European defence SMEs must ramp up but the struggle to access money is real. Here’s why

When an energy firm declined to renegotiate contracts with one of its high-energy-consuming divisions due to its defense-related operations, the major Western European defense corporation involved contacted the national government—one of its key customers for military equipment—and had the issue resolved swiftly.

However, some of their smaller suppliers do not fare as well.

"Their local banks often refuse giving them bank accounts or loans if they supply us,” a representative for the manufacturer, who spoke on condition of anonymity, told UbiNews.

The root cause stems from Environmental, Social, and Governance (ESG) criteria, which assess how well businesses perform in terms of sustainability. These metrics are closely monitored by both investors and corporations alike. According to the European Union's taxonomy—a comprehensive framework designed to classify environmentally friendly economic activities—defense-related sectors are considered "unsustainable" due to their perceived negative impact on achieving greener objectives.

That means that securing a loan, or services including energy provision or even transport, can become difficult for any company that works in defence or supplies companies in the sector and can result in small and medium-sized enterprises (SMEs), which have no direct line to the highest office in their country, being penalised.

“That's an issue because we might not get any notice about why a certain supplier stops supplying us with screws, for example,” the representative added.

Risk and opportunity slowly shifting

With a war on its doorstep, a main ally seemingly in two minds about continuing to provide military support going forward, and alarming reports that Russia could have the means to attack another European country prior to the conclusion of the decade The EU is hurriedly working to strengthen its military capabilities.

The plan is for member states to pour hundreds of billions of euros into defence over the coming four years to buy the weapons systems they need to protect themselves, preferably from domestic companies.

The EU, whose taxonomy initially came into force in summer 2020, less than two years before Russia rolled its tanks into Ukraine, is now trying to quickly change some of those standards so that European SMEs get the money they need to meet expectations.

The good news is that “over the past, I would say 12 to 24 months, a lot of ecosystem partners proactively start to re-enter and work with defence players,” Andre Keller, a partner at Strategy& Germany, who advises space and defence organisations in Europe and the Middle East, told UbiNews.

That’s largely down to Russia’s belligerence, the subsequent boost in European governments’ defence spending, and talks at EU level to further turbocharge this, which have led many companies and financial institutions to adjust the way they calculate risk vs reward.

From 2021 to 2024, defense expenditures among EU countries surged by 30%, totaling approximately €326 billion. The turnover within the European defense industry amounted to €158.8 billion in 2023, marking a significant increase of 16.9% compared to the prior year, as reported by the Aerospace, Security and Defence Industries Association of Europe (ASD). Additionally, exports saw an uptick of more than 12% year-over-year, reaching €57.4 billion.

"Currently, they have also identified significant market opportunities within the defense industry. This has led us to believe that this could be another reason for businesses to reconsider their tolerance for risk and assess whether they should engage or invest in this particular field," Keller explained.

A ' heightened risk' for investors

The European Commission, which presented a White Paper on the future of European defence Earlier this month, there was optimism that additional private funds could be directed towards the sector once member states finalize the proposed Savings and Investment Union. This would also include clarifying aspects of the Sustainable Finance Disclosures Regulation (SFDR).

It will also launch a so-called Strategic Dialogue with the sector, put forward a Simplication Omnibus package to cut red tape, and present a European Armament Technological Roadmap to boost research and innovation in disruptive technologies including AI and Quantum, for which SMEs and startups are crucial.

For defence startups, “the difficulties are more complicated, more integrated”, than for other startups, Xavier Pinchart, the founder and CEO of Hiraiwa, a Belgium-based start-up, told UbiNews.

“The main complexity is to find investors who can understand this sector,” he added, “because basically you need to raise more capital than another project for a single potential client in the longer term and that potential client is limited to maybe one, the state.”

“So it's like you are accumulating all the worst-case scenarios for a typical investor,” said Pinchart, whose company is finalising the prototype of a small grenade-size system that can detect, track and identify drones on the battlefield.

The European Defence Fund (EDF) is providing grants for such startups, but Pinchart said these handouts “are not good at all” because they come with a lot of reporting requirements that demand a lot of time and resources that most startups may not have or would rather invest elsewhere, including in drumming up business.

One idea he backs is that of the Lithuanian government which is providing guarantees for loans or non-equity securities into the defence and security industry. For Pinchart, this mitigates the “extra risk a private investor takes to invest in defence” and leaves the start-up more room to manoeuvre and grow.

$2.2 billion compared to $32.7 million

European defence companies say They urgently require orders as well. And ideally with advanced payments "to pass them along through the supply chain so that small and medium-sized enterprises (SMEs) or other suppliers can also expand," stated the representative from the major Western European arms company.

"What the European Union can accomplish is establishing a framework for European businesses so they can effectively perform their duties. Perhaps building up reserves of essential materials could be beneficial as well (...). Additionally, the current omnibus procedure holds significant importance," they noted, since the reporting obligations tied to ESG criteria are quite demanding.

We have the capability to handle this at our scale as a large corporation, but the smaller companies are truly frustrated; they feel drained.

In the US, where the sector is seen as a lot more prestigious and where reporting requirements are less stringent, financing is more plentiful. According to a late 2023 paper from the Publications Office of the European Union, between January 2022 and July 2023, US venture capital and private equity firms struck 80 deals in the aerospace, defence and security sector worth over €2.2 billion when only nine such deals were struck in the EU for a total worth of €32.7 million.

Providing clarification on ESG rules would therefore be a “step forward”, Keller said, “but it’s not helping overall”.

Perhaps we should hasten the integration of ESG by adding another 'S' at the start to represent 'Security,' making it Security, Environmental, Social, and Governance.

“What we hear very often right now from all ends - financial institutions, industry, armed forces and the like - is if you don't have security as well, all the sustainability aspects are not there to be maintained,” he added.