchers in the defence sector).
[4] In addition to investments or salaries, companies have to cover the financial needs arising from the time lag between payments received from their customers and those made to their suppliers. Longer payment terms from certain customers can have a major impact on the production chain.
[5] As regards the link between defence R&D and performance, we can cite an MIT study which shows that the increase in defence R&D (of just over 50%) in the United States between 2001 and 2004 translated into an increase of around 1.8 % in the country's TFP (total productivity of production factors).
[6] The total control of governments over the defence market considerably increases the risk of this activity from the point of view of financial investors.
[7] In the UK, all the defence companies studied are listed on the stock exchange, and a very large proportion are free float companies (83.5%). In this context, the identifiable national link (excluding free float) appears very small (9.7%).
[8] American investment funds are present in all the British companies on our panel and are also present in Airbus Group, Italy's Leonardo, France's Thales and Safran, Germany's Rheinmetall and Spain's Indra Sistemas. The most active US funds include Capital Group Co, Blackrock Inc, Franklin Resources Inc, Vanguard Group Inc, State Street Corp, Ameriprise Financial Inc, Capital group International and JP Morgan.
[9] Moreover, defence companies have significantly less financial debt than non-defence companies (9.5 % of the balance sheet vs 15.8 % see Belin 2015).
[10] The cash flow ratio of defence companies is higher than that of non-defence companies (4.8 % vs. 4.1 %). The public authorities, because of the strategic nature of these companies, the specific nature of this activity or the historical structure of this industry, also intervene in the financing of defence companies in addition to public orders. This takes the form of subsidies, research tax credits or public funding.
[11] This fund will be operated by BPI France. The FID will take stakes in innovative companies in the growth phase, start-ups, small and medium-sized enterprises (SMEs) and intermediate-sized enterprises (ETIs) developing dual and cross-disciplinary technologies of interest to the world of defence. The Ministry of Defence will contribute €200 million. The FID will also be able to raise up to 400 million euros by counting on the contribution of other (industrial) investors. It will run for six years.
[12] This rate is in fact lower because a significant proportion of defence R&D in certain countries (Italy, Spain, etc.) is in fact funded by other ministerial departments.
