The importance of public procurement

10National defence is a matter of sovereignty. States have the responsibility to ensure the defence and security of their country. As such, governments are very sensitive to the innovative capacity of this strategic industry, as this has a considerable impact in their ability to remain militarily superior to potential enemies (Dupuy, 2013).

11DTIBs are complex systems, which are both costly and risky. As such, they are inherently capital intensive. Public procurement therefore plays a significant role in reducing risk and attracting private investment in a given area or program (Uyarra et al., 2014). Defence systems are all the more complex because they usually imply longer development projects, thus exposing companies to strategic government changes or budgetary restrictions (Belin, Guille, 2008). This creates a double dependency between the governments and defence businesses (Bellais, Oudot, 2008). Indeed, the demand for military technology and equipment is highly dependent on the level of government involvement in armed operations. Therefore, in order to overcome the opportunity costs associated with military equipment production, businesses need to be reassured by public support (Borras, 2004). In other words, unless a continuous public defence policy is in place, there is an increased risk of losing national technological knowledge and capabilities (Carlsson, 2003).

12Domestic public demand thus represents an essential component in the business model of defence companies. A close cooperation exists between the military and their national suppliers in most defence systems, which is essential to the development of major weapons programs. This interdependence tends to greatly reduce learning costs because the practical experience of military officers on the battlefield becomes a direct input for product development (Mérindol, Versailles, 2010). Serfati (2008) also notes that program abortions are rare in this area, despite the fact that costs and deadlines are often underestimated. He argues that interrupting such programs would have indirect costs associated with decreased national security and sovereignty. Thus, the defence industry has its own mode of operation, which is quite distinct from traditional markets.

13Public procurement can be defined as programs designed to streamline the acquisition of goods or services by a public institution (Edquist et al., 2012). These “innovation inducing” acquisitions have to deal with at least three forces: international pressure, the socio-economic environment and the political context (Lember, 2014; see Table 1). In the case of defence, these programs aim at maintaining military supremacy (Serfati, 2008) by creating incentives to technological development. This is especially true in the event of external threats such as international instability or the risk of war. Such risks lead national states to maintain a continuous demand for weapons and equipment to their armies according to their economic strength and the perceived level of insecurity.

Table 1

Context of public procurement policies for innovation following the typology of Lember (2014): complementary factors in the case of defence policy

Level of analysis Institutional factors (Lember, 2014) Complementary factors in the case of defence policy International pressure Norms (administrative and economic standards and innovation policy) Regulations (trade) Economic pressures linked to globalization Evolution of perceived threats and the nature of conflicts Evolution of international power relations Socioeconomic Environment Economic climate and development (market capacity) National Innovation System Military budget and structure of the DTIB Financialisation of the economy and privatisation Political context State structure and governance, Public procurement systems and values, Innovation support policies Ties between government and defence industries Political propensity for war or peace Defence policy and national strategic choices

Context of public procurement policies for innovation following the typology of Lember (2014): complementary factors in the case of defence policy

14The influence of the state, however, is not limited to military procurement (Stowsky, 2004; Dombrowski et al., 2002). The state also plays an important role as industry regulator, establishing rules, authorizing or prohibiting exports, granting access to foreign capital, determining the degree of market openness to foreign competition.

15Moreover, the involvement of the state also depends on its position vs. military technology producers, as well as the overall priority of defence industries in the national innovation system (Moura, 2011). The state is therefore an essential part of any innovation network. As the primary customer of defence companies, governments exert enormous influence on the decisions to pursue dual military / civilian product lines (spin-off or spin-in effects). Their support is also a decisive factor for developing new innovative projects and stimulating companies to seek cooperation opportunities in R&D.

16In this context, the direct involvement of the state may create incentives and disincentives of various kinds (Borras, 2004). In the US for example, until the mid 2000s, companies were relatively little incentivized to export, as the domestic market guaranteed them enough revenues (Depeyre, Dumez, 2010). This was not the case in Europe, where national markets are much smaller and where state actors have different motivations than those of the United States at least for two reasons: European states have much stronger budget constraints and are positioned as “followers” in military innovations (Jordan, Williams, 2011).

