Europe frets over foreign investments in the defence industry

Written by Clara Marina O'Donnell [1], 15 October 2010
From Yale Global Online

A small number of sovereign investors, sometimes originating from non-democratic states, are buying shares in European aerospace and defense companies. Some EU governments have responded by calling for tougher controls on foreign investment in these industries.

But there is no need for alarm. The European defence sector is sufficiently protected by the heavy – and at times excessive – regulations already in place. In the long term, if EU member-states integrate their defence industries further, they should coordinate their efforts to regulate foreign investments in this sector, including those by sovereign investors.

Sovereign wealth funds and state-owned enterprises, SWFs and SEOs, with ties to governments from the Gulf, the former Soviet Union and emerging Asia have become increasingly powerful global investors. SWFs alone are estimated to manage close to $4 trillion of assets globally.

Sovereign groups have focused their investments in Europe predominantly in the financial sector and remain limited players within the aerospace and defence industry. But some sovereign investors have held small stakes in the industry for years, including the Government of Singapore Investment Corporation. And more recently, the number of sovereign groups interested in European aerospace and defence companies has grown. Attracted by the prospect of solid financial returns and access to advanced technology, various SWFs and SOEs acquire small European aerospace firms, invest in some of Europe's largest groups and set up a multitude of joint ventures.

In 2006, the Emirate sovereign fund Dubai International Capital (DIC), bought Doncaster, a British company which supplies aircraft components amongst other things. The same year, Mubadala Development Company, a sovereign investor from Abu Dhabi, bought around 30 percent of Piaggio Aero, an Italian civil aircraft manufacturing company. And a consortium of SWFs from Dubai and Abu Dhabi took over the German firm SR Technics Group, a leading independent aircraft maintenance provider.

In 2007 DIC became one of the largest direct shareholders in Europe's biggest aerospace company, EADS – European Aeronautic Defence and Space Company – when it bought just over 3 percent. That same year, the Qatar Investment Authority (QIA) expressed a desire to acquire a 10 percent stake of the aerospace giant. DIC and QIA have also been significant investors in EADS' largest shareholders, Lagardère and Daimler. In 2006, Russia’s VTB Bank bought over 5 percent of EADS, and people close to the Kremlin publicly expressed an interest in doubling that share. And in the summer of 2009, rumours abounded that a Libyan SWF was interested in buying up to 10 percent in the Italian defence conglomerate Finmeccanica.

The various joint ventures which sovereign groups developed with large European aerospace and defence manufacturers have occurred mainly within the civilian field. Mubadala has partnerships with EADS, Finmeccanica and Rolls Royce. The Russian defence firm Irkut has joint ventures with EADS and Rolls Royce, while several Russian groups, including Oboronprom Corporation, cooperate with Finmeccanica in building helicopters, jet planes and components in the railway sector. The Italian company also has various partnerships with government-owned groups in Libya.

SWFs and SOEs can be useful sources of capital for defence companies, especially now that fiscal pressures force governments across Europe to cut defence budgets. However, sovereign investors, like other investors, could leak information about sensitive military equipment produced by a defence company. SWFs and SOEs could also threaten the security of supply for a nation's armed forces. A sovereign investor controlling a defence manufacturer could stop the firm from producing some military equipment, be it for commercial or political considerations.

After the controversial investment by the Russian bank in EADS in 2006, such concerns led to calls in Berlin for stronger protections against foreign investors. The German government even considered introducing golden shares in the European aerospace group.

SWFs and SOEs can be useful sources of capital for defence companies, especially now that fiscal pressures force governments across Europe to cut defense budgets. However, sovereign investors, like other investors, could leak information about sensitive military equipment produced by a defence company. SWFs and SOEs could also threaten the security of supply for a nation's armed forces. A sovereign investor controlling a defence manufacturer could stop the firm from producing some military equipment, be it for commercial or political considerations.

But for the moment, European governments do not need additional legal safeguards to protect their defence industries against sovereign investors. The specific mechanisms in place vary across EU member-states, but all European countries with large defence industries can already prevent investments considered detrimental to their national security – be it through golden shares, ceilings on foreign shareholdings or ministerial committees that oversee foreign bids, similar to the US Committee on Foreign Investment.

If anything, some European governments actually maintain excessive controls on foreign investment, unnecessarily restricting the ability of their defence companies to access benign capital. For example, in France, one of the most closed countries to foreign ownership in Europe, not only is the state a significant shareholder in several large defence firms, but it resorts extensively to golden shares, strict shareholding agreements and ministerial committees to regulate foreign investments.

In addition, in the unlikely event that an unwelcome investor managed to take control of a defence company despite the government controls in place, the state could make it impossible for the firm to operate. For example, a government could refuse to grant export licenses to the company or buy the military equipment it produced. European states have often discouraged acquisitions within their defence industries by other European defence manufacturers – mostly to the benefit of their national producers. In light of such a cautious attitude, it is highly unlikely that a hostile investor from Russia or the Middle East would succeed where companies based in neighboring EU countries had failed. So, while remaining vigilant, governments and defence firms should be open to sovereign investments in principle.

While national rules are sufficient to control foreign investments in today's European defence industry, they will be less effective once governments take further steps to integrate their defence markets.

For years, EU member-states have acknowledged that their fragmented national industrial bases are too small to sustain and they have committed to liberalise their markets. So far, governments have been slow to deliver on that objective. But as the cost of defence equipment spirals and defence budgets continue to shrink, the pressure on member-states to open defence markets will grow.

If pan-European supply chains develop, EU countries will become increasingly reliant on defence companies based in other member-states to provide them with components or finished military equipment. For example, the German army might rely on radios produced by a company in Sweden, and deployed German troops could be put at risk if owners of a Swedish defence firm decided to stop producing such equipment.

Consequently, when EU member-states move to an integrated European defence market, they should introduce a coordinated system to monitor foreign investment in the defence sector across the EU. European governments should create a common investigative committee which would oversee foreign bids and block any that could pose a risk to the security interests of any EU member-state. The membership of the committee would include representatives from the different EU countries with large defence industries. Such a system would increase transparency and simplify procedures for investors. It would also help to give EU member-states stronger guarantees on their security of supply.