Funding Future Forces with Modern Finance for Pace, Power & Performance

‍Innovation

On all the contemporary battlefields, innovation is at the heart of tipping the balance of power in combat. Recent innovations have included fielding new equipment quickly, finding unusual applications for old equipment, rapidly developing software, accelerating hardware deployment through new processes, adapting communications for novel purposes, harnessing computing power in new ways, drawing on emerging tech in an unexpected manner or simply adopting new techniques on top of old data and systems. These have played out in Ukraine, Gaza, Yemen and the Red and S China Seas and all preceding conflicts. They are game-changers which have profoundly shifted the battlefield balance of power in favour of the adopter who, in most cases was out-gunned, -numbered, -manoeuvred or out of ideas.

Innovation is one of the sticky principles of war - surprise. As the consequence of shock and confusion induced by the deliberate or incidental introduction of the unexpected, surprise is amplified if an opponent fails to imagine what an adversary might do; misunderstands how allies and partners might react when under pressure; is unprepared when the battlefield situation shifts unexpectedly; or does not recognise the differences new technologies, techniques or approaches might offer if adopted.

But MOD struggles to accelerate and adopt technical innovations because its budget is sedimented long into the future. There is no headroom to scale successes into the core funding lines. The Department’s appetite to embrace acquisition risk (ie. to let some projects fail) is limited because acceptable risk thresholds are built around the larger programme thresholds. Frontline equipment is near-exclusively funded from within the Departmental allocation with little draw on the capital markets. The lack of headroom, appetite for risk and restriction to the use of Treasury finance only prevents ideas and innovations from germinating, scaling and deploying. If innovation is critical to battlefield success, MOD needs to approach it differently.

There is no doubt that the latest round of Defence Reform will help, but strategic changes have rarely stuck. The creation of the National Armaments Director will help channel effort and reduce the number of front doors to defence for industry, but this could be an overwhelming pressure on one individual. What is clear is that geo-politics, conflict and war will not wait for process to play out, technology to be exquisitely honed or diligence to be absolute. Warfare is literally moving at light speed; change is breath-taking pace and technology is evolving in front of operator’s eyes. Time is an enemy too. If we are to win battlefield advantage, we must evolve our approach to innovation and rapidly.

Challenges

The Services have all developed innovation centres to accelerate new capabilities into service: the RN Navy X, RAF RCO and DE&S FCG. Their meagre cash allocations are just enough for early-stage experiments, but not enough to scale successes. Individually these are around £50mn of £8bn per annum which seems an order of magnitude too small. Contemporarily almost no technology evolves to a production standard, in fact the Ukraine battlefield is more representative of F1 where nothing grows beyond a demonstrator. So, if the engine room of advantage is innovation, Defence must commit far more of its budget to innovation.

But Defence financial planning is tough, the cash is worked hard, budgets are routinely overspent in year, across the decade and beyond. Commands overfill them to attract as much cash as possible and protect what was previously allocated. There is never a surplus to accommodate unforeseen expenditure without extreme in-year saving manoeuvring around spending priorities. So, as tactical and technical evolutions occur inside 12-month horizons, there is an urgent need to mandate innovation headroom to scale successes.

Rightly MOD is very careful with public money, and it must always hit the overall in-year spending target, often achieved through painful equipment programme changes – descope, delay, defer, delete are the key words. The MOD needs the greatest scrutiny, highest levels of due diligence and most rigorous safety standards for its biggest programmes, but these criteria seem unduly onerous for much of the rest of the programme. Instead, a graduated risk appetite (commercial, financial delegations, failures, etc), where small projects have less onerous oversight and bigger programmes the most, would curate innovations to the point where they reach the battlefield.  

Innovation is required in the financial tool set as much as the battlefield technology. Other commercial financing approaches could be adopted, especially at medium TRL stages, to catalyse defence investment. Adoption of some UK National Wealth Fund’s (NWF) practices (debt guarantees, match-funding, etc) may offset some of the early-stage investment demands, especially where there may be a dual use for a particular technology. There is a clear case for an arm’s length Defence Growth Fund to complement the smaller ticket sizes of the National Security Strategic Investment Fund (NSSIF); more detail follows.

In all this, the centralisation of expenditure on the National Armament Director is a genuine opportunity but also a significant risk. Bringing skills, expertise, purchasing power, tech scouting and a wider perspective than any one Service can hold across the Defence portfolio is a huge opportunity. But the threat to innovation is suffocation through centralisation. If innovation is to thrive, it needs to be unleashed, not controlled, and developed as close to the point of use as possible. The fastest and most dynamic innovation is occurring on the Eastern plains of Ukraine, it is difficult to see the parallel with MOD Abbey Wood.

Choices

Innovation works in commerce because the financial and risk structure is built around finding and exploiting advantage and recognising that not everything is successful. Successes buy out losses and generate a net return on investment. MOD could adopt this approach with graduated risk, progressive scrutiny, dedicated finance and bolder delegations. Overseen by the NAD, it is vital that the innovators are as close to those who struggle with the challenges on a daily basis. Innovation isn’t defence acquisition on a small scale, it is comprehensively different eco-system, and it needs to be hard-wired to both cause and catalyst.

So, MOD could formalise the smallest Defence investments around the angel approach. More and smaller investments (£10-20k) could be distributed faster through less process, looking for 1 of 100 successes, managed with scientists and holding a tiny net financial exposure (£250k). This would work for emerging technologies where the very very small is grown to the very small and broadly TRL3 (experimental proof of concept). Finance, risk and management boundaries would formalise this tech scouting role and build a pipeline of opportunity.

