Since the end of the Cold War, the defense industry has been booming in mergers and acquisitions, big companies gorging on smaller ones with few challenges from the government. That could be starting to change, argues Bill Greenwalt of the American Enterprise Institute, and if it does, it would herald a new era for the industry — with potential rewards for taxpayers.
In 1993, Secretary of Defense William Perry held a historic meeting known as the “Last Supper”, where corporate CEOs were given a clear mandate: the Cold War is over and defense companies will have to consolidate or die.
Industry got the message and commercial companies subsequently sold off their compartmentalized defense units, resulting in a limited number of specialist defense bounties that now dominate most defense programs. As analyst Pierre Chao once observed, 107 defense contractors have become five. But that was not the end of the industry contraction, with major players such as L3 and Harris or Raytheon and United Technologies combining in recent years.
This has led to the belief that M&A activity will continue unabated for years to come. But two major shifts in the past year send a different signal an industry needs to wake up or face the consequences.
The first change comes from the government. Under the Biden administration, there has been a real pushback by the Federal Trade Commission (FTC) toward mergers and acquisitions for the first time in recent history. If the CEOs of major defense companies haven’t gotten the message from the FTC’s January lawsuit that scuttled the proposed Aerojet-Lockheed merger, they have no choice but to acknowledge that the FTC’s review of Northrop’s merger with Orbital ATK is the final chapter. on defense consolidation. This merger was completed over four years ago and yet it is now being reported that the FTC may seek to unwind it.
While such a forced divestiture would likely face an uphill legal battle — and Northrop has signaled to investors that it is unaffected — there is a huge signal being sent from the Biden administration: Not only is the government skeptical as for the ongoing consolidation, he is not happy with the execution of these promises made in the past.
Governments can change, of course, and it’s entirely possible that a Republican White House in 2025 will be more open to M&A activity. But the market itself is changing, with a variety of inputs coming from real world conflict, inflation, supply chain and labor shortage threats.
Thanks to Ukraine, the traditional defense industry will have its hands full in the future. It is now called upon to increase production of existing weapons systems on a scale hitherto unimaginable, first to replace US stockpiles destined for Ukraine and other frontline states, then to prepare for longer conflicts in the future. The industry should greatly benefit from this doubling of the production and maintenance of these systems. The reality, however, is that it will take the full attention, focus and resources of the current management to actually achieve this production bonanza in the face of continued market disruptions.
If the industry is struggling to meet current demand, imagine the constraints necessary if the United States were to go to war with China or Russia. Now imagine if all the production lines in the United States were more consolidated, with fewer points of failure (whether by accident or sabotage), with fewer needs to be competitive in terms of price and speed. For the United States to prepare for global conflict, it needs more, not less, production options. Consolidation simply goes against this reality.
How the arsenal of democracy was put to sleep
How did we get here ? Point the finger at the government and Congress, because for decades they have brushed aside the prospects of a great power struggle and deterred the defense industry from being seen as anything more than just a source of jobs for member districts. In the process, defense companies have developed an unhealthy reliance on government spending and direction, and a low appetite for risk.
Let’s look at the story. The arms industry has been shaped by three major changes over the past century. In the 1920s and 1930s, an American defense industry didn’t really exist. The army was supplied by government-owned arsenals, and the fledgling aircraft industry was kept alive after World War I by contracts from the United States Postal Service. The first big change began with the Lend Lease Act of 1941. The subsequent rise of the Arsenal of Democracy during World War II was based on the conversion of the dominant commercial industrial capacity of the time (mainly in industries automotive and steel industry) to support defense needs. The private sector was now the main player in defence. Large defense budgets as a percentage of GDP, the civil-military integration of the industrial base, and the development of a dedicated research and development enterprise that supported both the military and commercial sectors defined the first phase of the cold War. It was the golden age of American military innovation, but it didn’t last long – a few decades at most.
The next phase began in the 1960s with the decoupling of the defense industry from the civilian economy. Unique government practices and compliance requirements have led commercial companies to create specific defense units specializing in government relations. The passing of the Truth in Negotiations Act in 1962 and the subsequent creation of cost accounting standards were important tools in achieving this break in civil-military integration, but the new budget (PPBE) and the acquisition process finally completed the separation of the defense sector from the rest of the economy. A system of private government-run but still competitive arsenals then emerged in reaction to the DOD’s unique new set of rules. This construction spanned three decades and was dominated by centralized oversight and regulation and a growing culture of arms control that limited innovation in an attempt to manage technological competition with the Soviet Union.
Then came the Last Supper. While deregulation and decontrol was a complementary aspect of the Perry reforms, it never filtered down to the traditional defense industry. As a result, the United States has been burdened over the past three decades with the worst of all possible worlds – heavy centralized control over a small number of monopoly suppliers who have never had the incentive to innovate beyond marginal changes to the status quo.
The FTC rulings and the response to Ukraine may signal that we are on the cusp of a fourth major shift that could shape a new defense industry. If so, the government has the opportunity to extend its reach to the multitude of sources beyond the current traditional defense industry.
If it wants more competition and innovation, the DoD will have to create new opportunities for these foreigners to bid on and win defense contracts. Competition will come not from the FTC trying to force divestments, but from effectively soliciting mission solutions (not necessarily just programs), deregulating acquisition rules, and strategically picking winners and losers, which has become anathema in government today. Companies currently emerging through venture capital and private equity investments, large commercial companies not currently in the defense market, established players in the government services sector, foreign companies operating in the United States United and small and medium enterprises incentivized to grow could form the basis for a new renaissance of defense competition and innovation.
Whatever construction of the resulting industrial base should depend on clear DOD decision-making regarding future capability and innovation needs, but at the moment there appears to be little focus on the future shape of the industry in the halls of the Pentagon or in Congress. Not having a confirmed Assistant Secretary of Defense for Industrial Base Policy 19 months into a new administration probably doesn’t help matters. Yet change is coming, whether we are proactive or not.
If the government wants industrial change capable of responding to growing threats, it will have to act and act with force. It will take the courage and foresight of an Eisenhower to build companies out of thin air, like when Simon Ramo was plucked out of Hughes Aircraft to found TRW and given a contract to run the ICBM program. The DoD will have to drastically change course if it wants more than existing systems or slightly more production capacity. There are no signs of this happening at this time.
The era of defense industrial consolidation seems to be coming to an end. What will replace this three-decade trend of creating bigger and bigger single defense giants through mergers and acquisitions remains to be seen.
Bill Greenwalt, long the top Republican acquisition policy expert at the SASC, also served as deputy assistant secretary of defense for industrial policy. A member of the Breaking Defense Board of Contributors, he is now a Fellow of the American Enterprise Institute.