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On the Challenges and Opportunities We See in the Defense Industry

By : Ziad K Abdelnour| 29 July 2014
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The Pentagon was declared the big winner of the massive federal budget bill that Congress passed for fiscal year 2014. The spending bill approves $497 billion for the Defense Department, or about the same as in 2013. The Pentagon gets an additional $85.2 billion for war expenses — about $5 billion more than it requested.

Weapons manufacturers are not celebrating, though. Industry sees long-term decline, global trends that could upend the arms business, and a Pentagon customer that is becoming consumed by internal budget battles and is reluctant to commit to big-ticket programs.

The industry is indeed entering a period of change, and defense companies’ fortunes are tied to broader market shifts and government policies that could have lasting impact.

Though the defense industry has to sooner than later develop creative strategies and business models or risk catastrophic failure, we at Blackhawk Partners believe that despite a challenging environment, strong fundamentals in the defense and most importantly cyber security industry and unmanned aviation continue to offer some highly attractive investment opportunities.

We believe the industry’s fate largely depends on Pentagon’s decisions on how it will modernize U.S. forces to confront future threats. In its Cold War heyday, the Pentagon was the leading developer of cutting-edge technology and still commands the world’s most advanced military force. But at the same time, it has created self-defeating mechanisms that quash innovation and fail to capitalize on available opportunities. The United States is still way ahead of competitors in areas such as fighter aircraft and submarines. But there are segments of the weapons market such as ballistic missiles and cruise missiles where other people are doing quite well compared to us.

How companies might regain the innovation edge and whether they should become less dependent on the Pentagon are top issues of concern to industry today. Many consequential technologies still exist outside the defense industrial base. The defense sector has not come to grips with the outsize importance of non-defense technology, nor has it figured out how to diversify successfully into commercial business. The challenge is to understand how to piece together markets. U.S. companies have to prepare for a much more globalized defense business and we at Blackhawk Partners are ready to help them doing that.

Hence, we believe the ticket to growth is to back commercial technology to build modern weapons systems that do not take decades to develop. We identified gaps in the future and are making a bet on what is needed. We think this is where the customers will follow.

In fact, we believe the industry to brace for several years of fiscal pain which creates a great opportunity for us to acquire a number of critical assets at significantly distressed prices and create real value added in the process through roll-ups and further asset acquisitions. This is and will be one of the cornerstones of Blackhawk’s investment strategy for years to come. I hope that other investment groups will be following our lead too.

On the downside it is clear that consolidation usually brings enormous integration difficulties, clashes of culture/ego, and other risks such as:

Integration risk: It will be difficult to integrate the different businesses acquired as they will all have different systems (including IT, accounting and business systems), management styles and cultures. The more companies acquired the greater the integration risk;

Increased costs: sometimes the cost synergies don’t outweigh the additional costs of a head office (salaries and lease expenses);

Non-alignment of incentives: once the founders have received a large cash payout as part of the rollup they lose focus and become distracted by their new found wealth (decisions about which super fund to invest in and what holiday house to buy) rather than driving their business forward. In some recent deals, there are numerous cases where the founder actually leaves the group to start a new competing business;

Cultural issues: often the bolt-ons are run very informally with little or no corporate governance mechanisms in place and with limited finance/reporting systems. Under the new regime they will inevitably be forced to deal with a more formalized culture with far stricter reporting requirements and governance;

Execution risk: should not be underestimated and applies at both the acquisition stage and eventual exit stage. The greater the number of counter parties to be negotiated with, means the greater the risk that the deal will not go ahead and also increases the risk of “green mailing” where one stakeholder seeks to hold up the consolidation or the eventual exit by relying on some technical right (in other words refusing to sign the relevant acquisition or sale documents) to get a special deal.

The risks outlined above can be however mitigated through the careful implementation of the following strategies:

Clash of personalities: Use a governance model that is founder centric (e.g. The founders retain a majority of the equity, the CEO is appointed by the founders and the majority of the board is appointed by the founders).

Clash of culture: Use a “push” rather than “pull” strategy for new policies and procedures. In other words, it is up to each founder whether they accept certain policies rather than it being forced upon them.

Execution risk: To minimize “deal risk”, if possible, use one lawyer for all vendors, use standardized set of legal documents for all vendors, and same acquisition model for all vendors.

Integration risk: Consider whether a decentralized (or federation) model is appropriate rather than a centralized structure. While it makes sense to integrate/centralize certain aspects of the business (such as corporate governance, financial controls/reporting and management of future acquisitions) full integration is not always necessary.

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