Decoding the UK’s Defence Dilemma
Guest article by Ian P. Wilson, Grant Thornton UK LLP
Given unprecedented fiscal pressures inherited by the new UK Government, there is an increasing recognition that the UK will have to reassess how it seeks to assert itself militarily. Given the poor condition of the country’s public finances, it is a widely-held view that the UK simply cannot afford to buy and support military assets to simultaneously project air, sea and land force capabilities on a global scale; nor can it expect to address several major conflicts while maintaining effective security at home.
As it proceeds with its promised 2010 Strategic Defence and Security Review (SDSR), the new UK Government faces the dilemma of having to fund a fundamental realignment and upgrade of the country’s defence and security infrastructure, whilst seeking to reduce a record fiscal deficit. Inevitably, priorities will have to be determined and certain programmes will face cancellation or curtailment…
1. A Changing World
Governments and their suppliers are only beginning to adjust to the defence and security implications of the fundamental changes in the geopolitical landscape which have been taking place over the past decade. Recent events in Iraq and Afghanistan have highlighted the fundamental changes that are required to update legacy equipment and force structures which were designed for projecting massive amounts of kinetic energy against a uniformed national army on a defined battlefield.
Until the early 1990s, the world’s military powers were prepared for a large scale encounter involving thousands of tanks and fighter aircraft opposing each other across the plains of Germany. This clear focus, backed up by massive nuclear arsenals, created an elegant stand-off between the superpowers of the east and the west.
Whilst it is quite possible that such ‘conventional’ large scale conflicts may still arise, increasingly, the battles of the 21st century are being fought against an invisible enemy employing asymmetric tactics.
The number of smaller conflicts has increased in recent years as populations seek to redefine borders and assert identities whilst ethnic tensions boil over into armed conflict and extremist organisations attract the disaffected. Often today’s enemy is an amorphous association of ideologically-aligned individuals living in locations dispersed around the globe. Increasingly, however, ‘wars’ will be waged on home soil, where the enemy lives among those they seek to attack. The potential tactics of the ‘new enemy’ seeking to disrupt society from within, include:
- Creating fear among the population through isolated incidents (i.e. bombs)
- Attempting to cause chaos by disabling critical communications, energy or transportation infrastructure
- Carrying out coordinated catastrophic attacks such as the 9/11 attacks or a nuclear, biological or chemical incident with large scale casualties.
Such ‘asymmetric’ tactics are already being deployed in Iraq and Afghanistan by insurgents against coalition forces. Although not a new concept (consider the inventiveness and resourcefulness of the Viet Cong fighters during the Vietnam war), asymmetric warfare, characterised most vividly by the use of ‘home made’ improvised explosive devices (IEDs), has become an increasingly significant threat to sophisticated armed forces.
In order to respond to these new threats, Governments, security experts and military planners must align resources and tactics accordingly. It is imperative that the decisions made in the UK’s ongoing ‘Strategic Defence and Security Review’ (SDSR) create a defence and security force that both meets current needs and can also evolve as the geopolitical landscape continues to redefine the nature of conflict.
2. The Big Questions
Current UK procurement plans – key programmes
- CVF aircraft carriers (£3.9bn)
- Type 45 destroyers (£6.5bn)
- FRES armoured vehicles (£4bn)
- Eurofighter Typhoon (>£20bn)
- F-35 JSF (£10bn)
- A400M (£2.5bn)
- Trident replacement (£20bn)
The UK’s commitment to each of the major procurement programmes has recently been the subject of vigorous debate. Against the backdrop of severe financial constraints, determining which to pursue, curtail or drop altogether involves many considerations. Undoubtedly, the greatest strategic question facing the new Government is ‘what are Britain’s foreign policy ambitions for the foreseeable future’? Answering this question will determine the Government’s overall attitude to defence spending for the foreseeable future.
The next question is ‘how should the money be spent?’ This is where detailed assessments of what we have versus what we need based on predicted geopolitical scenarios are made. However, a new culture of fiscal austerity is likely to substitute established procurement concepts such as ‘best in class’ with ‘fit for purpose’.
Many factors will be brought to bear during the Strategic Defence Review. These include the potential for collaboration, financial consequences of cancellation and the need for a nuclear capability.
Increasingly, threats faced by the UK are the same threats faced by its neighbours and allies. The US is arguably the world’s only ‘superpower’. No other nation has the economic means to maintain a broad state-of-the-art war fighting capability to handle several concurrent major conflicts. However, recent events have emphasised the importance to world public opinion of the US going to war as a coalition, even if it remains the driving force behind such activity. Accordingly, in defining its own procurement priorities, the UK needs to consider interoperability with the world’s only superpower and hitherto it strongest ally.
Most of the UK’s European partners and other smaller allies face the same budgetary constraints as the UK and need to make similar decisions about how best to configure their armed forces to work effectively with likely coalition partners. In an ideal world, each country would focus on a specific capabilities which, when meshed with those of its allies, results in a large scale, integrated, effective fighting force.
