The defense and aerospace sector is in the midst of overlapping structural and technological revolutions. The Department of Defense (DoD), with strong Congressional support, is pushing defense companies to be more innovative. The military services have also taken up the mantra of calling for faster change and greater innovation. Emblematic of this drive was the first strategic message to his service by the Air Force Chief of Staff General C.Q. Brown titled “Accelerate Change or Lose.”
The change to which he is referring will be comprehensive: organizational, operational, and technological. The DoD is supporting this effort to move faster and be more innovative by adopting new ways of contracting with the private sector, and by creating special funds to help small, innovative companies enter the defense market.
An important tool that contributes to the private sector being more innovative and accelerating change is mergers and acquisitions. In response to the trend of reduced defense spending, as well as reductions in the number of major programs, the defense and aerospace sector has been in a continuous state of consolidation since the end of the Cold War.
In addition, until the recent drive toward shortening acquisition timelines, major programs often took fifteen years or more to go from initial design to full-rate production. Scale and financial resources were also important for the ability of defense companies to survive changes in national security priorities or decisions to cancel major acquisition programs. Therefore, small and mid-sized firms often found it extremely difficult to thrive in the defense and aerospace sector. As a result of these factors, the number of major prime contractors has shrunk to, at best, two or three companies in each defense subsector.
Mergers and acquisitions will continue to be an important tool for defense and aerospace companies in accelerating change, improving their performance, reducing costs, and providing the rapid innovation demanded by the Pentagon. Recent examples include the merger of L3 and Harris; the merger between Raytheon and United Technologies; the acquisition of Sanders Electronics from Lockheed Martin by BAE Systems; the acquisition of OrbitalATK by Northrop Grumman; and finally, the proposed acquisition of Aerojet Rocketdyne by Lockheed Martin.
But where mergers and acquisitions may be particularly significant is in bringing unique products to bear on critical defense problems. The acquisition of small and mid-sized companies (particularly those without a foothold in the defense sector) by larger firms is an important way of providing them with the access to customers, financial and human resources, and management support required to enter and survive in the defense market.
Over the past several years, the Federal Trade Commission (FTC) has pursued several misguided antitrust investigations and suits. One of these was against Qualcomm, despite senior DoD officials warning that this would harm national security. The recurring theme in these actions is the need to reign in corporations based on size or market presence. This reflects a growing sentiment at the FTC that corporate success as reflected in size or dominant performance is suspect. As a recent Wall Street Journal editorial observed, the premise of the new approach is that “big is bad.”
Efforts by the FTC to impose outdated antitrust standards on companies involved in multi-year defense procurement contracts could pose a direct threat to national security. Only companies that are uniquely capable of designing, developing, and producing sophisticated stealth fighters, such as the F-35, or secure cloud environments that operate from headquarters in the U.S., such as the Joint Enterprise Defense Infrastructure (JEDI) system, can ever meet DoD’s strict requirements to do so.
These companies need experience, scale, a breadth of talented personnel, and deep pockets. When it comes to bringing commercial products to the defense marketplace, it is also important to have experience in navigating the labyrinth of defense acquisition regulations, accounting standards, and approaches to funding.
It is common for innovative start-ups to focus intensely on developing and proving their technologies. They may expend all their resources to get one prototype developed. Smaller or newer companies may lack the personnel and resources to move their business from the laboratory to manufacturing and distribution. In addition, when it comes to entering the defense marketplace, such companies face additional headwinds if they must wait the eighteen months to two years it often takes to get money for their specific technology included in the defense budget.
This is one example of how innovative smaller companies can be set up to succeed through being acquired by a larger prime contractor. When the merger involves vertical, rather than horizontal, integration, the result is not a reduction in competition but rather an increase in efficiency and lower costs to the customer. The standard approach in a vertical merger is to address any potential competitive issues with behavioral remedies, such as contracts to guarantee pricing or access. These remedies have been proposed by Lockheed Martin in response to criticisms of its proposed acquisition of Aerojet Rocketdyne
This is where the FTC’s tendency to presume harm even where none can be proven goes beyond constituting a national security threat. It can also harm the nation’s health. For example, the FTC is opposing the effort by biotech corporation Illumina to reacquire another biotech company it had spun off some years earlier, Grail, which has developed a biopsy screening test capable of identifying more than fifty different cancers.
Illumina had branched off from Grail some years back. As in the cases of larger defense firms acquiring smaller companies that lack the resources to fully support their own innovations, Illumina can provide the support needed for Grail’s new technology to reach a global market. Any concerns about the impact of the acquisition competition can be addressed through corrective measures, which Illumina has already proposed.
There is a real danger in allowing the FTC to set the kinds of limits on vertical mergers that it is seeking in the case of Illumina and Grail. Not only could this impair the ability of the medical system to detect cancers more easily, but it could also set a dangerous precedent for vertical mergers in the defense, aerospace, and other sectors.
Daniel Gouré, Ph.D., is a Vice President of the Lexington Institute. He served in the Pentagon during the George H.W. Administration and has taught at Johns Hopkins and Georgetown Universities and the National War College. You can follow him on Twitter @dgoure and you can follow the Lexington Institute @LexNextDC