On the defensive: considerations for an Australian aerospace and defence fund

In early 2024, the Australian government projected a dramatic increase in the annual defence budget, expecting it to reach an estimated A$100 billion in the next decade, compared to the current budget of A$55 billion. At the time, this represented a significant commitment by the public sector to defence-related spending and strengthening the domestic aerospace and defence industry.

More recently, there has been renewed discussion and debate as to whether an even greater increase in the Australian defence budget is required. While there is yet to be a clear statement from the Australian government, it would not be surprising if the current or future government follow the lead of European leaders who have begun significant increases in military spending. For investors and fund managers, we think this signals an opportunity to invest in the businesses poised to benefit from a global surge in defence spending.

While private funds with a defence-focused investment strategy remain, at least for now, a relatively novel concept in the Australian market, the aerospace and defence (A&D) industry is a well-established asset class in the United States. Venture capital (VC) and private equity (PE) firms in the U.S. have long-recognised the sector’s potential for high growth and returns. As such, we could envisage Australian fund managers following the lead of their American counterparts and adopting similar A&D strategies given the recent spotlight on the sector.

It is possible that an Australian A&D fund could be spurred by Australian Government programs that incentivise the flow of private capital into the A&D industry. There is a model for such an approach in the A&D industry, and Australia is not unfamiliar with government-backed programs designed to attract private investment. For instance, the Commonwealth Government’s Biomedical Translation Fund leverages both Commonwealth capital and private sector capital to invest in early-stage biomedical companies to assist in the commercialisation of biomedical discoveries. A similar, nation-wide program focused on the A&D space could have a transformative impact on the sector in Australia, fostering innovation and driving private investment into A&D businesses.

Given the significant growth potential in the A&D sector, this is an area Australian fund managers may soon target. Establishing a defence-focused private fund raises several important considerations that will shape its viability and attractiveness to investors.

1. Fund structures

In Australia, private funds are commonly established as trusts as they provide limited liability for investors and potential tax flow-through treatment. However, other structures are available that offer similar benefits and may be more familiar or advantageous to certain investors. For instance, many Australian PE and VC managers choose to set up their funds as venture capital limited partnerships or early stage venture capital limited partnerships for the tax characteristics and benefits of those structures.

A further alternative is the corporate collective investment vehicle (CCIV), a relatively new vehicle type in Australia. Although adoption has been limited – perhaps due to the additional regulatory requirements that apply to them – a unique feature of the CCIV may make it an attractive vehicle for funds targeting the A&D sector: the assets and liabilities of a sub-fund established under a CCIV are transparently and statutorily segregated from other sub-funds established under the same CCIV. This feature may be particularly advantageous for a defence fund, where investors may have diverse ESG or other investment restrictions and cannot or do not wish to have any exposure to certain types of weapons and other A&D activities. With a CCIV, managers can offer tailored A&D exposure that aligns with individual investor mandates within the one fund vehicle.

2. Investment strategy and restrictions

Traditional A&D assets such as weaponry and munitions — whether offensive or defensive — are excluded from many institutional investor ESG and investment policies. As such, a well-considered approach to investment restrictions may be required to balance a fund strategy that can allow an A&D fund to invest across the maximum intended investment universe while accommodating the requirements of investors. In looking to strike that balance, managers may wish to consider the following:

• a targeted investment strategy: Limit the investment strategy to investing in certain categories or stages of A&D businesses. For example, invest in start-ups engaged in the research and development of non-military assets with potential A&D uses – cybersecurity, space exploration and surveillance.
  
  
• specific exclusions: Expressly restrict investment in A&D assets commonly restricted by investor ESG policies, such as cluster munitions, drones or other controversial weapons technologies.
  
  
• geographic and geopolitical restrictions: Restrict investing in companies that operate in, sell to, or have significant business in certain countries, particularly those outside trusted alliances or geopolitical groupings.
  
  
• allow for exposure to different investment strategies: Implement structures or mechanics in fund documents to segregate investors so that a single fund can accommodate investors with varying appetites of exposure to A&D assets. For example, different classes of interests in the fund could correspond to different levels of exposure to different types of A&D assets (eg some classes could include exposure to controversial weapons and technology and other classes could exclude them).

3. Excuse, exclusion and withdrawal

Given the greater likelihood of certain investments in the A&D sector being problematic for one or more investors, it would be sensible for managers to consider including in their A&D fund documents provisions that allow for investors to be excused or excluded from participating in particular investments or be withdrawn from the fund where it is necessary to comply with law or to avoid materially adverse effects. While such provisions are customary for international fund documents, they are less common in their Australia equivalents.

