Race to Modernization

Since 2020, alternative investment firms have been the leaders of the M&A market. We are expecting to see an increase in small business activity stemming from the structure applied by the Department of Defense. This unified governance structure of small business programs will help to create more synergy and transition pathways in this sector. Government assistance in the A&D sector will drive supply chain replenishment and modernization processes. Tremendous increases are shown in Air Force and Space Force spending, 8.44% and 40.00% respectively; while Air Force and Space Force R & D categories have increased 22.7% and 40.4% from 2022 to 2023. The Department of Defense spending within the small business Aerospace and Defense world reached an all time high in 2021, totaling $80.3 billion. Other key metrics including an increase in small business R&D of 83% and manufacturing by 28% suggest a larger focus in the lower middle/micro market. The DoD has prioritized several key areas as they dive deeper into their mission of modernization, including AI technology, small satellites, unmanned aerial systems, communication technology (C3 capabilities), and a 5G operations network.

Global Instability and Internet Dependance 

As the global hierarchy of power closes in on three main players in The United States, China, and Russia, we’ve seen insurmountable increases in military and technology spending. A common theme between these players has been an increased reliance on infrastructure and their ability to avoid technological warfare tactics coming from both foreign and domestic enemies to avoid leaking confidential information relating to our foreign policies and plans. If governments cannot afford next generation platforms on a military wide basis, there will be upgrades of existing equipment, increasing demand for the Tier 2 and Tier 3 suppliers who have experience designing and manufacturing these systems, but will now be using alternative softwares. In these circumstances, with the massive amounts of funding being poured into these military budgets, there is ample opportunity for alternative investment firms to deploy dry powder built up over the last few years. The resiliency of the A&D asset class has been proven over the years as it continually gains bipartisan support to increase funding, keeping The United States Military dominant on the global stage.

Statements released by the DoD earlier this year indicates building a resilient supply chain remains one of their top priorities due to increased pressures on global trade and political tension. There are five priority sectors listed: casting and forgings, missiles and munitions, energy storage and batteries, strategic and critical materials, and microelectronics; the DoD clearly lays out who will play a role in this supply chain revamp and among the leaders were small businesses and their manufacturing efforts. Modernization strategies have been put in place to combat foreign competitors' push to reach technology equilibrium. Two main areas the Department of Defense will look to improve are the use of low-Earth orbit satellites and their ability to improve command, control, and communications systems (C3), and Artificial Intelligence for numerous applications including Unmanned Aerial Systems. Innovation of new technology and equipment is also among the top priorities for the DoD as tensions rise internationally. This is evident by the R&D budget approval of $276 billion dollars, the largest in DoD history. This budget will see funds poured into areas such as the space industry, cybersecurity, hypersonic missiles, and 5G to strengthen national defense.

DOD objectives to modernize and spur increased competition in the dynamic A&D market

Increasing New Entrants. To counteract the trend of overall shrinking of the DIB, DoD should endeavor to attract new entrants to the defense marketplace by reducing barriers to entry. This will be accomplished through small business outreach, support, and use of acquisition authorities like other transaction (OT) authority and commercial solutions opening (CSO) that provides DoD the flexibility to adopt and incorporate commercial best practices to reduce barriers and attract new vendors.

Increasing Opportunities for Small Businesses. DoD should increase small business participation in defense procurement, with an emphasis on increasing competition in priority industrial base sectors.

Implementing Sector-specific Supply Chain Resiliency Plans: DoD should take steps to ensure resilience in the supply chain for five priority sectors: casting and forgings, missiles and munitions, energy storage and batteries, strategic and critical materials, and microelectronics. Detailed recommendations are included in DoD’s report on Executive Order 14017, America’s Supply Chains.

DoD also has the autonomy to deploy acquisition strategies to stimulate competition. The return from investments they made in small business R&D over the last 23 years is impressive, reaching 22-to-1, and generated $347 billion in total economic output nationwide. Under these circumstances, DoD seeks to minimize the barriers for new entrants to get involved in the market and develop innovative technologies in each domain. A priority for DoD is working to strengthen its partnerships with small businesses and make it easier for them to access the SBIR/STTR programs, which receive nearly $2 billion annually in DoD investment. In addition to paying close attention to small/micro companies, the DoD’s sub-department like PTAP program directly supports 96 Procurement Technical Assistance Centers (PTACs) across the country that provide counseling services and training to small businesses while also helping them identify potential contract opportunities with DoD. Besides attaching great attention to science and technology development, the DoD’s hand is forced to find solutions to shortages in the labor market at the same time. The growing shortfall of average skilled and highly skilled workers is a global manufacturing concern. It has been the truth that once these highly skilled workers move out of defense supply chains, they are difficult to recruit back and more expensive to retrain. Today, DoD and other stakeholders are working to reconnect the workforce development (training and education) ecosystem, which includes students, to defense industry needs they currently seek. With no sign of labor shortages improving across the U.S. many companies and asset managers are focusing in on automation to solve this problem. As AI and advanced manufacturing development increases the cost of implementing automation decreases allowing many companies that are essential in the A&D supply chain make the transition. The transition to advanced manufacturing and automation not only solves labor problems but creates substantial efficiencies reducing lead times, waste and ultimately improving the bottom line of these companies.

