Dispatch From The Farnborough Air Show: Five Challenges for Negotiating Aerospace and Defense JVs in 2016
WE RECENTLY RETURNED from the 2016 Farnborough Air Show, where industry executives get tours of the wares on offer from the likes of Boeing, Airbus, Lockheed, Embraer, and others, reconnect with their peers over daily coffee and nightly cocktails, and do business — to the tune this year of $35 billion in orders for Airbus and another $27 billion for Boeing, and plenty more for others.
Inevitably, the close proximity of hundreds of dealmakers led to discussions of partnerships and joint ventures as well. Over the course of the week, Thales and Elettronica announced a new JV for developing and selling electronic warfare equipment, and Safran and Hindustan Aeronautics agreed to a new MRO partnership to service helicopter engines in India. Yet it seemed like just as many were restructured or terminated — for example, Rolls-Royce announced its intent to buy-out the remaining 53% of its ITP joint venture for engine components, Thales and Raytheon restructured their TRS radar systems JV, and Safran and Honeywell terminated their electric taxi system JV.
When we mentioned this to the head of M&A at a global aerospace and defense company, he told us, “It’s strange, but fewer and fewer joint ventures in this sector are actually getting done, let alone succeeding — even though just as many ideas are crossing my desk as ever.” A look at the data confirms his view — annual JV deal volumes in the industry have dropped 40% from 5 years ago (Exhibit 1).
So what’s going on?
We asked a dozen dealmakers at Farnborough about this, and came away convinced that Western aerospace and defense companies continue to consider joint ventures as part of their international growth strategy — but there are five big challenges in 2016 that are causing real headwinds for getting JVs done in aerospace and defense:
- Regulatory restrictions on foreign ownership and control in the industry’s biggest growth markets: Arguably a factor that should lead to more joint ventures, strong limits on foreign ownership have actually kept many companies on the sidelines, given the heartburn caused by having to share sensitive technology with a local partner/competitor while being forced into a minority, non-controlling role.
- Negative experiences with significant JVs among key industry participants: Unlike industries such as oil and gas, where almost all business is carried out through a JV, companies in aerospace and defense see doing a JV as an “unnatural act” — to be chosen only when all other forms of partnering fail. Many JV negotiations then fail as the parties are unwilling to reach compromise on shared control, economics, IP transfer, etc. There’s also a feedback loop caused by the fact that so many JVs start out internally disliked and under challenging business circumstances — and when they fail, it simply re-confirms the notion that JVs should be avoided.
- National security and company concerns around IP protection and technology transfer: Aerospace and defense companies struggle with the traditional challenge of managing IP protection when doing deals in emerging markets with potential competitors — but they also have to manage their own regulatory regimes and restrictions on IP exports. One US executive outlined the concept of a JV in the Middle East that would buy US military equipment, make value-added changes, and then re-sell it to other GCC countries; the deal fell apart under the challenge of having every single JV sale reviewed and approved by a sclerotic US government bureaucracy.
- Misalignment between partner wants and needs (particularly around offset requirements): Part of why many western A&D firms view JVs with suspicion is that they are increasingly required as a way to meet offset obligations (for example, the UAE currently requires all offset obligations to be delivered through a JV). The offset JV typically comes with a whole host of misalignments, as the western firm is seeking to do as little as possible while gaining access to the market, and the local firm (backed by the government) is seeking maximal skills and technology transfer. This gap can be a bridge too far, particularly when the local firm has designs on being a regional or global competitor eventually capable of doing the work without help.
- Difficult business cases, particularly in offset-mandated relationships: Many JVs in aerospace and defense, particularly if being pursued for offset requirements (or even market access more generally), are likely to be financially challenging. When local partners lack necessary skills and infrastructure, there are significant costs involved to get the JV up and running — particularly if expatriate labor is required for the long-term. Often, JVs in the industry are a loss-leader — designed not to be profitable on their own, but to unlock billions of equipment sales whose overall margins are more than healthy after covering the JV’s losses. This is fine for the company CEO, and for the business unit president whose aircraft are profitably sold — but a tough pill to swallow for the business unit president who has to agree to, and carry, the unprofitable JV on his or her books.
Given these challenges, dealmakers continue to look at JVs in places like India, UAE, Saudi Arabia, Qatar, and Turkey, but it’s harder and harder to reach closure — and less appealing to go through the difficulty of forming a JV in the hopes of winning a contract. In the absence of new JVs, dealmakers are finding workarounds — more teaming arrangements, expanding existing partnerships, etc. — while trying to convince regulators to ease up on the structural barriers (witness India’s recent relaxation of foreign ownership limits in defense, and whispers that the UAE will again allow for offset credit to be earned without complex joint ventures).
One other thing that dealmakers seem to agree on is that the MRO sector seems to be exempt, where the increasing importance of the aftermarket is touching off all kinds of new civil and defense aerospace JVs to help manufacturers win the space (and, not coincidentally, sales and service is also the easiest part of the value chain to manage from an IP and export control perspective).
What does this mean for the future?
For starters, we expect to see more MRO JVs, particularly between OEMs and their customers (which is always a tricky). But we also believe that in the absence of M&A consolidation, more manufacturers will find themselves doing JVs to gain scale economies — like the new Airbus-Safran Launchers, or the consolidation JV of KMW and Nexter — as defense budgets are simply not large enough to support all of the programs on the books. And the costs — and risks — of developing new technologies and programs will continue to drive firms to consider partnerships as a defensive mechanism. Finally, as long as customers in emerging markets continue to require some form of joint venture, manufacturers will be hard pressed to say no to a JV forever, if it means saying no to a sale.
Given the global nature of the aerospace and defense industry, its costly and complex products, and the wants and needs of buyers, joint ventures will always be part of the discussion — but it will take a creative dealmaker to overcome the challenges and have a new joint venture successfully take flight.
© 2007–2015 Water Street Partners. All rights reserved.
Originally published at www.waterstreetpartners.net.