The geopolitical situation and corresponding national and supranational political initiatives have made it clear that investments in the defence and security industry are pivotal in contributing to safeguarding national interests and ensuring stability. However, the defence and security industry is generally associated with complexity and risks from an investor perspective, due to ethical considerations and the regulatory and political landscape. In this article, we highlight certain legal considerations for investors seeking to explore investment opportunities in the defence and security industry.
Increased focus on investments in the defence and security industry
Investments in the defence and security industry have gained increased interest over the past years. In Denmark and the EU, the urgency and necessity of strengthening the defence is clearly marked by political initiatives, recent examples being:
- The Danish Defence Agreement from June 2023, under which the Danish Government has allocated DKK 143 billion (approximately EUR 19 billion) for strengthening the Danish defence and security, a sum which was increased latest in April 2024 to DKK 190 billion (approximately EUR 25 billion) based on a further increased need for investing in military capacity and strengthening the compulsory military service.
- The European Commission's introduction of the European Defence Industrial Strategy in March 2024, which aims to enhance cooperation and competitiveness within the defence industry across member states and strengthen the defence capabilities of the EU through a more integrated and collaborative approach to defence procurement, research and development, and industrial cooperation.
While the current geopolitical scene calls for increasing investments in the defence and security industry, the nature of the industry and the inherent risks and complexity calls for specific considerations for private equity funds and in M&A transactions.
Examples of typical risks and opportunities related to investing in the defence and security sectors include:
| Opportunities | Risks |
|---|---|
| Global market: Defence and security companies can often access a global market, as governments worldwide invest in defence capabilities to address evolving security threats. Such international sales opportunities can diversify revenue streams and mitigate risks associated with dependence on domestic markets. | Political and regulatory risks: Defence and security companies are typically heavily influenced by government policies, regulations, and geopolitical dynamics. Changes in defence spending priorities, export regulations, or the geopolitical landscape can impact company reputation, revenues and profitability. |
| High regulatory barriers to entry: There are generally high regulatory standards and stringent compliance requirements in the defence and security sectors which can create barriers to entry for new competitors, and accordingly established companies with a track record of compliance and quality assurance may benefit from limited competition. | Technology obsolescence: Rapid technological advancements and evolving security threats can render existing defence technologies obsolete. Companies must continually invest in R&D to maintain competitiveness and relevance in the market. |
| Long-term contracts: Many defence contracts involve long-term agreements, providing companies with predictable cash flows and revenue stability over extended periods. This can reduce the volatility of earnings and enhance investor confidence. | Contract dependency: Dependency on a small number of large defence contracts can expose companies to significant risk, particularly if contracts are cancelled, delayed, or reduced in scope. Loss of a major contract can have a substantial adverse impact on financial performance. |
Considerations relating to private equity funds
Generally, the private equity sector has been reluctant to invest in the defence industry which may be due to a mix of investment considerations, heavy regulation, and potential impact on the investor base of the fund who may have certain restrictions with respect to making direct and/or indirect investments in the industry. However, following recent changes in the geopolitical situation, including the Russia-Ukraine conflict, governments are requesting and supporting additional investments in the defence industry and new and more relaxed investment restrictions may begin to gain traction amongst the investor base that traditionally makes investments in private equity funds, such as pension funds. The increased demand may present a great opportunity for private equity investors and managers to benefit from larger returns and higher growth potential as is currently generated in certain parts of the defence industry.
For the past decade it has been considered usual in particular for institutional investors such as pension funds to request side letter provisions (if not investment restrictions included at fund level) that prohibits investments in portfolio companies that engage in the distribution, development, and/or sale of weapons or ammunition. Accordingly, many private equity funds are subject to limitations in regard to investing in the defence and security industry.
Common investment restrictions of private equity funds
All private equity funds are established with an investment strategy defining the objective and purpose of the fund. The investment strategy is often complemented with investment guidelines and restrictions to which the fund will be subject. Common investment restrictions include risk exposure limits, e.g. investment size limits, geographical limits, and sector specific limits. Inclusion of investment restrictions in the fund agreement limits the types of investments that the investors' capital can be used for. This could be an exclusion of companies within, for example, the fossil fuel-, tobacco- and weapon sectors. If an investment restriction is included in the fund documentation, the private equity fund as a whole will be prohibited from investments covered by the investment restriction. If an investment restriction is included in a side letter, the provision will generally not limit the fund as a whole, but only the specific investor, which will often have the right to be excluded from the specific investment or alternatively redeemed from the fund.