The boom for small satellites is capitalizing on the hyper demand for data, lowered costs to launch, and lack of effective regulatory policy.An emerging market for unmanned aerial vehicles (UAV) stems from an initiative to decrease human risk and a variety of multi-faceted operational use strategies. An enhanced communications capability is essential to satisfying DoD’s goals of foreign supply chain consolidation, facilitated interagency cooperation, and tactical readiness.

Small Satellite

The satellite is expected to grow to more than $7 billion by 2026, at a compounded average growth rate over 19 % annually. The small/micro–Lower Earth Orbital satellite has emerged rapidly in recent years. As the size and weight of satellites get smaller, costs associated with production and launching processes can be reduced dramatically compared to traditional satellites. The business opportunities that small satellites carry cover both commercial and military industries. Currently, 40% of the world still doesn't have access to the internet, and laying fiber optic cable especially in rugged terrain can be quite expensive. By connecting a group of small satellites also known as 'meta-constellations’, a large land area can be covered, making the transfer of information significantly less burdensome. Simultaneously, different satellites can be equipped with multiple variations of devices in the sky, accounting for multi-tasking abilities, for example conducting surveillance of high-value targets for military purposes. The development of Small Satellites manufacturing is still in its beginning phase, many mature companies are working on minimizing their operation costs in this area. Due to the small size, the production process must be continuous with high volume to cut off the unnecessary wastes of margin costs. To achieve this purpose, companies like Airbus, Boeing, SpaceX, Rocket Lab USA, etc. are implementing a vertical integration process, preemptively assembling all parts of satellite manufacturing under their own houses. From this point of view, there are abundant opportunities for private equity firms to invest in the fragmented companies which lie on the supply chains to satellite manufacturing companies, which are in progress of building vertical integrations. Since 2020, the PE companies have been dominant in the Aerospace & Defense Merger & Acquisition market, and we believe this trend will keep growing during the transient period for the industry 4.0 revolution. The prototype for the next generation of manufacturing mode Cyber-physical System (CPS) for LEO small satellites is under development. The CPS will incorporate data analysis by machine learning/artificial intelligence techniques into the physical process control. In this format, most of the production activities can be optimized for the minimum cost, shortest cycles, etc., which is also a good solution to the shortages in labor markets. The best focus for PE companies now should be those fragmented companies which are compatible with the technology and philosophy requirements standardized by industry 4.0.

Unmanned Aircraft Vehicle

Similar to the small satellite markets, the market of unmanned aircrafts also stayed healthy at the post-pandemic stage with a compound annual growth rate of 5.7%, and the Unmanned Aircraft Systems market could be worth more than 10% of the Aviation industry in the next ten years by the increased applications in both defense and commercial areas. The rapid development of autonomous software plays a substantial role in this industry, allowing for less human capital expense, decreasing life at risk, and increasing data collection procedures.This autonomous aircraft sub sector, such as drones, will gain massive funding in years to come due to the lack of a necessary ground base control system and the overall direction that modern military operations are going. There are several different verticals to enter in this growing industry such as cyber security, data collection practices, surveillance capabilities, and the manufacturing practices that take place in all tiers of the supply chain. It is always the priority to keep drones safe from hostile hacking to maintain our data dominance. Information technology companies involved in relevant areas like advanced calculations, machine learning engineering, and precision manufacturing can receive direct contracts from the Department of Defense if they are qualified, and as the amount of small business contracts and subcontracts continues to expand, there will be plenty of opportunity. Though its military applications make the Unmanned Aerial Systems market extremely attractive, there are several industries we will see this market grow into. Alternative markets include infrastructure surveillance, natural disaster reconnaissance, urban air mobility, and multiple law enforcement opportunities.

Digital Communication System

The digital communication industry is an important part of modernization progress, the communication between different units in cooperative combat is quite significant. Multiple surveys have found that approximately 68% of DoD personnel believe adversaries will match or surpass U.S. Military communications capabilities within five years. We can expect the size of contracts awarded from DoD to communication technology companies will keep growing to equip the military with cutting-edge communication systems. The most valued areas in communication by DoD include commercial technologies, the incorporation of 5G, artificial intelligence, integration of machine learning into deployment, and a greater emphasis on interoperability. Manufacturing of smaller electronics areas such as microelectronics will see a significant increase in spending as these components play a key role in the development of these systems, allowing for more vertical integration. An emphasis on moving microelectronics and lithium-ion battery production back into the United States has been put in place by the Department of Defense as our foreign reliance on these products must come to an end. This will play an exponential role in the industry as we see more companies adopt these manufacturing skills in the microelectronics subcategory. The C3 modernization strategy,(Command,Control and Communication) announced by DoD in 2020 has been met with great responses in the market, and we expect a continuation of this as they seek to implement this strategy throughout the entire United States Military. The goal of this entire process being to provide real-time situational awareness for our troops, as well as decision support across all domains.