An excuse provision typically allows for an investor to be excused from participating in and having economic exposure to an investment of the fund that would cause the investor to contravene a law or a policy applicable to the investor. Exclusion provisions are similar except that they give the right to the manager to exclude an investor where their participation in the investment could have a materially adverse effect on the fund, the manager or the investors (eg by causing them to contravene a law). A withdrawal provision allows an investor or the manager to cause the investor to withdraw from the fund entirely such that they are no longer an investor in the fund. These provisions could be necessary to allow for investors that cannot invest in all categories of A&D assets or where the continued participation of an investor could become problematic for the fund or the manager.

While excuse and exclusion provisions might shield investors from economic exposure to prohibited investments, they remain investors in a vehicle that holds those investments which may not adequately address relevant prohibitions or reputational concerns. If the excuse and exclusion provisions are insufficient in the circumstances, there are a range of other potential solutions.

The manager could, if their fund documents allow it, have those prohibited investments made through alternative investment vehicles established for that purpose in which those investors do not hold interests. Alternatively, investors with specific restrictions could be funnelled at the outset through their own fund entity that invests (other than in those investments) alongside the main fund entity. As discussed above, the manager could also consider establishing the fund as a CCIV and making prohibited investments through separate sub funds.

In addition to structural solutions, the manager could agree to assist the affected investors in selling their interests if their continued participation becomes problematic.

4. Restrictions on investors

Beyond the fund structure and its investment restrictions, given the sensitive nature of the A&D sector, managers of A&D funds should carefully consider the identity of their investors.

While FIRB is a relevant consideration whenever a manager is seeking or has raised capital from foreign investors, potential A&D investments may qualify as ‘national security businesses’ requiring FIRB approval. More generally, A&D investments are likely to draw closer scrutiny from the Treasurer in connection with any FIRB application to be made by a fund or its prospective investors.

Additional challenges may arise with foreign government investors, particularly those from countries without strategic or military alliances with Australia. Those investors may face significant hurdles in obtaining FIRB approval to participate in Australian A&D funds. A&D funds that have foreign government investors may face similar hurdles in obtaining any necessary FIRB approvals in connection with their investments. To mitigate such risks, a manager may choose to limit the capital commitments accepted from certain foreign investors or foreign investors from certain countries and pre-screen foreign government investors for their likelihood of obtaining FIRB approval.

Investors (particularly any government investor) themselves may wish to know the identity of the other investors in the fund, including their upstream ownership arrangements. Investors may be conscious of the reputational risks that may arise from the composition of the fund’s investor base and the perception of investing in the A&D sector alongside certain entities or types of entities – eg, foreign governments or controversial A&D businesses. As part of the fundraising process for an A&D fund, managers should consider whether to limit their potential investor base to certain jurisdictions or types of investors or adopt a more rigorous approach to assessing prospective investors and the impact they may have on other investors.

Foreign investors should also be aware that there may be additional considerations for A&D investments in Australian entities that are a member of the Defence Industry Security Program (DISP). Any foreign ownership, control or influence could trigger reporting obligations under the Defence Security Principles Framework. This process is separate to a FIRB application, and it is assessed independently. Depending on the outcome of the assessment, foreign ownership, control or influence could have an impact on the entity’s ongoing suitability to maintain its DISP membership.

5. Regulatory considerations

In establishing an A&D fund, managers should also have regard to industry specific laws and regulations. For example, A&D funds may be subject to the Defence Trade Controls Act 2012 (Cth), which regulates the supply, publication and brokering of munitions and military related goods and technology, and the Security of Critical Infrastructure Act 2018 (Cth), which may impose obligations (if enlivened) on ‘responsible entities’ for a ‘system of national significance’ or ‘critical defence industry asset’.

As mentioned above, where foreign investors are investing in an Australian entity that is a DISP member, it is important to consider the implications of such foreign ownership, control or influence. DISP membership is not usually mandatory to participate in the A&D industry, except in some circumstances, for example, if it is prescribed as a contractual requirement for a Defence contract, or where the entity is required to access certain classified information or assets, deal with weapons or explosive ordnance, or provide security services to Defence bases and facilities, among others.

Conclusion

The A&D sector in Australia presents compelling opportunities for fund managers and investors. Historically underutilized outside the U.S., this sector is now poised for growth, with strong support from the Federal Government and rapid technological innovation meaning there are real incentives for A&D funds to take off in Australia. However, capitalising on this opportunity will require navigating a range of nuanced investor sensitivities and regulatory frameworks. Fund managers that approach the sector with a thoughtful fund structure, appropriate funds terms and a tailored approach to marketing, are well placed to take advantage of these opportunities and unlock a burgeoning market that could offer significant returns for investors.