The defense industry may not be headed for another merger wave, but something much more interesting.


Bankers, lawyers, and other business advisors have been waiting for years for that coming wave of mergers amongst military contractors. As one consultant told me recently, his firm was founded on the notion that some post-post-Cold War consolidation would eventually make the partners rich. Of late, however, most of what they’ve been seeing is what David Benoit of the Wall Street Journal called (18 February) the “New Push to Throw Assets Overboard”. Sure, the WSJ headlined this week that “Engility, TASC to Merge in $1.1 Billion All-Stock Deal” (28 October). But the two firms only got to that point because Northrop Grumman unloaded TASC back in 2009. The larger enterprise was seeking to avoid the organizational conflict-of-interest inherent in owning a subsidiary that advised the government on how to deal with the parent company. Back in 2001, Northrop’s management thought buying TASC was a great idea. So what accounts for these shifting sensibilities?


     the choice between focused, single-business firms and diversified, multi-business enterprises depends on the relative performance of internal and external capital and labor markets. The institutional environment—the legal system, regulatory practices, accounting rules—plays a huge rule here, but social norms, technology, and the competitive environment also affect the efficient margin between between intra-firm and inter-firm resource allocation.

The school solution thus varies strongly across national borders, as explained in two recent essays by several authors on Harvard Business Review’s blog. Conglomerates might thrive outside the US, where labor and capital markets are not as well developed, and the rule of law is less even. In these circumstances, personal networks are more important at higher levels of social organization, and sprawling enterprises find easy extension into one sector after another. In the absence of those inefficiencies, though, there’s still little reason to doubt that the focused Western firm has the superior organizational form.
And yet, the largest defense contractors are basically conglomerates. To find those that aren’t, one must descend below the first ten on the Defense News Top 100 list. At #12, Almaz-Antey is almost entirely focused on air defense systems, even if Russia is still firmly an emerging market, and perhaps permanently so. The first focused firm on the list in North America or Europe is the next entry. At #13, Huntington Ingalls is still mostly a shipbuilder, despite recent acquisitions in the related field of offshore energy infrastructure. All the larger firms continue to produce a wide scope of output, from planes to tanks to satellites and intelligence services.
So why do so many suppliers to the modern military pursue a Third World organizational strategy? I argue that defense itself may be a permanently emerging market. As defined by Ian Bremmer of the Eurasia Group, that’s one in which politics is at least as important to business as economics. Consider what’s said to matter most as these spinoffs continue. In September, Exelis, itself a spinoff from ITT, completed its spinoff of Vectrus. As Defense Mergers & Acquisitions Daily reported, the new company is still a large firm, as it
     begins life with revenue of $1.5 billion, some 5,600 employees, and “solid positions in infrastructure, logistics, and network communications,” according to president and CEO Ken Hunzeker. It may be the fourth services business spun off by a major defense firm [this year], but it says that it is “differentiated by operational excellence, superior program performance, a history of long-term customer relationships, and a strong commitment to the mission success of its customers.”
Flatly, each of those four cited hallmarks could be found in the marketing literature of almost any military services provider. But the one that may generally distinguish the successful could be those customer relationships. As I mentioned earlier this month,  in their book Buying Military Transformation (Columbia University Press, 2006), Peter Dombrowski and Eugene Gholz make a strong case that only the big contractors have the networks inside military organizations to make the big sales. In a related interview, they put it baldly: “we don’t need many small entrepreneurs to go out and find new market niches.” So are they saying that entrepreneurs don’t have the wasta to make it happen? Not quite. For as they continue, “the best route for entrepreneurs to get their ideas into the defense market is generally to partner with an established defense company that understands the customer.”
There’s certainly an ample supply of entrepreneurs with good ideas. By the figuring of Douglas Burdett at Artillery Marketing, 86 of the firms on Inc. magazine’s list of the 5000 fastest-growing private US companies are defense contractors. By raw counting, that’s over 1.7 percent of the fast-growing businesses, and defense contracting is less than 0.9 percent of the US economy. That means that defense seems to be attracting a disproportionate share of start-up activity. Perhaps American entrepreneurs are more patriotic, or at least politically-minded, than the stock image might suggest. The latter would be handy within the influence networks of the extended defense enterprise—or the military-industrial complex, if we’re in a darker mood.
In the long run, though, this de-merger wave indicates that connections aren’t enough to make up for the conglomerate discount. Perhaps then, there is a better way forward in the industry in response to shrinking spending. Rather than mindless mergers, or simply shrinking in place, is there a hybrid form—or perhaps, a different form that’s an endogenous factor of production in its own right? Political scientist Marc De Vore, who has studied the defense industry extensively, wrote that
     In 1972, economist G. B. Richardson theorized that corporate alliances constitute the optimal strategy for firms making complementary products yet employing dissimilar developmental and production processes. Since then, it has been demonstrated that collaboration is the ideal solution when there is an advantage to combining the capabilities of two or more firms that have structures and capabilities rendering it costly for them to join forces through normal market transactions (for example, contracting or mergers).*
I wrote extensively about this idea in Arms and Innovation (University of Chicago Press, 2008), and about its problems as well. In the highly politicized business of defense, we shouldn’t presume that these are easy to manage across borders. Just this week, binding arbitration was necessary to resolve DCNS and Finmeccanica’s dispute over a torpedo joint venture gone sour. In response, however, DCNS said that it is not looking to buy a different, whole company, but just to acquire the “bits and pieces” of another that might bolster its business in that line. If that’s the future pattern—sell, ally, selectively buy—industrially restructuring could prove a more intellectual exercise than a chapter from Barbarians at the Gate, and the bankers will need to work to earn those fees.
James Hasík is a senior fellow at the Brent Scowcroft Center on International Security.
* See Marc De Vore, “The Arms Collaboration Dilemma: Between Principal-Agent Dynamics and Collective Action Problems,” Security Studies, vol. 20, no. 4 (November 2011), p. 628, citing Richardson, “The Organisation of Industry,” Economic Journal, vol. 82, no. 327 (September 1972), pp. 883–96; and Benjamin Gomes-Casseres, The Alliance Revolution: The New Shape of Business Rivalry (Cambridge, Massachusetts: Harvard University Press, 1996), pp. 39–40.