The European Union’s Savings and Investment Union (SIU) is currently dominating the policy debate across European asset management. In this new era of global fragmentation and competitiveness, Europe wishes to leverage its vast pools of capital to better support its broader economic needs in an increasingly multipolar world.

At its most basic, the SIU seeks to transform European citizens from good savers into market investors by moving money out of their savings accounts into investments inequities, bonds, and other securities. This pan-EU investment account (similar to the Swedish ISK or UK ISA structures) would ultimately grow and diversify funding of the real economy while at the same time improving long term returns to citizens.

From banks to tanks
However, the SIU forms part of a wider industrial policy dubbed “The Competitiveness Compass.” One of the more interesting sub-themes of this political aspiration is that, if possible, the EU would also like to channel some of this additional capital into its defense industry. Or as I recently heard it, “move money from banks to tanks.”

The publication of the white paper “ReArm Europe” further outlines this defense commitment and urges the mobilization of private money to help governments towards the goal of strengthening pan-European defense capabilities.

ESG-D
Recent debate about the compatibility of defense spending with the notion of environmental social and governance (ESG) / sustainability in investment has introduced a new term, popular in policy circles, “ESGD” with the “D” being defense.

Defense has been grouped with sustainability under the notion that without appropriate European military deterrents and capabilities, the EU could be at risk from nations who do not align with the values regarding the environment, societal wellbeing, and good governance. However, others have argued redefining ESG for political goals is a stretch too far and that defense spending remains wholly incompatible with its original principles.

This lack of direction has left many caught between a rock and a hard place.

• Many managers are re-assessing whether they can or should change their approach to investments to the defense sector. However, any change in approach opens asset managers up to accusations of greenwashing or disgruntling investors who categorically do not believe defense to be compatible with ESG principles.
• Despite ongoing industry debate many firms have already committed to not invest in controversial weapons, such as cluster bombs, chemical, or biological warfare, within their corporate mandates. Regardless of regulations or industry discussions, these fundamental exclusions policies would need to be agreed, voted upon, and then re-written to allow for such activities.

Defining defense spending: Home bias?
The question of where the EU intends to spend these investments has also proved complicated. It’s clear, if possible, they wish to channel the investments to primarily benefit European contractors, which creates a potential protectionist stance. The notion of imposing geographic restrictions on investment to flow only to defense firms based within the EU has been touted but this could draw investor ire in the prevailing climate, which promotes that investors should be free to make unfettered investments in the best possible companies wherever they are based and not be restricted or forced to “shop local.”

While asking investors to “shop local” may come with additional incentives, ringfencing capital flows on a practical basis is difficult and goes against some of the core tenets of EU thinking in terms of cross border freedoms in any case.

A private markets play?

There are many large publicly listed EU defense companies likely to benefit from this focus on increased investment across the continent. However the manufacture and supply of modern defense equipment is supported by an extensive supply chain of critical components supplied by small and medium enterprises (SME) across Europe. These firms also require increased investment to scale up supply.

While increased funding of this defense SME sector is vital, the ESGD capital mobilization could also represent a strong private equity / private debt play for asset managers as opposed to solely an equity allocation.

ELTIF 2.0 could also prove to be a promising structure to house such products for a wider group of investors but this structure comes with certain distribution and operational challenges, particularly when seeking to capture retail flow.

European stakeholders want to see defense capabilities improved and that requires wider and more diversified sources of funding, including the mobilization of retail money. However, there are several ethical and policy frictions that must be considered and in the ever chaotic and competitive global arena these are the types of problems that require a shift in thinking from the orthodoxy. Can Europe ultimately succeed? Only time will tell.