1. Do your due diligence. Financial institutions and private capital investors will be no strangers to due diligence processes. However, defence and defence-related sectors have specific characteristics which call for additional due diligence focuses, as well as potentially challenges around accessing classified information or export controlled (e.g. ITAR controlled) necessary to conduct that diligence (e.g. jurisdictions of operation).

As well as knowing the customer and its business well, market participants need to understand the downwards supply chain, including the risk that assets might be diverted for activities which would be unacceptable to the lender and those which might affect insurance availability – this will depend very much on the policies and risk appetite of the lender and/or the investment criteria of the lender’s investors.

Finance needs to be in mind from the very beginning as standard terms of contracts often restrict disclosure of contracts, terms and related documents, hindering normal due diligence processes and information covenants. As a related topic, ESG due diligence will be part of the process and may influence whether an investment can be made if requirements are part of investment criteria exclusion lists, for example.

2. Check the transaction does not fall foul of unforeseen regulations. Defence is one of the most regulated sectors in the world. An array of cross-sector regulations may well apply and trip up the unwary, including those covering sanctions, export control and foreign direct investment. Defence and dual-purpose activities and products may also be subject to national security legislation, such as the UK Export Control Order, and the UK National Security Investment Act. Although layers of regulation can provide comfort (in particular in a due diligence context), compliance failures could lead to civil and criminal sanctions and, in some cases, the risk that security or investment rights become voidable by the relevant government.

3. Don’t assume that your borrower owns its inventory. In the defence market the end government often insists on title to a borrower’s inventory (including raw materials) as soon as it is allocated to the relevant project/contract in question. Supply chains and ownership need to be fully understood, and specific structural features to protect the lender should be considered.

4. Consider implications on enforceability of security. Many defence transactions  have only one possible end customer and, as mentioned above, the title to those assets may sit with them, hence no sale to  a third party is possible following manufacture. This may be because the product is bespoke, or is a part of a larger product, such as a turret for a tank or electronics which are hardened for defence. There may also be legal restrictions on use by other parties which may be set out in regulation (such as export control end user restrictions), and/or contractual restrictions (including in relation to intellectual property). The combination of regulation and contractual restrictions varies from jurisdiction to jurisdiction and from product to product, and in many cases the nature of the product and the customer can give significant comfort. However each deal needs careful consideration and there is no ‘one size fits all’ solution to ensure that lender security is sufficient. 

5. Check termination rights. A feature of defence contracts is often that they are capable of being terminated for convenience at short notice, and often with limited compensation payable. This is particularly important where structuring finance products around a single contract (or even a small number of contracts), and may potentially be mitigated by lending against a diverse portfolio of assets or taking wider security. Contractors that do not rely solely on defence are likely to be more resilient to this. But it is a particular challenge for those borrowers focused wholly or mainly on the defence sector, especially new entrants who have yet to build up a portfolio of products and/or contracts.

A further feature is that there are often broad termination rights for change of control in defence contracts – this will be a key consideration for enforcement analysis, especially in respect of share security.

6. Credit risks specific to defence. As mentioned above, there is a growing defence finance market, supported by clear government priorities to expand defence spending. This has encouraged a large number of new entrants to the market (including from other sectors), but not all defence companies are at the same level of maturity. Considerations around cashflows and liquidity are of course not industry-specific, however the highly concentrated defence customer base (sometimes just one) brings this to the fore, in particular when compounded with lengthy procurement chains and indecisiveness around product requirements (which often lead to purchasing decisions being delayed or even cancelled) as well as ‘on delivery’ payment terms and the termination risk described above.

In addition, although the revenue stream is likely to be ultimately backed by a government, the direct counterparty may not be (particularly further down the supply chain) with credit risk on smaller national subsidiaries and even special purpose vehicles needing careful thought.

The defence and defence-related sector clearly presents a huge opportunity for lenders and investors. There are, however, specific characteristics that need to be taken into account, with deals often requiring specialist input. Hogan Lovells Cadwalader is well placed to guide you through the issues related to defence investing with a cross-sector team of experts focused on managing your risk.

Please contact any of the authors of this article or your usual Hogan Lovells Cadwalader contact if you would like to discuss any of the issues raised in this article. 

This note is intended to be a general guide to the latest developments. It does not constitute legal advice.

Authored by Emily Julier, Malcolm Parry, Samuel Norris, Sinead Meany, Rita Hunter, Aline Doussin, and Sharon Lewis.