17Financial factors have also influenced European defence industries. The European Maastricht Treaty of 1992 imposed convergence criteria in public spending. As the defence budget has so often been an adjustment variable of public spending (Hébert, 2010), most states chose to limit their military expenditures. According to Hartley and Sandler (2003), this can be considered as a major disruption: seeking more efficiency in public procurement, governments prioritized “off-the-shelf” solutions and outsourced certain government functions, using public / private partnerships in some cases (e.g. UK). In this context, states were less reluctant to privatise certain industries or open their capital to private investors (Dupuy, 2013). Furthermore, according to Serfati (2008), the so-called “long war” that evolved since 9/11 inflated global military budgets, creating interesting opportunities for investors, leading to the financialisation of the defence industry in the 1990s (Gentilucci, 2013).

18Therefore, the end of the Cold War changes the position of the State and their role in defence procurement (Versailles, 2005). In a context of economic openness and liberalization, the general philosophy of its evolution was rather liberal. Motivated by the urge to lower costs, States have often incited competition among supplying companies, to the detriment of a long-term perspective of fostering innovation and creating new knowledge (Avadikyan et al., 2009). They also exploited the concept of dual military / civilian product lines to justify reduced military spending (Bellais, 2005). In this context, defence companies found themselves more directly subject to competitive pressures (Sachwald, 1999) and needed to diversify their activities to find new markets.

Consequences of the role of the State in industrial restructuring

19According to Hartley and Sandler (2003), the environment of defence companies is composed of three factors: political (nature of conflict and positioning of the States in relation to war and peace), economic (defence budget and overall importance of the DTIB) and technological (pace of innovation and product development). Pressured by these three forces, companies tend to seek to reduce transaction costs when they decide whether to invest in innovation and market expansion.

20In the early 1990s, both technological and political forces conspired to change the structure of the defence industry. On the one hand, technical complexity increased the cost of military equipment and barriers to entry in this market. As a result, the bargaining power of systems manufacturers in the United States improved significantly (Depeyre, Dumez, 2007). On the other hand, the shift from defence to security policies with the rise of terrorism and the changing nature of conflicts, particularly noticeable from the late 1990s, also tended to favour certain sectors such as defence electronics (Serfati, 2008).

21Thus, the positioning of the state as a defence client has had several impacts on the activities of defense companies such as:

• A sharp contraction in the DTIB, leading companies either to abandon the production of military equipment and refocus on civil products, or to specialize in defence operations or to pursue a dual strategy to take advantage of potential synergies between the two types of product;
• Significant structural changes, with mergers and acquisitions leading in some cases to an oligopolistic structure and the growing influence of financial actors.
• Increased competition among companies pushed them to pursue external markets and to develop cooperation agreements for complex weapons programs. In some cases, defence companies coped with competition by scaling up to the national, European, transatlantic and international levels, horizontally or vertically. Some chose to also open their capital to domestic and foreign private investors. In Europe, this trend also led to the privatization of defence companies.

22Blom et al. (2014) link the increased willingness of defence companies to export and cooperate domestically or regionally to two public procurement criteria: increased quality requirements and the demand for specialized (or diversified) expertise. Thus, as states require their suppliers to be able to produce a wide variety of equipment with increasingly specialized skills, companies tend to seek cooperation opportunities in order to benefit from resource complementarity and shared technological spillovers. This cooperation results, in a second stage, in an increased capacity to export and to develop a greater variety of products. As far as internationalization is concerned, however, defence companies have had a more heterogeneous reaction on how to adapt to the changing environment (Melitz, 2003; Helpman et al., 2004).