Investment restriction language
Due to the market standard for institutional investors to require provisions that prohibit investments in portfolio companies that engage in the distribution, development or sale of weapons or ammunition, many funds will have to carefully consider their investment restrictions before considering investing in the defence and security industry. In this regard, it is pivotal whether the provision states that the fund must not invest in weapon manufacturers or in any weapon-related industries, as the latter may include technology manufacturers or even the steel manufacturer that sells steel to the weapon industry.
The following are two examples of standard restrictions:
- "The fund shall not invest, directly or indirectly, in any portfolio company that, to the manager's knowledge, derives any of its income from the production, supply, trade and/or distribution of weapons."
- "The fund shall not invest in a portfolio company that, to the manager's knowledge, engages in manufacture, sale and/or storage of UN defined unconventional weapons."
Example no. 1 illustrates a strict limitation on the fund given that the fund may not make any investments, directly or indirectly, in the weapon industry. This would also limit the fund's possibility to invest in any portfolio companies that derive even a small part of their income from sale to the weapon industry regardless of whether the delivered product is considered a bi-product or a key component for the weapon manufacturer. Example no. 2 illustrates a less strict limitation given that it only covers direct investments in portfolio companies that engage in the weapon industry related to unconventional weapons. We also sometimes see hybrid restrictions covering subcomponents:
"The fund shall not invest in a portfolio company that delivers or makes available materiels, components or raw materials to a business operating within the production of weapons and ammunitions"
Needless to say, if a fund considers investing in the defence industry it cannot do so under the first example. In this regard, it must also be considered whether the first example would restrict investment in portfolio companies that produce products with a dual-use character, e.g. IT-solutions or quantum technology that is - or potentially will be - used by a broad range of sectors, including the defence industry. The fund may therefore need to amend the restrictions.
If a fund wishes to invest in the defence industry the fund may want to include the second example as an investment restriction to clarify that the fund will not invest in portfolio companies, directly or indirectly, related to unconventional weapons, e.g. the creation, manufacture and sale of nuclear, bacteriological and chemical weapons.
Similarly, the fund should also consider with whom the portfolio companies may do business. Accordingly, a restriction may be considered ensuring that portfolio companies do not derive any income from trade and/or distribution to specific countries, e.g. Russia, North Korea, Iran, etc.
Accordingly, private equity funds must in particular consider the investment strategy and restrictions to which the fund is subject. Even if these are in place, the heavy and complex regulation applicable to companies working within the defence and security industry and applicable to investments in such companies as well as the prospects for return on investment within a typical time horizon of 3-8 years may impact investment opportunities as well as exit opportunities. It will be interesting to see, whether and how the private equity sector may overcome these challenges.
M&A considerations
Also in relation to M&A transactions, the nature of the defence and security industry calls for specific considerations, which may impact the transaction process, including the due diligence process and the terms and conditions of the transaction:
Due diligence considerations
Classified information
The due diligence process is key in any M&A
transaction, as it allows the buyer to obtain various information
about the target company, thereby observing the buyer's duty to
examine the target (caveat emptor), and the seller to
provide disclosures, thereby limiting its liability exposure
towards the buyer. However, obtaining (or disclosing, as
applicable) all relevant information of a target operating within
the defence industry may be limited or restricted if the
information is classified.
Different levels of classification
| National level | EU level | NATO level | Applicability |
|---|---|---|---|
| "YDERST HEMMELIGT" | "EU TOP SECRET" | "COSMIC TOP SECRET" | Applied to information where the unauthorized disclosure could cause exceptionally grave prejudice to the essential interests of Denmark, the EU, NATO, or one or more of the member states of EU or NATO. |
| "HEMMELIGT" | "EU SECRET" | "NATO SECRET" | Applied to information where the unauthorized disclosure could seriously harm the essential interests of Denmark, the EU, NATO, or one or more of the member states of EU or NATO. |
| "FORTROLIGT" | "EU CONFIDENTIAL" | "NATO CONFIDENTIAL" | Applied to information where the unauthorized disclosure could harm the essential interests of Denmark, the EU, NATO, or one or more of the member states of EU or NATO. |
| "TIL TJENESTEBRUG" | "EU RESTRICTED" | "NATO RESTRICTED" | Applied to information where the unauthorized disclosure could be disadvantageous to the interests of Denmark, the EU, NATO, or one or more of the member states of EU or NATO. |
Sikkerhedscirkulæret (retsinformation.dk)
Classification may apply to e.g. information on pending military operations, information on sources of confidential information etc. but could also be applied to (parts of) contracts regarding software or equipment developed or purchased for military use or defence purposes as well as technical specifications for such software and/or equipment. Accordingly, a target company's contracts entered into with a governmental entity - e.g. the Danish Ministry of Defence Acquisition and Logistics Organisation (Forsvarsministerets Materiel- og Indkøbsstyrelse) - may be subject to classification.
