Banks look to lend to defence companies, but many lack the track record to qualify

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Canada’s banks are facing roadblocks to financing the ambitious growth plans of defence companies as the lenders wade into the sector after decades of largely neglecting the industry.

Burgeoning defence companies, meanwhile, are keen to land lucrative government procurement contracts, but are navigating challenges accessing the critical financing required to navigate what is typically a prohibitively long bidding process.

While banks that historically shied away from defence financing are now pledging support for the sector, they need to see that defence companies have secured procurement contracts before they are willing to lend – especially to smaller businesses with uncertain revenue streams and nascent compliance programs.

“They need to get the contracts before they get financing,” Dominique Babin, Dentons Canada LLP partner and co-lead of the law firm’s defence and national security practice, said in an interview.

She has been advising defence and dual-use technology companies – businesses whose products have both defence and non-defence applications – on how to improve their risk assessment, regulatory compliance and other measures to help them appeal to the larger lenders.

“Compliance is an issue. If I’m a bank, I’m requested to invest in an SME that is involved or wants to be involved in the defence sector, I’m going to look under the hood and see if they’re actually ready to do that.”

The disconnect threatens to slow Prime Minister Mark Carney’s initiative to rapidly expand Canada’s defence capabilities. The government has earmarked more than $84-billion in defence spending over five years, aimed at reducing Canada’s reliance on the United States for protection.

The impending explosion of government contracts is expected to ignite a flurry of deals as companies bolster their defence capabilities, including upgrading equipment, building new facilities and recruiting talent. The industry is capital intensive and businesses are seeking equity, lines of credit and working capital loans.

But bankers say the buzz has yet to translate into signed contracts for defence companies in their home market.

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Without defined terms and guaranteed revenue, lending to smaller companies in the sector is a risky bet for banks. Lenders are waiting on more details from Ottawa on how the money will be spent.

Canada’s largest lenders – Royal Bank of Canada RY-T, Toronto-Dominion Bank TD-N, Bank of Nova Scotia BNS-T, Bank of Montreal BMO-T, Canadian Imperial Bank of Commerce CM-T and National Bank of Canada NA-T – must comply with strict regulatory requirements on the amount of risk they are exposed to in their client portfolios.

The defence sector has also dealt with reputational issues in recent decades, with banks avoiding the criticism that comes with investing in or financing businesses linked to military weapons and equipment. That stigma is beginning to ease as global threats rise and governments bolster their defence budgets.

The costs for financial institutions to lend to the sector are high as lenders must balance the increased risk of loan losses and tighter capital requirements by offering less attractive financing terms to defence companies.

“Banks are looking at different roadblocks and they are wondering how to lift those roadblocks,” Business Development Bank of Canada chief executive officer Isabelle Hudon said in an interview.

“Without government guarantees, or loan guarantees that we could provide, it’s difficult for the banks to do it from scratch without the help, support and influence of the federal government.”

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Ottawa has been investing in initiatives in part aimed at attracting funding to the sector. The federal government’s new defence industrial strategy aims to more than triple Canadian defence-industry revenue, as well as boost exports and create jobs.

It has provided additional funding to BDC for loans, venture capital and advice to smaller companies aiming to contribute to defence.

BDC has been building a team of defence and security experts to work alongside bankers and ensure “investments will be aligned to the problem that defence is trying to solve,” Ms. Hudon said.

In January, BDC tapped former Canadian Armed Forces general Peter Dawe to lead its new $6-billion defence financing program.

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But several barriers stand in the way for burgeoning defence businesses, such as long procurement cycles – it takes about seven years from the time a project is presented for businesses to receive a final decision on whether they will win a government contract – and difficulty securing financing.

Governments typically award contracts to prime contractors, which are large companies that design and develop defence systems. While the banks do business with these corporations, Ms. Hudon said small and medium-sized enterprises (SMEs) need additional support to enhance Canada’s defence supply chain.

“We want to make sure that we support the defence sector SMEs, but as well as SMEs that will need to be included in the value chain of those prime contractors giving big contracts,” Ms. Hudon said.

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Banks in Europe were among the first movers to step up their defence practices. Last year, Germany’s Deutsche Bank AG set up a team dedicated to working on deals in defence and infrastructure. Denmark’s largest lender, Danske Bank A/S, has also signalled its plans to increase financing of the defence sector by lending to newer dual-use technology companies.

