Why ESG frameworks are not a barrier to investing in defense assets

Defense and energy security have become significant political priorities for most western governments and are overtaking ESG as the primary lens through which policy and capital allocation are assessed.

The forces driving this are well understood: Russia’s invasion of Ukraine, which prompted a fundamental reassessment of the merits of defense-related investments; the challenge to NATO allies and its Enhanced Opportunity Partners to increase defense spending, which has intensified pressure on national budgets; and a growing desire for sovereignty amid a changing international order. For private capital firms, the question now is how to navigate existing ESG commitments while capturing the opportunity that defense presents.

Sustainable Finance Disclosure Regulation constrains what assets funds can hold

Funds and institutional investors considering opportunities in the defense supply chain must examine their investment criteria carefully. Under the EU’s Sustainable Finance Disclosure Regulation, fund classifications (“dark green,” “light green,” or otherwise) constrain what assets a fund may hold.

Here, the strictest limitations apply to Article 9 (“dark green”) funds: controversial weapons banned by international treaty are subject to zero-tolerance exclusions, conventional weapons are often capped at low revenue thresholds, and investments must pass “Do No Significant Harm” and Principal Adverse Impact tests.

At the same time, the EU Taxonomy, the classification tool for labeling investments as sustainable, continues to evolve. There is also wider discussion around whether ESG needs to become ESSG (environmental, social, security and governance) given current geopolitical volatility.

Both the UK government and the European Commission have provided helpful arguments that defense investments can align with ESG goals, particularly in supporting social sustainability by promoting peace and national security. The EU’s Defence Readiness Omnibus also clarifies that the EU Taxonomy does not automatically exclude defense provided that investments bolster national resilience.

How dual-use assets and side-letters can help address ESG limitations

Against this backdrop, funds are exploring how to gain exposure to the sector, including by revisiting current restrictions in their limited partnership agreements and sustainable investment principles.

Investing in dual-use technologies (which we explore in more detail here) is one potential path through ESG limitations for many investors, with defense-adjacent infrastructure, hypersonics, cybersecurity, and AI assets facing fewer sustainability obstacles than kinetic defense goods.

Side letters are another way for investors to navigate potential ESG limitations at the investor level rather than the fund level. Article 9-classified investors or those with equivalent restrictions (for example sovereign wealth funds subject to national security restrictions or pension funds with fiduciary and stakeholder concerns) can use side letter provisions such as tailored investment restrictions or excuse rights to opt out of specific defense-related investments that would breach their regulatory classification, allowing fund managers to accommodate their wishes while pursuing defense-related opportunities on behalf of other LPs. They also support enhanced sustainability reporting by creating an auditable trail that the fund has honored its commitments to ESG-mandated investors.  

The operational implications, however, should not be underestimated. Where investors hold excuse rights their committed capital may not be available for certain deals, and if too much capital is excused it could trigger default provisions in subscription credit lines secured against those commitments.