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Europe is rearming at record speed.

The Russian invasion of Ukraine and Donald Trump’s US presidency have bolstered Nato commitments in defence spending to a total of 5% of the members’ GDP by 2035. The European Union has pledged a €800bn investment package through its ReArm Europe plan by 2030.

Individual member states including Germany and Poland have stepped up their plans for military spending, too. And the European Investment Bank (EIB), the EU’s lending arm which channels a mix of private and public loans into project across different continents, has also expanded its spending limit to €100bn this year to support defence, energy, and technology initiatives.

Most of the measures have yet to be implemented. But, as most of Nato allies’ public finances are under strain, there’s high hopes that private capital will support the block's galvanisation of its military-industrial capabilities, as investors are hungry to see at least part of those commitments funnelled through capital markets.

Already last year, European small and medium-sized defence companies lacked up to €2bn in debt financing needed to add production capacities and to build up military stocks, according to a report by the European Commission.

“We’re happy to underwrite defence deals,” said one leveraged finance banker. “It’s all about the sector and the specific deal, but defence might turn out to be a good space in the same way the health industry had been up to a couple of years ago.”

Allianz and UBS announced earlier in the year that they were dropping defence exclusion policies on some of their sustainable funds and Danske Bank has followed suit, abandoning its exclusion policies for nuclear weapons, with more firms likely to follow.

M&A leads the way

Rising geopolitical tensions have already ignited European deal-making in the industry.

In the first six months of 2025, defence M&A hit $2.3bn in Europe by value, up 35% YoY and higher than 2024’s annual total, an A&O Shearman study shows. Globally, the combined value of aerospace and defence transactions in H1 25 stood at $21.7bn, more than double that of H1 24, and the highest figure since the same period in 2021.

These increases, however, haven’t trickled down to leveraged loans or high yield bonds so far, as LPs and lenders alike are still split on defence investments due to ESG regulations and ethical concerns associated with military investment.

Most of recent M&A deal flow has been driven by investment-grade credits and government-backed companies. The largest M&A deals this year include Italian defence contractor Leonardo, which acquired Iveco’s defence business portfolio for €1.7bn, and Germany’s Rheinmetall, which took over Expal Systems, a Spanish company specialised in artillery and ammunition manufacturing, for €1.2bn.

“We’re not seeing a lot of sponsor activity in our market,” a second syndicate banker said. “It’s more in the US than in Europe, where there’s still focus on ESG restrictions. But this has started to shift a bit.”

One banker from a continental bank told 9fin that the bank is working to rebuild its capabilities in defence financing, including sector analysis and compliance abilities, after historically shying away from the area.

While ESG sensitivities still shaping portfolio mandates, another way for investors to gain exposure to the sector’s growing budget is to look into “defence-adjacent” businesses — companies that provide technology, logistics or services to defence contractors, but don’t manufacture weapons or ammunition themselves.

The European Investment Bank, for instance, can’t directly deploy capital in weapons or ammunition, but it can fund the so-called “dual-use” initiatives, such as GPS systems, helicopters, drones, or buildings and infrastructure for army bases.

“We never had a problem on defence,” said a CLO portfolio manager. “But where you get some problems is on the definition of defence. People say we don’t do guns or offensive weapons, but a weapon is defensive till the moment you turn it offensive. This mentality is driven by compliance and ESG regulations.”

9fin previously published an analysis on the impact of defence spending for European leveraged credit, breaking it down across three distinct tiers here.

Will private credit step in?

When public debt markets won’t open their gates, it’s often private capital providers who step in to make transactions happen.

But private credit firms have been uncertain on defence deals and this is only changing slowly. ESG frameworks still restrict investments in this space and direct lenders prefer safer ground, namely the software and financials sectors, as highlighted in 9fin’s European Private Credit Data Review Q2 25.

But some firms venture forward. JP Morgan’s direct lending unit lined up a unitranche of around €200m to support Tikehau Capital’s acquisition of Belgian aviation and defence firm ScioTeq from OpenGate Capital, as reported by 9fin in June.

The deal is part of a push by private equity firm Tikehau, which launched a dedicated fund focussed on defence, aerospace, and cybersecurity also in June, backed by Société Générale Assurances, CNP Assurances, and CARAC Group.

For direct lenders, the appeal is obvious. Mid-sized defence suppliers often benefit from long-term government contracts and stable cashflows, precisely what private credit seeks. These firms also benefit from rising defence budgets amid constrained traditional financing channels.

Can defence be sustainable?

ESG has long considered investments in defence incompatible with sustainable investment principles. However, with an increase in geopolitical tensions and initiatives by the EU to bolster its defence capabilities, investors’ stances on ESG and defence are beginning to shift.

Between 2021 and 2025, the number of ESG funds that held stocks in defence increased from around 25% to 35%, according to the Financial Times’ Sustainable Views, compared to 51% of conventional funds.

Despite apparent investor appetite for defence investments, EU and UK sustainable finance rules are seen as blockages by investors, prompting regulators in both regions to issue clarifications affirming that defence investments are not prohibited.

“There are a few firms, especially in direct lending, that are trying to finance all the SMEs in Europe that are part of the military complex, in Germany, France, and Italy for instance,” the portfolio manager said. “You can definitely make a case, if you're a European LP, that you are actually helping Europe be more secure by financing these companies.”

In March 2025, the UK’s Financial Conduct Authority issued a statement indicating that its sustainable finance rules do not prohibit investments in defence. The response came after MPs raised concerns that UK regulations were blocking capital from reaching the sector.

The FCA noted that the UK’s Sustainable Disclosure Regulation — which governs labelling and naming rules for financial products — does not define what constitutes sustainable investing, thus does not exclude defence by default.

Similarly, on 17 June 2025, the European Commission issued a statement asserting that its sustainable finance rules do not prohibit investment in defence.

What defence is sustainable?

There are several EU frameworks that indicate how financial institutions can be transparent with their capital deployment. But the lack of clarity on the definition of sustainable investment has posed some challenges to lenders.

The EU Sustainable Finance Disclosure Regulation establishes how financial market participants in the EU have to disclose sustainability information. But it does not clearly define sustainable investment, and instead requires market participants to carry out their own assessments.

The EU Taxonomy — is the EU’s official classification system that defines which economic activities can be considered environmentally sustainable — has already clarified that defence-related activities can claim taxonomy alignment.

Under new EU laws, companies with more than one thousand employees have to carry responsibility for the human rights and environmental impacts of their operations and their global supply chain.

This has been set up by the Corporate Sustainability Due Diligence Directive, but the EU Commission has indicated that due diligence obligations do not extend to activities of companies’ downstream business partners that are related to military when their export has been authorised by EU state authorities.

But while regulators may be easing the path for defence investment, reputation and ethical concerns remain a sticking point for many investors.

Many firms still maintain internal exclusion policies, particularly regarding weapons manufacturers, and often also have voluntary exclusion policies written into fund documents.