The federal government has been urging Bay Street to take a similar approach. Canada’s Defence Minister David McGuinty told a room of financial institutions, entrepreneurs and investors that defence companies are ready to scale advanced manufacturing and compete globally, but they cannot achieve those ambitions without private capital.

“I know this is, in some ways, a difficult thing here for the banking sector in Canada, because we don’t, and your shareholders don’t, often talk about defence investments,” Mr. McGuinty said in May at a defence and security conference held by CIBC.

He added that the government is working on removing “blockages” to financing defence companies, including export approvals and security clearances.

“But I’ll be really blunt,” Mr. McGuinty said. “We don’t have any choice. We need to move forward now. We need to look out for ourselves. We need to step it up domestically.”

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While barriers persist, there are early signs that Canada’s approach to defence procurement is beginning to change. In early July, Ottawa chose Germany’s TKMS to build Canada’s first significant submarine fleet. The Prime Minister said the government completed the procurement process in less than a year – five years ahead of schedule.

That deal is expected to create hundreds of thousands of jobs and tens of billions of dollars in economic impact. When the government selects a prime contractor, it will trigger the Industrial and Technological Benefits, or ITB, policy, aimed at ensuring that the contractor invests equal amounts into the Canadian industry. The Canadian government refreshed the ITB in May to tie the policy to the sovereign capabilities outlined in the government’s defence strategy.

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Those commitments will trickle down the Canadian supply and open up opportunities for small and medium-sized defence companies, Dentons lawyer Ms. Babin said.

“It’s going to give confidence to banks and investors to invest and lend to Canadian SMBs,” Ms. Babin said. “It’s going to have a multiplying effect.”

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TD’s head of Canadian business banking Barbara Hooper said the lender does not have many pure-play defence clients in her division – which serves small and medium-sized commercial businesses – but rather those that are suppliers for military and government projects, including construction, satellite and other equipment. Those clients are seeing increasing demand.

“Some of those are seeing an uptick in orders from our allies,” Ms. Hooper said in an interview.

“We have clients that build precision parts for satellites and different types of high-tech equipment, and that is benefiting from infrastructure investments by the Canadian government, but also by our allies and other private companies that are supplying governments.”

In Canada, banks have long financed larger clients that have defence divisions, such as the aerospace sector, where companies are bigger, more established, and build equipment and technology that are less controversial than tanks or drones that could be used to carry weapons.

These types of companies used to avoid describing products and services as defence-focused out of concern over scaring away investors, but that has changed significantly as major aerospace and defence companies are benefiting from the spending boost.

In May, Montreal-based CAE Inc., which builds flight simulators and trains military and commercial pilots, said it expects to boost earnings through a new strategy that focuses on defence clients. Jet manufacturer Bombardier Inc. has said it would consider acquisitions in the sector as interest grows in its defence products.

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Canada’s bank CEOs have signalled they are considering ways to increase access to capital for defence companies. National Bank CEO Laurent Ferreira said the lender is working with clients with ties to Canada’s military and infrastructure efforts, including the aerospace sector. He expects small and medium-sized defence companies to play a key role in growing the country’s supply chain.

“Priorities of our government are going to be our priorities as well,” Mr. Ferreira said in an interview after the bank’s annual meeting in April. “If we are going to build an even larger defence security complex in Canada, we’re going to be there to support it.”

In 2023, RBC’s capital markets unit created a dedicated aerospace and defence subsector focus in its Canadian industrials group.

The bank already had teams covering the sector in the U.S. and saw a growing need in Canada as more companies focused on defence in the wake of Russia’s war in Ukraine and demand for enhanced space and satellite communications.

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In recent months, RBC has been boosting its support of Canada’s defence sector. The bank was a joint lead bookrunner on Brampton, Ont.-based MDA Space Ltd.’s initial public offering in the U.S. The Globe and Mail also reported that RBC is advising Ontario on a $500-million bond to fund defence projects.

The bank recently committed $1-billion in the coming years to bolster investments in Canadian companies, including the defence sector and industries that support critical infrastructure.

In April, RBC CEO Dave McKay said the private sector must play a role in supporting the defence and dual-use sector, as well as industries that support critical infrastructure, including apparel, food services and technology to supply military bases.

“We’re looking at every one of these investments as a dual-purpose investment, and that requires public and private capital to co-exist to get a greater return on military industrial,” Mr. McKay said.