However, uncertainty about future defence policies of individual nations and the desire to retain a degree of autonomy, make this scenario an unlikely outcome. The last UK government frequently referred to potential defence partnerships with its European allies. In reality, France is the only European nation with military assets and a force capability comparable with that of the UK. Even prior to the recent UK elections, members of the shadow cabinet had engaged in preliminary discussions with the French government about potential military cooperation.
UK cooperation with the rest of Europe is most likely to be focused on the acquisition of common platforms, particularly in the areas of fast jets (e.g. F-35, Typhoon) and transport aircraft (A-400M) where the sharing of development costs enables smaller nations to acquire state-of-the-art equipment. In addition to common platforms, enhanced interoperability will be facilitated by information sharing, joint training exercises and simulation.
Cancellation too costly?
The UK has managed to negotiate a reduced commitment to ‘Tranche 3′ of the Eurofighter Typhoon programme and further reduced its obligation by selling part of its allocation to Saudi Arabia.
Given the substantial delays to the Airbus A400M programme, the MoD considered alternative solutions for its troop and equipment transportation requirement, including leasing or acquiring Boeing C-17s. The problem is that even if such alternatives were justified on logistical grounds, the penalties for withdrawal (insisted upon by the UK at start of the programme) would be crippling.
Similarly, pulling out of the F-35/Joint Strike Fighter programme would have a severe economic impact, estimated at the loss of tens of thousands of jobs. In the current environment, the prospect of further job losses (as well as substantial cancellation penalties) is likely to keep the aircraft carrier programme on track. Some commentators believe that the UK will retain one of the new carriers whilst the second may be sold to India.
Need for nuclear?
Also looming on the horizon is a decision about a successor to Britain’s independent Trident nuclear deterrent. Whilst several prominent politicians recently described the UK’s nuclear-armed submarine fleet as “expensive and irrelevant”, most share the view that Trident secures Britain’s place in the world. Accordingly, it is unlikely that the UK is prepared to relinquish its seat at the ‘top table’ of global diplomacy. With the cost of a full replacement estimated at up to GBP 20 billion, the real questions are:
- How many submarines are required?’
- Can the service life of the existing fleet be extended?
- Are there any realistic alternatives to proposed replacements?
While these and other factors will be brought to bear in determining the outcomes of some of the largest platform procurement programmes, much of the current debate has focused on the immediate needs of the UK forces fighting insurgents in Afghanistan (most notably the need for additional helicopters and MRAP vehicles). Recent criticism of the adequacy of equipment available to British military personnel in Afghanistan has created substantial pressure on the government to continue to provide Treasury funding at or above the current level for the foreseeable future. Consequently, companies delivering products and services into the UOR (‘urgent operational requirement’) supply chain can expect to see continued robust order books for the short to medium-term.
Procurement requests will include everything from helicopters and tactical support vehicles to body armour and personal communications systems to support increased troop numbers. However, because of the lead times involved in deploying additional helicopters and vehicles, at the top of commanders’ shopping lists are IED counter-measure devices, surveillance and other counter-insurgency technologies designed to protect them. This immediate need for in-theatre equipment was a key driver behind Esterline’s acquisition of battlefield communications equipment supplier Racal Acoustics from ECI in 2008.
Besides the platform procurement programmes and the short term operational needs, substantial investment will be required in myriad other aspects of national security and homeland defence. These include increasingly sophisticated detection and surveillance technologies, cyberwarfare capabilities, enhanced integrated emergency response communications and control systems. Increasingly, both war zone operations and homeland security are drawing upon the same technologies and services, encompassed by the term C4ISTAR (Command, Control, Communications, Computing, Intelligence, Surveillance, Target Acquisition, Reconnaissance).
As threats migrate from the battlefields to towns and cities, military technologies are being adapted to meet the needs of homeland security. Variants of battlefield drones, infrared cameras, night vision goggles, secure communications systems and signal jamming devices are being developed for deployment by the UK’s police and intelligence services. Companies such as BAe Systems, through its Detica unit, are constantly exploring new ways to detect potential threats to national security.
3. Defence procurement priorities – our view
These tables present our view of the key medium-term priorities for effectiveness in both the homeland security environment and the battlefield.
Table 1: Homeland Defence priorities
Table 2: Force projection and war fighting priorities
Based on these priorities, certain segments of the defence sector, and by inference some of the category leaders, are expected to see steady growth over the next decade, while others will face revenue pressures.
Unlike the massive procurement projections for the large platform acquisitions which can run into the billions of pounds, (the through life cost of the F-35 programme for all participants is estimated at more than $500 billion) many of these discreet spending areas typically involve relatively modest outlays. The growth opportunity presented by the broadly-defined ‘C4ISTAR’ (identified as a priority in the recent US Quadrennial Defence Review) sector is already a focus of the large integrators and Tier 1 players such as BAe Systems, Finmeccanica (Selex), Lockheed Martin, Qinetiq, General Dynamics, Raytheon and Thales.
In addition, each sub-category is being targeted by a number of smaller, innovative companies, many of which will ultimately be acquired by larger players. In conclusion, we foresee a challenging medium-term outlook for defence suppliers, but significant growth potential for those targeting priority spending categories.