Access to classified information requires security clearance (sikkerhedsgodkendelse) and, further, classified information may only be shared on a "need to know" basis. Security clearance is granted (or denied) by the Danish Security and Intelligence Service (Politiets Efterretningstjeneste or PET). The process of obtaining a security clearance is lengthy and does not align with the typical M&A process. Accordingly, as the seller may only share classified information with persons who have obtained such security clearance and as the buyer often does not have such clearance - and will not be able to obtain it during the typical due diligence period - the buyer will not be able to review any such information as part of the buyer's due diligence. In addition, if the target company has entered into contracts with governmental entities in various jurisdictions, several security clearances and/or licenses may be needed for a buyer to review the relevant documents as part of the due diligence process.
How do investors and sellers handle this in the context of the M&A transaction?
"Clean team" structures will only be a solution if advisors and/or buyer representatives such as legal advisors have security clearance which will normally not be the case. If this is not the case, the information may not be disclosed as part of the transaction process and a buyer must rely on the representations and warranties provided by the seller while the seller will need to carefully consider the wording of such representations and warranties to avoid a potential liability for breach thereof given the lack of disclosure of the documentation that would otherwise serve as disclosures against such representations and warranties. To the extent that information may be shared on an anonymous basis or in aggregated or similar form, the seller may prepare a vendor due diligence report containing such information that a buyer is entitled to receive.
It may be considered whether such representations and warranties can be covered by a W&I insurance when limited or no due diligence has been made in relation hereto. Typically, a W&I insurer requires that a sufficient level of due diligence is made before confirming its cover position. Although such due diligence may not be possible for classified documents, we would anticipate that many insurers would be willing to cover (customary) representations and warranties on e.g. governmental contracts and compliance with the terms thereof without disclosures being made, inter alia, considering that a seller may be liable for fraud or the like, if such representations and warranties are untrue or false.
In relation to classified information, a buyer should also consider and ensure that relevant persons of the buyer and the target company obtain or maintain security clearance post-Closing, including to ensure that the target company post-Closing can continue to perform its obligations under any classified contracts with governmental entities.
Governmental contracts
Many companies within the defence and security industry have or will enter into contracts with governmental entities. When considering acquiring a target company that has been awarded contracts with governmental entities attention should be given to whether the change of control of the target company will have an impact on such contract, as the contract will often include a change of control clause with certain triggers. Accordingly, as part of the legal due diligence it should be examined whether there is a risk that any of the triggers will apply in the event of the change of control. To the extent that this risk is present, a process should be agreed for obtaining any consents from the relevant governmental entities or informing the relevant governmental entities of the change of control.
Further, if the contract has been awarded based on a tender process it should be considered that the procurement law restrictions on changes of contracts apply, meaning that material changes to the contract will require a new tender procedure. This - generally - means that the contract may not be extended beyond the term of the contract and that the services and/or deliverables can only include those described in the contract. Therefore, normal considerations of upselling may not apply. A good business relationship with the government entity is obviously a plus, but if the upselling is such that it entails a material change of the contract, this will require a new tender process. In a tender process the government entity will award the contract based on award objective criteria and respecting the general principles of equal treatment and transparency.
Supply chain and offset requirements
In order to develop and maintain national defence industrial capabilities, most governments will have a form of local content / offset / industrial cooperation regime, which requires foreign suppliers of military equipment to use local sub-suppliers. Rules vary across countries, but will limit - and potentially - challenge the supply chain of the target company. In addition, as the production is expected to increase globally across manufacturers in the industry, supply chains will be strained. Accordingly, as part of the legal due diligence special attention should be given to whether contracts include requirements for use of local sub-suppliers. More generally, the due diligence should investigate the supply chain of the target company, including its delivery set-up across jurisdictions and ability to accommodate local content requirements.
Export control restrictions and compliance set-up
When investing in a target company within the defence and security industry, an increased focus should be given to the target company's compliance with sanctions and export control regulations. Export control regulations in Denmark inter alia require Danish companies to apply for an export license from the Danish Business Authority (Erhvervsstyrelsen) to export certain products, technologies and services such as e.g. weapons, military equipment, dual-use items and technical assistance outside of Denmark.
