Private equity has long had an on-again/off-again history of investing into the aerospace and defense sector and recently has been careful about increasing investments in aerospace and defense (A&D); limited partners (LPs) are leery about investing in defense as a profitable exit can be problematic. Since 2021, the number of deals in defense companies worldwide have decreased year over year: from 124 deals in 2021 down to 40 so far in 2024. However, ignoring the A&D segment entirely means that PE misses a number of opportunities for value creation and growth. For example, PE firms and LPs will find untapped value in companies that are:
- Adjacent to defense
- Largely civil/commercial aerospace with a portion of defense
- Rollups of aerospace segments and sub-segments, such as engine parts, composite components, satellite/space components, including EO/IR and optical communications
Because A&D is focused on developing highly-engineered products with innovation and its revenues regularly exceeding the cost of goods sold, the aerospace and defense industry as a whole is considered “high value.”
Once the decision to invest is made, the goal is to exit at a pace that matches the PE firm’s value-creation and monetization point rather than moving the investment to languish in a continuation fund. The Total Value Optimization (TVO)™ approach, which finds and implements value creation initiatives throughout the supply chain, can bring profitable growth in operations, market expansion, and competitive advantage.
Adjacent to Defense
Advanced manufacturing is a perfect example of companies adjacent to defense which have attracted significant venture capital funding, with a success rate predicted to be over 90% in 2024. This sector encompasses robotics, nanomaterials, exoskeletons, and associated software (predictive maintenance, product lifecycle management, operational technology security, and industrial IoT, for example).
Growth in this sector reflects the labor challenges that any manufacturing company faces, including supply and material shortages, volatile supplier lead times, and skills gaps in labor; the overall movement toward in-shoring and near-shoring in the supply chain, which brings advanced manufacturing closer to buyers; and government support, such as the CHIPS and Science Act that promote domestic production. Opportunities abound in aerospace hardware and software.
In one case, an investment management firm wanted to find cost savings and improve the competitive position of a company that develops and manufactures public transportation systems and defense C4ISR and radar technologies . By identifying opportunities in procurement, engineering, vendor, and labor strategies, the company garnered $15.2 million in annualized savings, improved design for manufacturing, improved make-buy processes, reduced engineering change orders, and reduced SKUs 26%. A playbook was developed to allow the company to continue to drive sustainability of the change transformation and achieve further targeted cost opportunities.
Solely Aerospace
“Aerospace” does not always mean “A&D.” However, PE firms and investors may bypass potential opportunities in A&D so as to not take on the risk of having an asset that takes longer to exit. In some A&D companies, investors might choose to build and/or carve out the non-defense portion to increase the likelihood of exit. The bottom line: not all aerospace companies are alike. Electro-optical/Infrared for satellites, and surfacings and coatings for aerospace are two examples. Drone technology and unmanned aerial systems have industrial and commercial applications as well as defense. Although they represent a major opportunity, these markets are currently undercapitalized and represent missed investment opportunities.
Rollups of Aerospace Segments
Many companies are ripe for roll-up, including companies manufacturing products for aircraft that are late in lifecycle and parts that are becoming obsolete. In this case, the strategy is buy-and-build, rather than investing in startups or innovations.
Recently, a PE firm acquired 9 metal machining businesses over a 5-year period that serve the aerospace new and replacement engine markets. Strategic sourcing initiatives allowed this purely aerospace company to achieve economies of scale that resulted in a cost reduction of over 18% ($10.9 million savings) in major spend categories. The client had a significant growth trend in inventory and had a target to reduce the roughly $100M of inventory to release cash for potential acquisitions. Just by rolling up a fragmented industry and finding the growth opportunities, the PE firm is increasing the revenue of their holding to $500 million in less than five years.
Methodology
Favorable economic conditions are propelling an upsurge in PE activity in aerospace and defense, including acquisitions aimed at consolidation and achieving economies of scale. PE firms that decide to take advantage of these conditions will find companies with considerable latent value ripe for EBITDA growth, especially small companies in the manufacturing and emerging technology sectors.
To identify and capture that value, portfolio companies are undertaking initiatives like the following:
- Focus design for excellence (DfX) on design for commonality both to control complexity and drive engineering change order (ECO) improvement
- Accelerate strategic procurement, and stronger negotiation tactics
- Conduct cost, capacity, and capability (C3) analysis to assess and re-orient the company’s cost of goods sold, footprint, and make vs. buy identity
- Analyze opportunities to create economies of scale through strategic sourcing and in-sourcing of services
- Enable more accurate and reliable engagement with legacy and new suppliers
- Classify inventory into addressable/non-addressable for disposition, and developed disposition action and governance plan.
Private equity’s hesitation to invest more deeply in aerospace and defense (A&D) because of concerns about defense-related investments and challenging exit opportunities has reduced more recently and the growth potential for A&D acquisitions is valid. The fluctuation in the number of deals within the defense sector means that PE firms are missing significant value creation opportunities in adjacent sectors, purely aerospace companies, and aerospace rollups. Implementing Total Value Optimization (TVO) can uncover supply chain and operational efficiencies, enabling profitable exits and growth. Sectors like advanced manufacturing and drone technology offer untapped potential, while rollups can achieve economies of scale and substantial cost reductions, increasing the value of holdings significantly.
If you would like to talk to Chris about any of the points raised in this blog, contact him below.