23In a globalized world of increased competition and major technological change, strategic changes also affected the way defence companies invest in research and innovation. For governments and businesses facing limited financial resources, the concept of technological duality seemed appropriate. Military products could benefit from civilian technology and, conversely, companies could also monetize their military research by exploiting these technologies for civilian purposes. However, the benefits of technological duality have been often overestimated. A weapons system is built with specific military requirements that give it superiority over competing systems; when civilian technologies are used, they often need to be adjusted (Uzunidis, Bailly, 2005). Indeed, military requirements are very specific and so are the related technologies (Quenzer, 2001). According to Mérindol (2005), armament programs require tacit and explicit knowledge which is oriented towards solving a specific military problem. Therefore, even if the duality may be possible on the domain of basic research, very rarely is it the case when it comes to developing dual-use equipment. Caught between the constraints of an imperfect duality strategy and increased competition fostered by public procurement policies, companies had to review their R&D priorities.

The role of the state as customer since the 1990s: the cases of Germany, France and the UK

24The evolution of military spending among these three countries followed different trajectories since the early 1990s (Annex 1). Budget reduction was much more massive in the German case. The French DTIB benefited from constant support from the government, with military equipment expenditures suffering less cuts over the period, stabilizing around 1998. The UK maintained its overall equipment expenditure levels throughout the period. After 2001, Germany kept its budget constraint policy, while France and the UK boosted their military spending until 2001. Despite reductions after the 2008 crisis, expenditure levels remained quite high for these two countries, with the UK spending more in 2014 than it did in the early 1990s. The decision by France and the UK to sustain the levels of expenditure over the last two decades despite strong financial constraints, in contrast with Germany’s low budget policy, reflects the different positions of these states, as described in Appendix 2.

The positioning of the state in Germany, France and the UK in their defence industry since 1990

25In the UK, the liberal policy of the British government from the early 1980s led to the gradual privatization of enterprises, including defence companies. Moreover, a policy known as “best value for money” for acquisitions, initiated by Peter Levene (director of defence procurement) in 1988 aimed to overcome the double shock of limited public resources and the explosion of development costs (Masson, 2008). He believed that offering greater autonomy to defence companies would give them new opportunities to restructure. Large companies had indeed a global scale, which enabled them to participate in contracts in the United States or Europe. Yet the British military engagement in the Balkans and in Afghanistan in 2001 and Iraq in 2003 highlighted the risks in terms of military capabilities related to excessive autonomy of defence companies. Without abandoning its policy of “best value for money”, the Ministry of Defence (MoD) developed their so-called Defence Industrial Strategy [4] (DIS) and Defence Technology Strategy [5] (DIS) based on the concept of Smart Procurement. These two initiatives aimed to identify strategic partnership opportunities between the state and the defence industry in order to develop critical skills and technologies. In this context, public-private partnerships multiplied.

26The strategic development of the British industry over the last two decades can thus be divided in two phases (see appendixes). In the first phase, during the 1990s, European or US investors managed to acquire UK defence companies while the British themselves invested heavily in the United States. Foreign investment funds thus increased their presence in the British DTIB during this restructuration phase. During the second phase, however, as the UK was involved in the aforementioned conflicts in the early 2000s, the government was determined to play a more influential role in public procurement. In 2007, for instance, the MoD refused to contract with naval manufacturers until they accepted to update their innovation programs (Masson, 2008). Due to this repositioning of the British state, larger companies sought to develop advanced skills in the fields of national defence and sovereignty. This is the case of BAe systems which, through acquisitions of specialized subsidiaries in the British territory over the last 10 years, have gained an increasing share of funding from the MoD (Matelly, Maulny, 2013). In spite of these efforts to liberalize and open up the British DTIB, apart from a few cases such as Rolls Royce, the majority of British defence firms remain very specialized – perhaps due to the overall national trend to divest from industrial activities in favour of the financial marketplace.