A national controls list is introduced into Danish law with effect as of 1 July 2024, resulting in an additional need for Danish exporters to assess the potential applicability of needing to obtain regulatory permits from the Danish Business Authority for exports, i.e. even outside of the more typical dual-use scenarios under the Dual-Use Regulation (Regulation (EU) 2021/821 of the European Parliament and of the Council of 20 May 2021 setting up a Union regime for the control of exports, brokering, technical assistance, transit and transfer of dual-use items (recast)).
Accordingly, as part of the due diligence process it should be assessed whether any non-compliance with such regulation can be identified and whether the target company conducts its exports in alignment with the risk-based approach under the applicable regulations. This could include, inter alia, having relevant, sound and robust screening procedures and compliance programmes in place supplemented by strong recordkeeping practices. If the target company has contracts with governmental entities, also it should be assessed whether any non-compliance may constitute a default with potential significant consequences for the business of the target company. For target companies that produce components to weapons it should also be ensured that the components are not used in weapons of war that are made illegal under international treaties such as anti-personnel mines and cluster munitions.
Foreign direct investment (FDI) approval and other regulatory approvals
Investments by foreign investors in the Danish defence and security industry require FDI approval when the foreign investor directly or indirectly obtains possession or control of no less than 10% of the shares or voting rights (or similar control by other means) of a target within this industry with domicile in Denmark. Approval is also required for investments in certain other sectors such as targets active within critical infrastructure or in critical technologies or dual-use items.
To obtain an FDI approval, the foreign investor must file an application with the Danish Business Authority (Erhvervsstyrelsen) accompanied by various documentation and information. Approval will typically be announced to the foreign investor within 45 calendar days upon filing of the application along with all required documentation (phase 1 screening) but an additional 125 calendar days (phase 2 screening) may be commenced in certain complex cases where an approval cannot immediately be granted. In rare cases, the application may further be submitted to the Danish Minister of Trade and Industry (Erhvervsministeren). The decisions by the Danish Business Authority are not made public but are kept confidential - including the grounds for granting approval or denying approval. Applications can also be approved under either agreed or mandatory terms.
In addition to the mandatory FDI approval, a foreign non-EU/EFTA investor who directly or indirectly has obtained - or is considering obtaining - possession or control of no less than 25% of the shares or voting rights (or similar control by other means) of a target with domicile in Denmark may also file a voluntary notification with the Danish Business Authority to obtain approval of a foreign direct investment if the investment may pose a threat to national security or law and order. The voluntary notification ensures that the Danish Business Authority will not afterwards ex officio be able to take measures against the investment. The voluntary notification regime is relevant in relation to targets not active within certain sectors subject to the mandatory application regime, as a mandatory application will otherwise have to be filed. Voluntary notifications can also be approved under either agreed or mandatory terms.
Approval by the Danish Minister of Justice (Justitsministeren) must be obtained in relation to investments in a target company that is privately owned and engaged in production or assembly of military equipment (e.g. weapons other than merely for sport or hunting activities) or parts hereof, ammunition, or similar, if:
- the shares owned by Danish persons or companies becomes less than 60% of such target company,
- the foreign investor directly or indirectly through ownership of shares or otherwise will control more than 20% of the shares or voting rights of such target company,
- the foreign investor by other means will obtain a controlling interest in such target company,
- the target company has executive managers (or other persons authorised to sign on behalf of the target company) that are non-Danish nationals, and/or
- the portion of the company's members of the board of directors who are Danish nationals is or becomes less than 80%.
The transaction documents should regulate the filing of any such required approvals - e.g. FDI approval, approval by the Danish Minister of Justice or other. Generally, any such mandatory approvals are included in the transaction agreement as a condition precedent with the seller and the buyer negotiating relevant obligations in relation to the filing process as well as hell or high water provisions.
Other regulatory approvals may also be required depending on the target company and the jurisdictions in which it operates.
Other legal considerations
In addition to the considerations above, various other considerations (legal, commercial and other) should be made by an investor. Investors who will need debt financing or use leveraged financing as part of the acquisition should ensure that lenders are willing to provide financing and that they understand and are able to satisfy the terms hereof.
Further, particular attention may need to be given to certain aspects of a target company's business such as e.g. its cybersecurity robustness if the target company produces complex technology or equipment for the defence industry and have confidential - and classified - contracts with governmental entities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.