Sustainability insight | 04 Apr 2025 |

Travers Smith's Sustainability Insights: Investing in Europe's defence

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A regular briefing for the alternative asset management industry.

At the end of last year, Bain & Company argued that private capital "is poised to play a critical role in the modernization of the US defense industry". They pointed to the growing number of private equity and venture capital investments, and they identified a significant funding gap and the need for innovation as the key drivers.

In principle, the same is true in Europe – but investments have so far been fairly sparse. As European countries prepare to significantly increase their own spending on defence, there is now a clear opportunity for private capital firms active in the region – and that goes way beyond the more obviously defence-focused businesses. Many adjacent industries, especially in the technology sector, will be among the beneficiaries.

However, investments in defence are far from straightforward. Some commentators are asking whether decades-long restrictions on certain types of investment will constrain sponsors. That's an important question, but regulatory obstacles in Europe are also likely to be problematic – especially for private fund managers taking control or significant minority stakes.

Some press commentary has highlighted European sustainable finance regulation as a possible barrier, especially given the wave of capital that is now badged as "Article 8" under the EU's Sustainable Finance Disclosure Regulation (SFDR). Regulators, including the UK's FCA, have been quick to point out that their rules do not create a barrier – unless the asset manager has itself chosen to erect one.

It would be tricky to justify the inclusion of many directly defence-related companies in an SFDR "Article 9" fund and the EU's rules for "sustainable" funds do include a prohibition on "companies involved in any activities relating to controversial weapons" – anti-personnel mines, cluster munitions, chemical weapons, and biological weapons. Although that is unlikely to be a huge obstacle – at least for the time being – the European Commission has pledged to clarify "the relationship of defence with the investment goals of the sustainability framework" in the forthcoming SFDR review – and will try to quell any remaining concerns that its rulebook is in opposition to its policy objective.

In fact, the more demanding obstacles lie in other European regulations.

Perhaps most importantly, national security screening regimes are now well established in the UK and almost all EU member states. Although investments made by domestic acquirers in local businesses are unlikely to raise substantive national security concerns (or even, in some cases, trigger the relevant regimes in the first place), the position may well be more complicated for the sponsor of a private fund with international investors – even if the sponsor is domestic. The rules vary from country to country, but an investment fund with international investors will usually need to factor these regimes into its pre-deal planning.

The EU's Foreign Subsidies Regulation (FSR) may present another hurdle for alternative asset managers looking to invest in EU defence businesses. Since the roll-out of the regime in 2023, the expansive definition of "foreign financial contributions" has posed real headaches for asset managers, who are often required to carry out extensive data gathering exercises, spanning multiple funds and portfolio companies. Where the manager's existing portfolio includes defence businesses, this task is likely to be made harder, given the need to disclose details of R&D subsidies and government contracts.

        
"This could be a particular opportunity for the private markets. Investee companies tend to be smaller, and the investor will have significantly more understanding and oversight of the investee's due diligence policies."

Then there is the increasingly complex framework of international sanctions and export controls. The defence industry is used to dealing with such restrictions, but asset managers may find them hard to navigate. The potential for sudden changes in political allegiances, and delays that can result from licensing and other authorisation requirements, add risk and make due diligence more complicated.

Regulations aside, any private capital fund that wants to benefit from these investment opportunities also has to navigate restrictions imposed by their investors.

Public asset managers are already taking advantage of the opportunity, and the Dutch pension funds are among those who have recently highlighted their willingness to invest. But many – including the European Investment Fund itself – have exclusions or limitations on investing in weapons or munitions. These restrictions come in various forms, and are usually reflected in product-specific side letters and investment exclusions agreed by alternative asset managers when they raise a fund.

Many asset owners are reviewing those exclusions, and others – including the huge Norwegian sovereign wealth fund – are under political pressure to relax them. Public sentiment has clearly shifted in Europe, and that will inform those reviews.

It is possible that any resulting policy revisions by "responsible investors" – those whose investment policy is guided by more than risk-adjusted returns – will alight on human rights concerns. In that case, they might look to well-established international standards on human rights due diligence to shape their approach.

The United Nations Guiding Principles on Business and Human Rights (UNGPs) set out the key principles. The relevant UN Working Group has published guidance for companies in the arms sector on how to ensure compliance. That note makes clear that human rights due diligence – specifically in relation to the use of products – is deficient in the weapons sector.

This could be a particular opportunity for the private markets. Investee companies tend to be smaller, and the investor will have significantly more understanding and oversight of the investee's due diligence policies. It should be easier for sponsors to assure their LPs that portfolio companies are compliant with international norms.

Many asset owners are also reluctant to invest in companies with links to nuclear weapons. That can be hard to avoid – many publicly listed defence companies are linked to nuclear in some way. Alternative asset managers investing in tech companies and smaller, more focused businesses, will also find it easier to navigate those restrictions.