11
Examination of witness
John Godfrey.
Q83 The Chair: Good morning and welcome to this evidence session of the Industry and Regulators Committee as part of our inquiry on the relationship between Government and the defence industry. The meeting is being broadcast live on the parliamentary website. There will be a transcript, taken by Hansard. You will have a chance to look for any corrections or misunderstandings before that goes public. We are delighted to have with us John Godfrey today from TheCityUK.
John Godfrey: Thank you for inviting me. I am the managing director for public affairs, policy and economic research at TheCityUK, a member organisation which represents the whole ecosystem of the financial world in London. Prior to that, I worked for many years in business, latterly for a long time for Legal & General, the insurance company. One of the things that I do at TheCityUK is look after our defence and resilience group, which is one of our largest groups and works on aspects of financing for defence and resilience. Thank you for having me today.
The Chair: You have led straight into my question. What were your reasons for setting up that defence and resilience group, which we are particularly interested in? We are interested in how well it is working, the main issues that you have identified and what is needed to address any issues that you have looked at.
John Godfrey: It is a very broad question and there is quite a lot to unpack. We set it up for four reasons. First, there was member demand for it. There has been a sea change in the appetite of financial institutions to lend into defence and resilience. The high point of ESG (environmental social and governance frameworks), which was a blocker, has passed. The Russian invasion of Ukraine turned defence into a positive component of “S” because we recognise as an industry how important it is to defend democratic institutions and values. About 70 members have signed up to this out of the 165 or so who are part of our organisation.
Secondly, we recognised a big demand for financing. Initially the driver was to deliver the Strategic Defence Review (SDR). We recognised that Government on its own would not be able to do that. It had to leverage in the private capital. Therefore, there was an appetite from that point of view as well.
Thirdly, we had identified a number of blockers which made it hard to invest in defence. That was something which our work has very much picked up on. I will talk about that as we go through the session.
Fourthly, we got a lot of encouragement from Government to do this, particularly from the Department for Business and Trade (DBT), because defence is one of the eight sectors in the industrial strategy. It was supportive of what we were trying to do for broader economic growth.
Our first meeting was last December and at that meeting was Nikhil Rathi, the CEO of the Financial Conduct Authority (FCA), our industry’s main regulator. He came along to talk to us about the interaction between regulation, defence and finance. He was fascinating and very much on side to help. He was building on a speech that he made at Mansion House last October, which I would strongly recommend for people to read. It encapsulates a lot of what we have been trying to do.
We have focused on four things. We have different groups which are broadly structured along the lines of the different balance sheets in our membership. There is a funding group, which has focused so far on bank lending. The problem identified there is bank lending to the SME component—the £2 million to £10 million companies that sit in the supply chains of the big primes. This is essentially about lending. It is a little bit about equity, but more about debt. We have been looking at how we can increase the flow of lending to those companies.
The second group is about venture capital (VC) and private equity (PE). In defence, similarly to many other sectors, you find that the very early start-up is financeable through angels, EIS and SEIS-backed schemes and so on.[1] It is the scale-up that is the problem. We have been working on that. The group has focused quite a lot on patriotic venture capitalists. This often is family offices.[2] We needed to do some work on improving the documentation for those types of investors, which inadvertently had excluded a lot of defence. We have managed to succeed in changing that.
The third group is about defence and resilience infrastructure. This applies much more to pension fund or insurance balance sheets, which were my background. Here we are looking at, in some cases, complex infrastructure—ports, airports, secure storage facilities and so on. We are looking in the first instance much more closely at military housing, because if you look at the SDR this is a £7 billion challenge. There must be a better way to leverage some private investment into that without replicating what happened with Annington Homes, which is the big red flag in that space.[3] There are ways to do it better.
The fourth group is a horizontal group which tackles the blockers and frictions to getting the money moving. Those tend to be much more around procurement and the interaction between a credit or investment decision and the MoD procurement process, which is slow and very self-contained, making it hard for a lender or investor to know what you are investing in or lending to. There are also some regulatory frictions. The regulatory issue, which we will be able to help solve, is that there is a duplication of the checks on anti-money laundering (AML), know your customer (KYC), and all those things which happen as part of MoD procurement. These have to be repeated almost identically by any bank or institution that is investing. This is a pointless process. There must be a case here for a compliance passport, which is what we are talking to the FCA about.
There are some other regulatory issues not in the financial space which are cited to us as creating difficulty. Some things around civil aviation and military aviation make it very difficult to test drones, for example. There are some things around the telecom space, but I am not an expert on those; my bailiwick is very much the financial piece.