27The German model is different from the aforementioned case. The end of the cold war brought two contradictory goals that are still visible in the country’s defence policies: on the one hand, a willingness to legitimize an autonomous national defence in the context of German reunification and European integration; on the other hand, a desire to downplay the cold war legacy by massively reducing military spending while trivializing arms production. Thus, military spending decreased by 31.4% between 1990 and 1997; in comparison, military spending in France fell by 9.7% over the same period, while in the United Kingdom it fell by 20.8%. The drop in equipment expenditures in Germany in the same period was even steeper, at 58%. These policies emphasize the belief that the defence industry is dynamic and efficient enough to evolve with little direct support from the state.

28This position is not new. The German Federal State had never, until recently, held shares of defence companies (Masson, 2010). This detachment explains a certain decline of the German defence industry, with many companies choosing to discontinue production for the Ministry of Defence. Recognizing these difficulties, the federal authorities have started to prioritize domestic suppliers in their arms acquisitions programs. Procurement bids were now offered mostly without competition, with domestic companies enjoying systematic preference as suppliers of land and naval military equipment (Uterwedde, 2009). Since 2009, the Defence Ministry established a policy of focusing their investments in large companies, hence limiting the ambition of SME subcontractors. Likewise, the 11^th Amendment Act on foreign trade of July 2004 imposes strict and systematic control over foreign acquisitions of defence companies, limiting its participation to 25%.

29Under these conditions, German defence companies who have chosen to continue producing arms became ultraspecialized and heavily dependent on public orders (as in the case of Diehl). Their perimeter of activities evolved little (Krauss-Maffei Wegman, for example). Investments remained private, and capital remained in the hands of existing investors, mostly traditional German families. More recently, however, the quality reputation of the industry has facilitated their access to emerging markets. German investors have thus started a process of acquiring interests in foreign companies (in the case of Atlas Electronik Group, for instance, 55% of their 2013 turnover was realized in Greece, South Africa and Malaysia – see annexes).

30The involvement of local German Federal States (the so-called Länder) is also very important for defence companies. This is the case of OHB, a major industrial player in the European Galileo program. Their growth of almost 600% in turnover since 2004 is due to the massive support from the Bremen region. This policy resulted in the formation of important regional clusters around large companies, creating opportunities to develop a dense and diversified network of small and medium enterprises. Such clusters facilitate the multiplication of cooperation agreements with the civil sector, boosting regional growth (see, for example, the case of Rheinmetall and the involvement of the automotive industry in the development of a light armoured vehicle). However, as a result of this regional focus, German companies have little interest in European cooperation. The recent partnership between KMW and Nexter seems to be an exception to this rule (Masson, 2012).

31France’s trajectory constitutes a third model. Public policy has prioritized national independence and strategic autonomy (Fontanel, Hébert, 1997). The end of the Cold War has definitely had an impact on this model, without however altering its core principles and general structure (Hébert, 1993). Based on a framework of deterrence, France’s DTIB has played an important role in the national innovation system, even if it is sometimes seen as an inertial factor leading to national specialization (Miotti, Sachwald, 2004). Underlying French public procurement policies is the notion that the market alone cannot ensure the adequate development of technologies and equipment necessary for national defence.

32Even though the public procurement program was reviewed in the 1990s with budget cuts in mind, the government agency known as General Delegation for Armaments (Délégation Générale de l’Armement or DGA) remained a strong influencer of technological defence capabilities through its direct involvement in major weapons programs. In spite of a wave of privatizations, the State retained a significant stake in these companies while seeking industrial partners rather than institutional investors (Hébert, 2006). The French state proposed the concept of “competitive autonomy” without actually opening the domestic market to foreign competition. The policy was clearly mercantilist in nature, relying on a strong support to the export of arms and the systematic use of national preference as a criterion for arms acquisitions. As a result of this state policy, key players in the meso-system of defence chose to merge in order to create large defence groups in their domains. Armoury specialists like DCNS and Nexter chose to remain focused on arms and equipment production, while less traditional companies in electronics and aerospace companies (like Airbus, Safran and Thales) chose a dual strategy of serving both military and civilian markets.

