Defense's Next Wave Is for the Little Guys

Editor's note: Following the Cold War, the defense industry's focus was on consolidation. But three decades later, that playbook is changing, according to Joel Litman, chief investment officer of our corporate affiliate Altimetry. Today, smaller defense companies are attracting more funding and deals – and it's creating a new opportunity in an industry long dominated by a select few...

In 1993, the Pentagon gathered executives from America's biggest defense contractors for a dinner that became known as the "Last Supper"...

The meeting's message was simple: The Cold War was over, defense budgets were falling, and the government did not expect the existing defense industrial base to survive.

The executives took the hint. If the government wasn't going to keep them all afloat, the only path forward was to combine forces.

The mergers and acquisitions (M&A) started shortly after...

Lockheed and Martin Marietta combined to form Lockheed Martin (LMT). Northrop bought Grumman to create Northrop Grumman (NOC). Boeing (BA) later absorbed McDonnell Douglas.

Across the 1990s, more than 50 defense suppliers ultimately consolidated into five major contractors.

Shrinking budgets reinforced the trend. By fiscal 1998, the real Department of Defense budget was roughly 40% below its 1985 peak. With the big defense companies getting bigger through M&A, that left little room for the companies further down the chain.

Today, I'll explain why that pattern is changing and why investors are now moving to the smaller end of defense.

The Defense Industry Is Rebuilding From the Bottom Up

Carlyle (CG) has spent nearly three decades investing in aerospace and defense...

Historically, it worked with larger companies in the industry. For example, back in 1997, it acquired United Defense Industries, the maker of the Bradley Fighting Vehicle, for $850 million.

Now, it's pivoting toward the smaller businesses left behind in the wave of consolidation.

In May, Carlyle launched a fund aimed at developing smaller defense companies. It followed that move by acquiring military-encryption company Secturion Systems in July. A month later, Carlyle helped lead a $1 billion funding round for missile startup Castelion.

Over the past six months, the number of aerospace and defense M&A deals has jumped 140%. At the same time, the average deal size has fallen 60%.

That says activity is spreading to the smaller part of the defense market. More companies are changing hands, even as the typical transaction gets much smaller.

For decades, defense M&A was defined by the moves that created today's defense giants. This time, the trend is developing from the bottom up as small and mid-sized defense businesses become much more active in the market.

Washington is helping push this forward... The defense budget is supporting greater participation from small defense businesses. Programs in AI, cybersecurity, drone warfare, and missile defense are opening doors for smaller firms that can move faster than legacy giants.

And clearly, Wall Street agrees. With more defense M&A and a surge in investment funds for these small defense companies, this part of the industry is in high demand.

The large defense giants remain central to the industry. They have huge manufacturing footprints and balance sheets that can support long-term contracts. We'd never count them out.

That said, they'll also face more competition. And we don't want to ignore where Wall Street's activity is moving...

A 140% increase in transaction count, alongside a 60% drop in average deal size, shows where activity is shifting.

That means, for the first time in decades, the defense search can widen beyond the giants. Smaller-cap defense names are often more nimble... and they can focus tightly on the newest capabilities that private investors want exposure to.

As these companies start to get more funding and attention for M&A, they'll be better able to scale quickly.

The status quo in defense is changing. And the smaller companies have the most to gain.

Regards,

Joel Litman

Editor's note: Joel says that the biggest defense buildup in 45 years is quickly approaching. And he believes the opportunity stretches far beyond the defense contractors we all know. That's why Joel is going on camera in just a few hours to reveal the new group of smaller companies that could see the biggest impact from Washington's historic spending spree.