Dual-use technologies offer attractive defense entry point for private capital firms

Dual-use technologies (i.e., items that are designed for commercial/civil use but that can also be used in battlefield, security, or weapons proliferations purposes, such as drones, artificial intelligence, cybersecurity systems, and quantum computing) are a rapidly expanding area of investment focus for private capital firms.  

The broadening definition of defense beyond traditional hardware is creating significant value creation opportunities, but it also brings legal, regulatory, and practical challenges that require careful consideration.  

Dual-use portfolio companies attract interest from primes and private equity 

The rising interest in dual-use investments is in part a response to increasing government investment in defense. But it also reflects the fact that dual-use companies are often easier to reconcile with limited partner ESG mandates and ethical sensitivities than direct munitions manufacturers (an issue we explore in more detail here).

They also offer a more diverse set of exit options, with dual use assets potentially of interest to both defense primes and private equity buyers. For the latter, we see particular interest in commercial-first, defense-adaptable technology under AUKUS Pillar II, which covers cyber, AI, electronic warfare, quantum, hypersonic/counter-hypersonic missiles, and undersea systems. 

The principal deal execution challenge for investors is regulatory. Dual-use companies are subject to the same scrutiny that applies to munitions manufacturers in areas including foreign direct investment reviews and export controls.  

Personal data now treated as a dual-use asset 

Sensitive personal data is also now expressly treated as a dual-use asset with national security implications. In the U.S., the Committee on Foreign Investments in the United States examines whether transactions may expose personally identifiable information, genetic details, or other sensitive data of U.S. citizens to access by foreign governments or persons.  

The Department of Justice’s Data Security Program (which prohibits, with some exceptions, the transfer of “bulk” sensitive personal data and government-related information to countries of concern including China, Hong Kong, and Russia), goes further, requiring any U.S. business that shares such data with a non-U.S. entity to have in its contracts a provision to stop it being transferred to the countries of concern. 

Robust diligence requires detailed assessment of financing structures 

Diligencing a dual use company (which may be relatively early in its growth journey) requires a detailed understanding of their financing structures. Again, in the U.S., government-affiliated investors such as In-Q-Tel (the CIA’s investment fund) often inject capital into early-stage businesses developing technologies in aligned areas.  

These stakes are credentializing for the business but are likely to come with extensive governance rights which may include board observer seats, information rights, and rights to negotiate future use of the technology. This is the case even where the initial investment may be relatively small.  

In preparation for an eventual exit, we are seeing private capital investors split dual-use portfolio companies into separate military and non-military arms connected by inter-group licensing agreements. The separation is designed to maximize exit value by broadening the potential acquirer base for the civilian business while preserving the higher-value military component for a more targeted sale.  

And as the definition of what constitutes a defense asset expands, private capital investors need to assess the profile of their existing portfolio companies with this in mind when considering their exit options. As we explore here, initial public offerings (IPOs) are an increasingly attractive option given investor interest in defense-related assets, and the fact that national security restrictions mean the universe of trade buyers for such businesses is likely to be limited.