Successful angel investments could graduate and be funded by small investments (£100-200k) and limited processes. MOD could look to solve Defence challenges with proven technology being content with around 1 of 100 successes. The Services’ CTOs, closely advised by operational personnel, could run this enterprise with a small net risk exposure (£1-2m). Those tech picks that work should get to at least TRL4 (proven in a lab) in 6-12 months, no more.

These could be pulled to TRL6 (demonstrator) through a dedicated Command-specific Growth Fund with a net £10-20m pa. Distributed through fewer investments £0.5-1m aiming at a 1 in 10 conversion rate, governed by a Board chaired by the Service’s head of equipment and managed by people ‘just back from the frontline’ with a hunger for pace. This could be the engine room of innovation looking simultaneously upwards at the operational challenges, downwards at the technology coming through and sideways into the core programme to secure scale headroom.

These investments would be regulated by risk profiles, financial terms and scalable commercial practice, overseen by the Services’ ExCo, directed by the head of capability, managed by a ‘fund manager’ and be financially accommodated within the core budgets. The Command net financial exposure should not be more than £40m pa (of £8b or 0.5%) or £200m across the Department.  

Some of these protocols exist, UK Defence Innovation will add energy and detail to bringing this together, but not all the plugs are in the sockets. Rarely do big bets deliver significant shifts in innovation and there is substantial risk if they don’t, so MOD may wish to broaden the innovation enterprise in a manner far more aligned with successful commercial market practices.  

Capital

If innovation flow can be fixed, Defence could also look at using more market capital. Historic Private Finance Initiative excess profit margins (>25%) have tainted the notion of market money, but a refreshed approach would unlock opportunity. Key Treasury policies regulate the use of private capital around risk ownership and the degree of control MOD retains, but market capital could be a much bigger and direct component of Defence investment.

The UKIB was commissioned to catalyse green investments, but is spreading its wings under the NWF moniker. Its £27.8bn, Bank of England debt guarantees and match-financing from the markets at 3 to 1 investment should see some £100bn of net investment. Whilst much of the Defence Investment Plan must be on the MOD balance sheet for obvious reasons, there is a lot which could sit off it, especially tech that is purchased ‘as-a-service’ like cloud storage or has dual use applications in some way.  

The aggregated Defence Innovation Funds are around £200m when matched with debt guarantees (£200m) and match-financing at 3:1 would generate an eco-system of £1b pa. Whilst this represents 2% of the MOD budget, it is big enough to make a very big difference to propel innovation into combat whilst protecting much of the core programme from wider acquisition pressures within Defence and elsewhere.  

Alternatively, MOD could create a Defence Growth Fund. It could take an allocation from HMG and investment funds for deployment into Defence and security priorities, specifically to identify and scale successful innovations. Saibre Capital has the national interest at its investment heart (security, energy, health, transport and communications) and is catalysing projects with dual-use application and scalability at home and in friendly foreign companies and countries. Holding risk outside the department and withholding control allows investments to sit off the MOD balance sheet. Some £5bn of MOD investments per year, or £50bn over ten years, could be funded through these service models, flattening the capital requirement and making lethal tech more accessible and faster to the war fighters here and overseas.  

Similarly, extending the 1991 European Reconstruction and Development Bank principles – continentally-centralised financing of major capital projects – to a European Rearmament Bank has benefit. A strongly capitalised facility, offering AAA credit, cheaper than the national bond markets, would allow MOD to borrow and invest more for less debt interest per annum. A centralised facility could pressure defence price points down, flow in innovative approaches and extend unit sales across a broader number of countries.  

All these approaches – a national defence growth fund, a national deals/advisory business or a continental defence bank – all have the ability to drive investment up, price points down and make defence more affordable. Innovation is not just about hardware and software, it is also how we finance, purchase, support and decommission capability. Collectively, these approaches could:

- raise a £100bn private fund (in £10bn chunks) to develop new technologies

- invest in sovereign start-ups and established businesses, within the UK

- focus on projects that are strategically important to the UK government and military

- operate across Government security interests with spin-outs aiming at other sectors

- provide the best financial returns for investors

- own the created IP through its spinout businesses

- use creative business thinking to make important projects privately investible

- market these technologies internationally.

To access these benefits, the UK government would need to:  

• define the terms more clearly around which market capital could be used

• define more clearly where HMG wants innovation to act

• collaborate on the development of solutions

• direct/endorse where IP might be sold on into

• contract for services developed without a competitive procurement process.

Lord Willets’ 1993 Opportunities for Private Financing in the NHS pamphlet advocated growing MOD employment of market capital. Measured adoption of government grants, debt financing, equity match-funding and bond-issuing could help address some of the financial challenges. Commercial practices can help in some of this. Bank of England and London Stock Exchange advice could flesh out the opportunity. The UKRI, BBB and UKIB models could be mapped across into Defence. The British Private Equity & Venture Capital Association could steer structure and rule setting. The National Association of Pension Funds could advise on Defence investment risk weighting. The CBI and FSB could champion Defence capability. And the London City Corporation could act as a form of fulcrum.  

Commitments

Innovation is key to surprise which is vital on any and every battlefield since records began. But there are significant hurdles preventing its flow to the front line; these are institutional and cultural. If MOD were to mandate headroom in budgets to accommodate new capabilities in year, adopt an angel-venture-equity approach to regulate their speculative investments and access more market capital to grow its breakthrough technologies, it would get close to the 5% apportionment to emerging technology.

Fixing Defence innovation flow, through accessing market methods and capital, would be central to an enlightened Defence budget that propels emerging technology, capabilities and concepts more quickly to the battlefield to directly ‘protect the Nation and help it prosper’.