The last thing is that we want to add two other workstreams to what we are doing. One is around the international component of this, which takes us into thinking about things like the Defence, Security and Resilience Bank (DSRB), potentially the Multilateral Defence Mechanism (MDM)—the multilateral procurement operations—and how we work better with our allies to ensure interoperability of military kit and interoperability of the financing. Very finally, there is resilience, which we consciously differentiate from defence. There is a lot that our sector and our industry can do to help with national resilience. For example, in the cyber space, banks and big institutions of course are very good at this. There is knowledge there that can be deployed more usefully to help the national interest in serving greater resilience, including potentially through the way we operate military reserves.
I will stop there, Chair, because that was a very long answer, I am aware, but it may set up further questions.
The Chair: I think it will. Your third point was about military housing. As someone who was brought up in military housing, I am delighted that that is on your radar. Actually, thank you, because you have nicely sketched out more or less the agenda that we are looking at, so some of our questions are likely now to drill down a little bit about the responses to those challenges.
Q84 Baroness Harding of Winscombe: You alluded to this in your very well set-out introduction: defence companies have explained to us that they really struggle to obtain financing, particularly at that scale-up point, so I wanted to go into a bit more detail really. Now that the DIP—the defence investment plan—has been published, what more do you think investors need to have confidence to be able to invest in those scale-up SMEs?
John Godfrey: I would divide it a little bit into two parts. The first part is about signalling. For a long time, investors, understandably, were waiting for a demand signal from the Government, so the delays with the publication of the DIP meant that people just sat on their hands, because there is ultimately one customer for defence materials. If that customer is uncertain, you are not going to invest, so there was a long pause, waiting for the DIP.
Now there are a number of signalling opportunities that the Government have. They have the Defence Investment Finance Strategy coming up, to explain in more depth where the opportunities for investment lie. That is something they could do. It would be very helpful if there were a strong message about this in the Budget. There is a Defence Investment Summit planned. It is uncertain, I think, whether it is November or December, but it is coming up and that should be an opportunity to bring the industry together, to get the financiers and the investors alongside the manufacturers and the companies in the sector to tell them what is needed. Those are some of the signalling opportunities.
We need to get the MoD, particularly the National Armaments Director and his team, to make it a regular event that they come down to the City and explain what they are doing and how they are getting on with doing it. At the moment, there is quite a gap of understanding, and quite a communications gap, between the money and the MoD, as it were. Those are some of the softer signalling things.
In terms of the harder things that the Government could look at, one is to explore in a bit more depth what the opportunity is to engage private capital alongside public capital through the public finance institutions. You upscale what the British Business Bank is doing in this space—and it is doing good work, so it is a question of accelerating and enlarging that. There is what you can do through the UK wealth fund. There are a number of other agencies where investing alongside the private sector gives an additional degree of confidence, and to some extent de-risks making that investment. That is part of it.
There was a lot of work—which, Baroness Harding, you will recall—done a few years ago around the LIFTS programme, which was to target money into science, technology and life sciences, and some of those ideas should be reopened and looked at in the defence and resilience space.[4] Co-investment is an example, but on slightly different terms for the public and the private side; so you can have a slightly asymmetric investment if that delivers value for money and brings in the capital.
There are plenty of ideas already in a filing cabinet somewhere which could be taken out and re-examined with a defence lens.
Baroness Harding of Winscombe: I have just one brief follow-up. All of that sounds just incredibly sensible. Why has it not been happening?
John Godfrey: I sort of alluded to that when I spoke about the need for the MoD and the NAD to get on the Tube and come down and see us in the City, or vice versa. Those conversations have not been happening anything like enough. To give you an example, we are running a series of events called “How We Fight”, which were the brainchild of the co-chair of our defence and resilience group, General Sir Richard Barrons, who I think has given evidence to you before. Richard was very keen to educate in this space. We are getting senior military figures to come down to Canary Wharf and address the finance community. We have had one on combined services, we have one coming up on the Army and the Navy, and then there is an Air Force one. Then hopefully there is a National Armaments Director one to round it out. What that shows you is that there is a big knowledge gap. There are a few specialists in the City of London who really understand this sector, but it is nothing like systematic or well enough understood. Old-fashioned communication is required to make these things happen.
Baroness Harding of Winscombe: One of my colleagues is going to follow up in more detail, so I will not go any further into her territory.
The Chair: We will see whether we can come back later on some of the follow-ups, but I call Lord Camoys for the moment.
