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Arlington Capital Partners didn’t follow the usual private equity playbook with its Keel Holdings deal.

The sponsor acquired the company, then known as Pegasus Steel, last June and funded the deal entirely with equity. It wasn’t until six months later that it finally made moves to put debt financing in place, through a syndication process led by Citizens Bank.

Although all-equity deals are uncommon, they’re not entirely unheard of — and last year, when borrowing costs were high, it definitely made sense to wait a few months. Waiting also enabled Arlington to line up the acquisition of Merrill Technologies Group, which will be funded by the new debt.

Arguably, the decision to wait also put Citizens in a better position to win the financing mandate, as the markets have swung back in favor of syndicated debt in the months since Arlington first acquired Pegasus. And that is something of a blow for private credit firms, because Keel Holdings is exactly the kind of investment they love.

At $50m of EBITDA, and with the government as a major end customer, the steel fabrication roll-up strategy that Arlington is pursuing with Keel is catnip for private credit firms. They love the aerospace and defense sector almost as much as they love healthcare and tech.

Despite being slightly different animals, defense and aerospace are often lumped together by credit firms. There’s a very good reason for that: the government is a major customer in both sectors, which offers the kind of stability that lenders like.

“Credit people like government contracts because once you get on one, and you don’t f**k up, you won’t get replaced,” said one source who invests in the sector.

That’s partly because suppliers often get ‘spec’d in’ once they become a government contractor, meaning that whatever components they supply become a part of the standard specifications for whatever end product they are used in. Once you’re in, you’re in.

But to even get to the table, vendors have to:

prove compliance with certain regulatory standards

convince the end user (the government) that their product fits their needs

be sure there’s funding for it in the government budget

show they deserve the contract more than their competitors

It’s a lot of work, but it’s worth it for the stability. Pegasus and Merrill was a good example: with its history of manufacturing parts for aircraft carriers, submarines and military combat vehicles, it has a long-standing relationship with the government, and that makes it an attractive credit.

Projections for the defense budget suggest that defense and aerospace companies will become even more attractive opportunities for private equity and credit firms in the coming years.

The Department of Defense’s proposed budget for 2024 is $842bn, which is almost unchanged from 2023 when adjusted for inflation. That is likely to increase by as much as 10% between 2028 to 2038, according to a report from the Congressional Budget Office.

Here’s some history of how that money is allocated:

Graph of how the Department of Defense's budget is allocated over time. Source: Congressional Budget Office

You’ll notice that some areas are pretty steady, while others — like research and development — are on the rise. This highlights a key challenge for smaller defense companies: taking on the ‘primes’ like Lockheed Martin, RTX, General Dynamics, Boeing, and Northrop Grumman, which receive a big chunk of the defense budget.

Middle-market companies have a better shot at winning government contracts in areas where the budget is growing faster, sources said. For example, AE Industrial Partners, a private equity firm that specializes in defense and aerospace, has highlighted four such areas as a big opportunity: space, cybersecurity, AI, and autonomous technology.

“The war in Ukraine opened the eyes of Europe and European investors,” said Kirk Konert, a managing partner at the firm. “It opened the eyes of Silicon Valley investors.”

With any defense investment, ESG is going to be a question. Understandably, some investors don’t like funding the production of machinery used in armed conflict.

But there is some level of nuance. For some GPs and LPs, there is a clear demarcation between companies directly involved in military efforts, and ancillary businesses with only indirect exposure to conflict.

"We avoid anything in defense that is going to be used ‘in theatre’,” said a credit investor. “If their products are going into an attack fighter jet, that's an absolute no. If they are private parts going into a defensive weapon, like radars, then you can argue [it is ESG compliant].”

There are other ways to thread the needle. Konert of AE Industrial Partners, for example, has a well-honed pitch on why defense and ESG aren’t mutually exclusive.

“Governance and sustainability and equity — you can have all those things only if you have a free society, and you can only have a free society if you can defend yourself,” he told 9fin. “So we’ve seen an increased interest in what we do, and defense investing overall globally.”

Nevertheless, this is an election year, which generally implies a certain amount of uncertainty around government budgets.

However, many defense investors we spoke to for this article are sanguine at the prospect of either political party gaining control of the White House. They don’t expect an overhaul of the defense budget, which has been pretty stable over recent years.

New administrations don’t tend to alter defense contracts, sources noted, and there has been been stability in US defense policy over recent years despite the see-saw between Republican or Democratic control of government.

“We’ve been investing for a while now, whether it was Obama, and then Trump, and now Biden though there’s certainly been some nuances,” said another credit investor. “But big picture, none of the key thematic topics changed, despite the administration changing.”

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