In the same week that Afghanistan's capital, Kabul, fell into the hands of Taliban militants, ushering in a new era of regional instability, two major deals in the defense sector also hit the headlines. 

On Monday, Advent International-owned British aerospace company Cobham agreed to buy Ultra Electronics, a major UK supplier of sonar equipment to the Royal Navy, for nearly £2.6 billion (about $3.5 billion). A day later came news that TransDigm—a US-based aerospace company that counts The Vanguard Group among its investors—is seeking to acquire UK aerospace defense specialist Meggitt.

Ultra and Meggit are the latest in a series of British companies that have been targeted by foreign firms rummaging through London's stock exchange for bargains. The deals have caused concern about whether the UK is doing enough to protect its defense sector from outside investors in the interest of national security. Kwasi Kwarteng, the government secretary for business, energy and industrial affairs, has already called on regulators to review the Ultra transaction on security grounds. Whether this will impede a deal remains to be seen, given that Advent's acquisition of Cobham underwent similar scrutiny in 2019, but the deal still went through.

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What's more striking about these pacts is that they underscore a growing, and arguably cynical, appetite for aerospace and defense assets against an increasingly unstable geopolitical backdrop. In an era when many PE firms are seeking to burnish their credentials as socially responsible investors, it seems counterintuitive (at best) to invest in a sector traditionally eschewed by many public market investors concerned about ESG.

In a July report, KPMG detailed the opportunity for private equity in the aerospace and defense sector, citing the "increased geopolitical instability" that is driving increased government defense spending. Not unlike the kind of increased instability that is unfolding in Afghanistan as I type.

PitchBook data shows that investors have been jumping on that opportunity. Last year saw a record $9.9 billion worth of PE investment funneled into 140 deals in the global aerospace and defense sector. This year, meanwhile, has so far brought in $5.5 billion across 116 deals.

Companies that sell so-called dual-use civilian and military products related to aerospace, radar equipment, or even software, offer an acceptable proxy for private equity to invest in conflict. Investments in explicitly offensive-defensive assets—such as missile and gun manufacturers—go beyond what many limited partners would consider to be compliant with their ESG mandates.

However, as the technology deployed in warfare has gotten more sophisticated, the definition of "defense assets" has broadened. Defense now includes a whole range of non-kinetic technologies such as cybersecurity, radar and reconnaissance equipment, which arguably remove what KPMG's report describes as "reputational barriers to investment."

That said, aerospace and defense is still regarded as a high-risk sector from an ESG standpoint. According to a July 2020 report from Morningstar's Sustainalytics unit, the sector ranked 37th out of 42 industries, with 62% of companies classified as high-risk, and 21% considered a severe risk.

Moreover, it's hard to ignore the fact that defense contractors still stand to gain from conflict and instability. So while these companies may not make weapons, they still reside in a gray area in ESG risk terms.

If the definition of defense investing has evolved with new technology and new methods of waging war, it's probably also time to revise our definition of socially responsible investing.

Featured image by Drew Sanders/PitchBook News

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