Q85 Lord Camoys: Thank you, Chair. John, you mentioned in your introduction the slow procurement processes at the MoD as a blocker and friction. I would like to take that a bit further. If you had to name three changes to MoD procurement that would do the most to make defence companies—in particular, SMEs—more investable, what would they be?
John Godfrey: The first one would be about joining up the procurement process more closely with the credit scoring process that banks and investors have to go through. Here is what you find in practice. Let us take a firm which is negotiating its contract with the MoD. As soon as it looks as if it is going to win that contract or actually wins it, it all goes dark—and understandably so, because a lot of these goods are very sensitive so you do not want the wider world to know necessarily. But that makes life incredibly difficult for a lender or an investor.
What we are trying to work up is some thinking on how you get a very small and limited group of trusted and appropriately cleared banks and bankers into that process so that, as this company is evolving its contract with the MoD, the lenders know why you need 10 million quid to expand your factory or whatever it may be, because at the moment it is very hard to get a handle on this. Lending decisions are almost expected to be taken on “Here’s a thing which is so good I cannot tell you what it is”, and that does not work well with financial institutions. There are technological ways to do that, which Joe Cassidy, the other co-chair of our group, is very focused on. He is the head of technology, media and telecom at KPMG, and this is very much part of the group’s work. That is the first thing.
The second thing, which is particularly SME-related, is about an acceleration of the process. There are a vast number of SME contracts held directly with the Ministry of Defence. Can we have a quicker way through that process? I do not know whether there is a specific stage of it that can be shortened, removed or concertinaed in some way, but the prize must be to have this happen more quickly. What you have seen, most notably in Ukraine as they are at war but also in the US, is that these decisions on whether to award a contract happen very quickly. This involves some government acceptance that not all of these will work. There must be some risk acceptance and failure acceptance, but this would accelerate the process.
The third thing goes back to financial regulation. This is the compliance passport that I mentioned before. Can we remove the requirement for this to be completely repetitive? Banks and lenders will want to take their own precautions, but they should not have to run through quite such a deep, systematic and time-consuming process when the MoD has already, one assumes, checked the bona fides of the company and the people that they are dealing with.
Lord Camoys: Does that problem of the requirements on the regular financial regulations come from the MoD?
John Godfrey: No, that comes straight from financial regulation on the anti-money laundering rules and the know your customer regulations. From our meetings with the FCA, which administers those regulations, I would say that it is up for a serious discussion about how to get rid of this blocker.
The Chair: I hope that you have more success than those of us who are politically exposed persons and have constant and continuing issues on this. I wish you luck.
Q86 Baroness Drake: Building on Baroness Harding’s question about what is happening on the ground to make the sensible possible, my question is in two parts. Can you give us more granularity on how Government has engaged with the finance sector on investment in defence companies, particularly referring to the qualitative and quantitative content of that engagement? Also, you have articulated the need for greater engagement. What aspects of form and content do you want from that engagement?
John Godfrey: The qualitative and quantitative data on this that I have seen comes less from Government and more from organisations such as techUK, which monitored very carefully when we were waiting for the DIP and ran some quite depressing but very interesting numbers about the SME world in the defence and resilience space and the extent to which they were going bust or into stasis and putting everything on hold. I can send you those numbers. That is the best quantitative evidence that I have seen.
On the qualitative evidence, one hears anecdotally reasons for investments not being delivered and not working out. Quite often one hears that there is a problem, as there is in all sectors, with the UK venture capital and private equity world not being evenly distributed around the country. There is a focus on the geography of London and the golden triangle, whereas the defence economy is geographically different.[5] That is part of it. There is not a big enough infrastructure—not in the technical sense of the word but in the numbers of venture capitalists that are active in different regions.
The other part of it is this endemic problem that we have with scale-ups. One hears that quite a lot of firms would find it much easier to attract money from overseas, particularly the US. I have spoken to people who operate in this space. Some of them are former serving people who are trying to create a business. They say, “I am staying here because I am British and want to stay here, but I keep being asked to put my house on the line to do this, whereas if I went to Texas it would all happen much more quickly and I would not be asked to provide such personal security and take such personal risk for my business”. Those are some of the things, but there are many factors. Defence is not alone in encountering this problem.
Baroness Drake: You referred to demand signalling. To what extent have you got the long-term visibility of the MoD’s priorities to give the investor community that confidence? To what extent is the DIP meeting that visibility demand?
John Godfrey: The DIP has had a negative political reception. In terms of markets, it has a reasonable amount of detail and is encouraging in some areas. There is, for some areas, a very broad price list of what is needed, which helps. We are all waiting for the Defence Investment Financial Strategy, which will put a little more flesh on those bones and go down a level or two to tell us what is needed and in which spaces.