M&A Reshaping the competitive landscape
by Ian Cookson, Director, Investment Banking, Grant Thornton Corporate Finance LLC (US); and Ian P. Wilson, Aerospace and Defence Sector Leader, Grant Thornton UK LLP
Notwithstanding recently depressed levels of overall M&A activity, competition for strategic acquisitions within the defence technology sector remains robust. Acquirers, including prime defence contractors, government IT providers, and private equity players are building capabilities in market niches including homeland security, cyber-security, logistics support, navigation & guidance, and interactive training & simulation.
The major primes (eg Raytheon, Lockheed Martin, Northrop, Boeing, BAe Systems) are especially interested in acquisitions that can be incorporated into current offerings to create fully-integrated intelligent platforms. Meanwhile, government IT providers (e.g. SAIC, ManTech, Kratos) are pursuing acquisitions that secure valuable relationships with the defence establishment, in particular, the US Department of Defence and the UK Ministry of Defence International players, including QinetiQ, Ultra Electronics, Cobham, Finmeccanica and Safran are pursuing acquisitions of US defence technology companies in order to strengthen their position in the world’s largest defence market.
This trend has accelerated as the United States Government, through CFIUS (Committee on Foreign Investment in the US), has become more comfortable permitting sales to non-US entities, with information classified as “top secret” or above being controlled through proxy agreements/voting trusts. Private equity has also been active within the sector with buyers coming from 2 camps: those traditionally focused on technology and those with a defence specialty. Over the last 12 months, half of sponsor-led deals were bolt-on acquisitions that added expertise and capabilities to current portfolio companies, while half were new platform investments.
Recent successful private equity exits such as the sale of BBNT to Raytheon and ECI’s sale of Racal Acoustics to Esterline are likely to attract investment into the defence technology segment. Organizational conflict of interest (OCI) legislation within the US Weapon Systems Acquisition Reform Act of 2009 is also likely to impact transaction activity of prime defence contractors. As a consequence of the OCI legislation, US primes are currently auditing existing systems engineering and technical assistance (SETA) contracts to assess potential conflicts with large acquisition programs. SETA opportunities may therefore shift back to traditional government IT providers, as prime defence contractors withdraw from those areas that pose potential conflicts of interest.
M&A activity within the defence software, service, & technology solutions sectors continues, albeit at a slightly slower pace than in previous years. Despite the economic downturn, defence IT and aerospace/defence electronics deal volume declined by 12% and 31%, respectively from their 2007 peaks, outperforming overall M&A activity which fell roughly 40% over the period. Deal volume has been particularly strong over the past six months, with smaller businesses being the focus of attention, as transactions with values under $100 million accounted for 90% of acquisitions. Cyber and homeland security were segments of particular interest, accounting for 35% of deal volume over the last twelve months, as buyers took advantage of accelerated spending aimed at protecting against cyber and terrorist attacks.
Each of the US primes, including Raytheon, Boeing, Lockheed Martin, and Northrop as well as international competitors, BAe Systems, Smiths Group, Finmeccanica, EADS, Safran and Thales are looking to expand in the sector via acquisition, as they morph their services to mirror shifts in defence spending priorities. The M&A landscape within defence IT has changed significantly over the last decade. In the late 1990s to early 2000s serial roll-ups consolidated the fragmented government IT sector and created businesses of scale. Growth was fuelled by the government’s transition towards outsourcing government jobs combined with the technology bubble, Y2K preparation, and the abundance of IPO capital. Prime defence contractors largely remained on the sidelines and comprised less than 10% of buyers. In recent years, primes have accounted for around a third of transactions, as defence IT has become increasingly central to national security. Defence software, services, & technology solutions businesses are being courted by prime defence, government IT, and private equity buyers, as deals within the sector continue. International players have been active in recent years, as the US Government has become more accepting of internationalization. Prime defence contractors have become especially interested in smaller acquisitions providing access to attractive growth niches.
Read “Sector Outperforms: Grant Thornton Lookback on Defense M&A 2009” for more background.
Ian P. Wilson leads Grant Thornton UK LLP’s Aerospace and Defence Sector practice. To contact Mr. Wilson in the British practice, phone +44 0121 232 5151, or use ian.p.wilson at gtuk dot com.
Ian Cookson leads the Aerospace and Defense Group of Grant Thornton Corporate Finance LLC in the United States, where he advises on M&A transactions for clients ranging from leading multinationals to privately held companies. For further discussions and lists of defense IT and A&D electronics transactions, phone Mr. Cookson at area code six one seven, 848 dash 4982. Or email Ian dot Cookson at gt dot com.
- DID (July 25/10) – Sector Outperforms: Grant Thornton Lookback on Defense M&A 2009. By Ian Cookson.
- DID (July 21/10) – Lessons from the Automotive Supply Chain: Surviving a Downturn. By Vince Pavlak.
- DID (July 11/10) – “Grant Thorton: US Defense Budget Outlook for 2011 and Beyond. By Vice-Adm. Crenshaw (ret.)
- DID (March 15/09) – Grant Thornton on US Aerospace Component M&A, 2008