Asset Management | Time to examine mandate restrictions concerning weapons-related investments amid increased defence spending?

Background and context

Demand for military equipment in Europe is rising, as reflected by the EU’s recent allocation of a €175 million Defence Equity Facility to support innovative dual-use products. Strengthening defence capabilities will lead to increased procurement of defence materials, including within technology, a sector that typically attracts venture capital and private equity investments.

Recently, investor preferences and a shift in positions and trends concerning weapons investments have received significant attention in the markets and media. Examples include Danske Bank, which in 2024 opened up for investments in components for nuclear weapons (further explored in BAHR’s newsletter here). Several managers are taking the position that investments in defence are compatible with strategies focusing on sustainable investments, citing that this could help to raise ethical standards and force transparency in a sector historically plagued by opacity and corruption scandals, and whose products present risks of social harms.

Other examples include Norwegian asset manager DNB Asset Management which recently announced two defence- and security-oriented funds. The Financial Times are reporting that asset managers are rushing to establish ETFs focusing on European defence companies.

Simultaneously, a debate is ongoing in Norway concerning the ethical guidelines that govern the investment universe of Norway’s sovereign wealth fund managed by Norges Bank Investment Management (NBIM). For over 20 years, the fund has been restricted from investing in defence companies. Any changes in the mandate of the sovereign wealth fund, although not yet close to being adopted, should be expected to have significant indirect impacts as a large number of Norwegian institutional investors follow the exclusion list applied by NBIM.

Implications for asset managers – mandate restrictions

In our experience, restrictions relating to weapons banned by international humanitarian law – such as cluster bombs, anti-personnel mines, biological and chemical weapons – remain uncontroversial for both GPs and LPs. However, far-reaching restrictions on dual use products and components can result in unintended exclusions. The anticipated increase in defence spending may end up limiting the investment universe for future (and potentially existing) funds more than anticipated, particularly concerning restrictions on investments in military-related materials such as equipment, services, and technology.

We often see investor requirements in the form of side letter provisions along the lines of the following:

• The Fund shall not invest in the production of or trade in military goods and services of any kind 

• The Fund shall not invest in any company earning more than 30% of its income directly from the production of or trade in military goods or services of any kind 

• The Fund shall not invest in any company involved, directly or indirectly, in producing, trading with, the procurement, storage or transportation of, weapons of mass destruction or components to the same
  

Such restrictions can have broader implications than apparent at first glance. Depending on the factual circumstances, such restrictions can hinder investments in portfolio companies involved in technologies such as GPS equipment, satellites, night vision technology, thermal imaging, drones, lasers, and others. Also, companies producing high-density alloys, used in civilian infrastructure might be excluded if some of their customers use the alloys for nuclear warheads.

BAHR comments

We recommend asset managers to:

• Thoroughly assess which restrictions to accept for new funds: Managers in the process of establishing new products should strive for necessary flexibility and seek to identify investor concerns to avoid unnecessary broad exclusions that – in hindsight – may not be aligned with the fund’s (or its investors’) strategy.
• Review existing restrictions: Existing exclusions in fund agreements and side letters should be examined to clarify current restrictions. A key practical issue is whether a fund is barred from investing in companies that develop technology and components with dual use capabilities, which can be utilised in both civilian and military applications. Managers who find that existing, far-reaching restrictions are not actually compatible with fund objectives – such as returns – or hinder the fund in pursuing its investment strategy may consider engaging with investors to explore the possibility of aligning interests by clarifying or amending side letters.
• Be attentive to specific risks for investments in defence: Investments in defence-related products or technologies face certain regulatory and security-related risks. Compliance with sanctions and export control laws and regulations is highly relevant. These legal frameworks are inherently complex and subject to rapid changes. Furthermore, general security measures are crucial, particularly in addressing cyber risks due to the growing dependence on digital technologies and networks in defence operations, as well as physical security risks that may impact facilities, personnel and assets.