Private credit is readying itself to finance Europe’s defence supply chain, but investors will need to tackle trade-offs before stepping onto the battlefield.
With geopolitical tensions at an all-time high and the Western alliance under threat, national security is top of the agenda for European governments, whose domestic budgets are being redirected at bullet speed to accelerate investment in the continent’s defence industry.
For companies operating in the defence supply chain this means having to quickly scale up production to respond to rising demand, impacting everything from the sourcing of raw materials to the hiring of skilled workers.
“There is a huge pile of money coming in the sector. This has spurred a massive growth in the order books of small- and medium-sized enterprises (SMEs) linked to defence, creating urgent financing needs,” says Laurent Dubois, Chief Executive of Private Credit at Sienna Investment Managers, part of investment group Groupe Bruxelles Lambert.
He argues private debt markets are ideally placed to provide this type of liquidity given SMEs do not have the same bandwidth as large players to raise capital from public markets. “These companies are ready to pay more to access capital quicker which represents an opportunity for us,” he says, adding that investment risks are reduced given the assets’ future cash flow is backed by government spending.
Last year, Sienna IM launched a dedicated defence private credit strategy targeting SMEs and mid-caps. It received €30 million in funding from the EU through the bloc’s Defence Equity Facility (DEF), which aims to mobilise approximately €500 million for European companies developing defence products and technologies. DEF is designed to specifically support private debt, private equity and venture capital products that strive to scale up SMEs in the EU and Norway.
Sienna IM’s credit strategy raised over €270 million at first close but is targeting up to €1 billion by the end of 2026.
The average duration of Sienna IM’s debt facilities is five years. The expectation is that after this time, the SME has grown enough that it can tap public markets, says Dubois.
Simon Abrams, founder of Elpis Impact, a strategic advisory consultancy, agrees SMEs in the defence sector represent a clear opportunity for private market players.
“Rearming Europe through public procurement means governments are not just going to the main players but also aim to support smaller companies, such as drone manufacturers, which are more tech oriented,” he says.
Because the share price of large, listed defence players has already grown exponentially over the last few years, investors can now find more upside in private markets, he adds.
Regulatory scrutiny
While private credit is notorious for providing financing that carries higher default risk, investing in defence comes with its own legal hurdles.
A recent report by Deloitte notes that antitrust and competition law, foreign investment regulations and sector-specific compliance makes investing in defence “far from straightforward for private capital”. The authors, however, also point out that pure debt financing – as opposed to equity stakes – faces less intense national security and foreign investment screening given it does not represent ownership.
“Unlike equity transactions, debt financing is often bilateral and less public, which suits defence companies seeking capital without the spotlight of ownership changes or public filings,” the report says.
Dubois agrees the current environment is favourable for private debt players, but more challenging for private equity participants as they will be looking to exit their investment in a few years’ time. “Questions will arise as to whom is the potential buyer five years down the line and how the company transformed under their ownership,” he says.
Abrams notes private market players investing in the defence sector will also need to ensure the governance systems of fast-growing acquisitions are robust enough to deal with strict regulations around, for instance, export controls, that may be bound by government decisions.
Investors doing their due diligence ahead of an investment are likely to ask who the end-customer is of certain defence products and services. “They will want to inquire about what kind of protections are in place so that these products go to some end-users not to others,” he says. This has shown to be a particularly difficult area to navigate, with, for instance, the provision of weapons to high-risk countries, a grey area for certain companies operating in the space.
“Companies will need to do more than just saying they follow export licensing regimes,” according to Daniel Neale, Responsible Investment – Social Lead at Church Commissioners for England, an ethical endowment fund.
While defence is a heavily regulated sector, it still carries high risks for investors because of the actions or activities the products and services are designed to enable or support, he says.
The sector needs to be viewed with a lot of nuance; a bomb is different from a uniform, says Neale, but companies making them are both defence-related. Individual investors will have to assess what is acceptable to them based on their own mandates and approach.