Picking up on the military housing piece and the infrastructure piece, you have had a lot of work done inside the MoD by the Defence Investors’ Advisory Group. The DIAG has taken 12 potential infrastructure and housing opportunities down to six, then down to three. However, this has taken a very long time. We are still waiting to hear what the three are that the DIAG would like to see expressions of interest in. Meanwhile, the industry is firing in ideas and opportunities, but they do not seem to make fast enough progress.
Q87 Lord Best: I want to dig a bit deeper on the regulatory barriers to investing in defence. You have identified the key blockers and are identifying this pointless process of time-consuming checks for anti-money laundering. You are telling us that the FCA is on the case and that progress is being made. Is this a tick in the box or should we be concentrating on this one? Is this a big number?
John Godfrey: It is not a tick in the box yet, but the pen is hovering over the square to put the tick in. It would be a helpful move if progress was made there. It is not the silver bullet that solves all problems. I am told that it would be helpful to do that but that the bigger thing is the credit decision and how that operates alongside the procurement decision. However, it is a positive if we can pull it off, and we can be reasonably confident that we can. The answer lies largely in regulation, not in legislation, so there may be a quicker way through for that.
If you are digging deeper into regulation and such granular issues, then what I mentioned earlier about standard form documentation for private equity and venture capital is important. It is not a thrilling point, but it is an important point. In the past we had standard forms of documentation which on a blanket basis tended to exclude a lot of defence. It was loosely defined and people would veer away from it. The standard industry documentation now says that the United Nations controversial weapons are excluded, as has always been the case, but everything else is explicitly included. If the underlying asset owner—the person whose money it is—is happy with that then that is what the fund can invest in. That makes quite a big difference. It is a slightly dull change, but worthy and important.
Lord Best: Those are important. On military housing, there is £7 billion at stake. For a progress report, are we near to finding private investors who will take on this challenge?
John Godfrey: There is a lot of appetite for this. It always depends on the details of the individual project and the terms of any transaction, but there is undoubtedly interest. I slightly aim off for this because this is part of my past career, so I have a bias in this direction. If you think about the defined benefit pension schemes which have been bought out by insurers, that is a flow of capital of about £40 billion a year. That money lands with insurance companies. It must be invested into something.
The constraints around what it can be invested in are quite tight because they are driven by the UK solvency rules. You must have certain security of credit and a very predictable or set cash flow. These are the types of assets that could be made to work in that type of structure. Economically, military family housing is not particularly different from social housing, which is highly investable. Serving single persons’ accommodation is economically not very different from student accommodation. The models exist to do this. We need to know how we avoid the problems that Annington Homes ran into with the maintenance contracts. That requires some serious thought.
Lord Best: It certainly does.
Q88 Baroness Valentine: I have known John in various roles in the past. You have touched on the financial sector investing alongside Government in defence capabilities. Can you give us a little more detail on what support and commitments investors would need to do that?
John Godfrey: On the equity side, the potential exists for the private sector to work with the British Business Bank, co-investing in single situations or by, for example, co-creating a fund or playing into a fund-of-funds model. On the equity side, the models exist to do that.
On the debt side, it is largely around guarantees. With defence companies which manufacture items that are destined for export, there is a UK export finance guarantee which can cover up to 80% of the value of those products. The definition of exports is quite flexible. When an SME produces and sells something to one of the big primes, it may subsequently export the completed item. Let us say that you are making door handles for aeroplanes and that the aeroplanes, when sold, are exported. That guarantee can apply.
What is sometimes a challenge is whether you can increase the guarantee status by using some of the balance sheet of the UK’s National Wealth Fund, for example. Alternatively, in the housing space, what would be potentially the role of Homes England’s new-ish banking subsidiary to support some of the creation? There is an idea here which is potentially interesting around mixed use in housing. This also has the benefit, as Lord Best would know, of taking some of that off the government balance sheet. A number of PuFins (public finance institutions) could play into this space, in debt and in equity.
Baroness Valentine: The National Wealth Fund and Homes England traditionally have been pretty risk averse. Quite often one was trying to work alongside them. The private sector needs to take the early-stage policy government confusion out of the equation. Is anything in what you have just said easier now than it used to be?
John Godfrey: There may be many other examples using the other PuFins, but I know that Homes England certainly has been effective in de-risking on a number of projects. It is important to emphasise that the private investor is not looking for a subsidy here. There is a question of de-risking and making it more possible for their money to flow through on the normal kind of risk-reward basis. More could be done with the military housing in that sense.