Industrial restructuring in Germany, France and the United Kingdom since 1990 and the role of public procurement

33The tables and graphs presented in the appendices are intended to portray the strategic evolution of defence companies in the three countries studied since the early 1990s. The state, main customer of these companies, played a key role in those strategic changes on at least three aspects: by influencing the nature of their activities (Appendix 4), by opening up their capital to foreign investors (Appendixes 3, 5 and 7) and by being a leading provider of funds (Appendix 6).

34German companies show a significant drop in their defence sales. Some of them, like Siemens, even dropped out of the SIPRI ranking. Those that remained had to concentrate (Krauss-Maffei, Wegman, for instance) and specialize in defence (44% of total revenues in 2013 as compared with only 28% in 1990). The decline in defence-related employment has been much more massive in Germany than in France or the UK. There are more British companies in the ranking in 2013 than in 1990, suggesting a high concentration in niche expertise areas (for example, Cobham, Meggit) that were prioritized by the Ministry of Defence. The central player in the British DTIB is BAe Systems, whose turnover in the defence area has increased exponentially thanks to a strategy of mergers and acquisitions. Ultraspecialized on military equipment production, the company is present in all areas of defence, thus becoming an essential partner to the MoD. The French DTIB is positioned as an intermediate model. The number of French companies in the SIPRI ranking has, as in the German case, sharply decreased. This was due rather to the process of mergers than to French companies leaving the defence sector, as was the case in Germany. The numbers concerning defence activities and defence-related jobs have also remained fairly stable in France between 1990 and 2013. The defence turnover of these companies has, like the UK, increased significantly (see, for example, the case of Dassault).

35The choice to open up the capital of defence companies to foreign investment was also influenced by public policy in some of the cases. Like the model described by Blom et al. (2014), liberalization and competition have pushed British companies either to export or invest in foreign markets, particularly the US. Cobham, for instance, acquired 60 US companies between 2000 and 2010 (Masson 2010). On the other hand, foreign companies also invested in the British domestic market. The German government favoured a twofold strategy: to protect specific sectors where dual product lines proved complicated (such as land and naval industries) while inciting companies in aerospace to diversify and find European partners. The birth of EADS / Airbus is an illustration. It was initially the product of an ongoing cooperation between the German company DASA and British BAe systems.

36Another aspect about the role of the state concerns the decisive importance of the traditional relationship between companies and their country of origin. After opening up their capital, British companies invested primarily in the US, a very familiar, Anglo-Saxon culture with a heavy presence of the state in defence. German companies, but also to a lesser extent the French, took longer to open up but they eventually succeeded in exporting or investing in more diversified markets in Europe, Asia and the Middle East, among others.

37In the area of corporate finance, again the three models differ in large part due to the role and position of their states. In the post-World War II era, only the French and British states had ever taken part in the capital of defence companies. The change of context in the 1980s and 1990s has led to the privatization of these companies. In the case of the UK, the government has chosen to widely open up the capital of these companies while establishing a Golden Share which limited the weight of each investor. Company shares were held by many investors, often institutional. These private investors held each a small part of the capital (a 13% limit for Invesco Asset Management in the case of BAe Systems, for instance). In France, the government preferred to favor industrial investors and maintain a state presence in the capital. Their IPOs came a later stage (Belin and Guille, 2008) and their capital structure is less diverse. The shares that are not owned by the state are held by other defence companies. The German case is less dynamic; the German State did not wish to hold shares in their defence companies but at the same time chose to limit the presence of foreign investors. These companies continued to produce military equipment, usually remaining in the hands of large industrial families. In a few cases they were briefly owned by foreign interests, as was the example of ThyssenKrupp Marine Systems (25% of its shares were acquired by US investor One Equity Partner in 2006 and then sold back to ThyssenKrupp in 2009).