Responsible defence investment
Exclusions against funding weapons manufacture have long been a foundation of ethical investment strategies that seek to ‘do no significant harm’.
The Church Commissioners for England is part of an investor group which last year launched an initiative to create principles for ‘responsible defence investment’. Supported by the US-based EIRIS Conflict Risk Network, the initiative seeks to assist investors with establishing due diligence frameworks that assess the financial, human rights, environmental, reputational and legal risks of investing in the defence supply chain.
A lack of reliable data to support investors’ decision-making is one of the areas the group is raising awareness about. It argues that opacity in the sector is driven by several factors, including insufficient human rights due diligence by arms companies; the failure by states to mandate such practices and poor transparency in relation to arms exports globally.
Abrams warns that investors aiming to assess the sustainability impact of their defence investments need to be aware that military equipment may not be subject to the same disclosure requirements as other sectors for security and confidentiality reasons.
Since Russia’s invasion of Ukraine, the responsible investment community has been divided on whether defence investments can be considered aligned with ESG principles. Many investors have tweaked their exclusion policies to gain exposure to defence areas while others continue to steer away from the sector all together.
According to sustainability data provider Clarity AI, the defence sector exposures of equity funds disclosing under Article 8 of the Sustainable Finance Disclosure Regulation (SFDR) by almost 60% in the 12 months to Q4 2025.
“Positions towards defence investments change once the enemy gets to the front door,” says Dominic Hall, Associate at Elpis Impact. “Views are different in Poland and Finland , for example, compared to Spain.”
What complicates the investment case, however, is that a clear division between peace-keeping efforts and harmful use remains complex to establish given the vastness, intricacy and diversity of the defence supply chain, Hall says.
“Potential investors need a clear framework allowing them to quickly decide which companies are investable, which are not investable, and which require additional due diligence.”
Such frameworks need to take account of investments in companies that deploy dual use technologies, whereby products have both military and civilian applications. The most high-profile example is drones, but this fast-growing sector also includes cybersecurity, robotics, AI, satellite navigation, and biotechnology.
One approach investors have used to tackle this dilemma is to look at the percentage of revenues derived by certain products or services to decide whether a company is investible according to their own in-house criteria, says Neale.
ESG-minded investors also have to get their investment selection criteria aligned with their values , says Abrams. “ESG investors need to clearly articulate how they approach defence. Asset owners need to know what choices and trade-offs you have made given the defence supply chain is so broad.”
“Ethically-driven investors might understand their exposure to defence investments as necessary prevention, aimed at generating a financial return, but in the hope those products will never be used outside of, for example, UN-sanctioned actions or a NATO Article 5 defence,” adds Hall.
Regulatory bottleneck
Whether defence-related investments should be labelled as sustainable has become a bottleneck for EU regulators, who do not want sustainability rules to prevent investment in the sector.
In a notice adopted in December, as part of the Defence Readiness Omnibus package, the European Commission clarified that the EU sustainable finance framework does not exclude any sector, including defence.
But Neale says the debate around sustainability semantics has not been that helpful. “Defence is necessary and legitimate, just as police and the justice system, but should they all therefore be labelled as sustainable?” he asks.
As part of its plans, the EU is also finalising rules to reduce red tape by speeding up permitting approvals, procurement decisions and better coordinate its military capabilities.
A proposed relaxation of the rules related to ‘controversial weapons’ opens the door for more investment in nuclear weapons.
In the past year, several European investors have changed their exclusion policies, allowing their funds to invest in nuclear weapons as long as they are aligned with the Treaty on the Non-Proliferation of Nuclear Weapons – the most widely recognised international agreement governing the production and use of nuclear weapons. Germany’s Allianz Global Investors, Belgian state-owned bank Belfius and the asset management arm of Danske Bank now all allow this type of investment.
With geopolitical tensions continuing to rise, one of few certainties is that defence budgets will follow suit.
Estimates suggest that, if the US were to withdraw support, Europe could need 300,000 more troops and an annual defence spending hike of at least €250 billion to deter Russian aggression in the short term.