There are some very interesting things where public-private arrangements could be brought to bear in the more complicated infrastructure—airfields, for example. There is an existing interesting model in Belfast International Airport, which is both military and civilian. There is a question here. If you need to refurbish Brize Norton in its entirety, is there a route which gives you a partly commercial and partly military application and how do you divide the two?
These are big and difficult projects, but they are not without potential to be solved.
Q89 Lord Fuller: I have listened very carefully. It seems to me that a lot of the problems that you are describing are what the AIM was established to fix.[6] You are from TheCityUK. You have not mentioned AIM or PISCES (the Private Intermittent Securities and Capital Exchange System), a similar private company exchange in which you cannot raise capital but can switch shares among yourselves. I can understand that venture capital, private equity and debt have a role. However, has AIM, the junior stock market, been forgotten and what could it do about it?
John Godfrey: It is a very interesting question and not unique to defence SMEs or companies. There is a shortage of listings into the AIM, which is a broader thing. There are much bigger potential solutions required to revive the UK listed company markets, whether that is big listed companies or smaller listed companies. Some of those things revolve around listing rules which have been amended. That has not worked its way through the system. Some of it is about competitive valuations. Some of it is about the amount of documentation that is required. Some of it is simply about competition that smaller potentially listed companies are seeing from private equity. We need to solve all those bigger problems. That should be helpful in this sector as well. However, I would not distinguish defence specifically as finding it difficult to go into the listed markets.
Lord Fuller: I find it odd that you are with TheCityUK but the junior stock market has not been mentioned once. This is not just for defence companies but smaller companies in that £25 million range.
Q90 Lord Camoys: Grace Cassy, who was involved in preparing the SDR but is also an investor in defence, told us that there is a lot of interest and that there are a lot of funds to invest in defence—apart from the final 5%, the bits that go bang. What can be done beyond relying on patriotic family offices to invest in a very crucial bit of the defence industry?
John Godfrey: I take my cue a little from General Barrons on this, who likes to describe the defence environment as being a bit like an iceberg. The DIP is the bit that is above the water; these are all the obvious things that need investment. But below the water is a lot of the ongoing defence work, which equally requires a lot of investment and in some ways is much easier to invest into because it is established. The thinking is that the more that can be pointed into the bit below the water, the more that frees up the public funds to drive the bit that is above the water. It is a rather tortuous analogy—I am sorry, my Lord—but that is very much part of it.
If we can simply increase investment into the 95%, then the 5% does become more fundable. There is also possibly an element still of the hangover from ESG about this last 5% of energetics and so on. The change that I mentioned to some of the documentation for PE and VC investors should help in that space, which will leave only a smaller percentage uninvestable—clearly, nuclear and things that are on the controversial list that nobody has ever invested in, really.
Q91 The Chair: I found this fascinating. There is a very broad question I would like to pose. It is the wrong analogy but, when Notre-Dame burned down, my understanding is that Macron met every week, and when there were all these different problems and there would be hold-ups here and there and everything, he basically sorted it and said, “We will deal with that,” whatever it was. Do you feel the Government has a similar desire to make sure that SDR happens? What you have told us is that there are lots of little problems in all sorts of ways. Do you feel that there is a driver from Government that is saying, “We will do these things”? They can be quite small things. The one you have given is an interesting example, but do you feel there is a driver in Government that is making this happen?
John Godfrey: I do not think there is a sufficiently forceful or united driver to make this happen. It is always depressing when you say that the French do something better than we do, but there is some truth in this that we do need to have some strong leadership on this. The Ministry of Defence, particularly the National Armaments Director, is in a good place to do that and is able to do it now that the DIP is published; they had rather gone to ground while waiting. You are absolutely right that we need to pull all that together and make it happen. There is a Defence Industrial Joint Council, and one of the simple things that could be done is to get financiers into that council at a senior enough level to help them take decisions. The opportunities are enormous. If you think about just JP Morgan— “just”; it is the biggest bank. It has a global initiative for defence and resilience of one and a half trillion dollars. It is an unthinkably huge amount. Even if we get 5% of that invested by it into the UK, that is probably three times or so more than the DIP. We need to get people like that to the table at a very senior level and, as you say, bang the table and make it happen.
The Chair: Thank you very much for your time. It has been invaluable and we appreciate the work you have done—the submission you gave as well as today.
John Godfrey: Thank you. If anybody wants to follow up, please feel free.
The Chair: That ends this session.
