Rising interest rates are restricting capital investment and slowing nonorganic growth, which affects the mergers and acquisitions (M&A) and venture capital markets. However, defense technology—and specifically space—is getting a lifeline from the government, which is still investing in critical cutting-edge opportunities.

With the new addition of the Office of Strategic Capital, we expect the government to join space and defense investors in providing much-needed funding for technology to maintain national security and further space innovation and exploration.

Rising interest rates are squeezing liquidity and slowing M&A activity, as shown in the table below.

Further, venture capital investment has slowed compared to prior years, as shown in the table below. 

Funds are being more selective, and management teams are hesitant to make heavy investments without a clear line of sight into the return on investment while debt markets are tightening. However, what is unique about this ecosystem is that space technology companies serving the U.S. government have nontraditional capital sources and programs to lean on during challenging times.

Defense primes have invested heavily in their venture portfolios over the last few years. Now, most are integrating those acquisitions and working to realize the value sought from their acquisition strategy. Like private equity and venture capital, overall private investment in space has dropped to its lowest quarter since 2015, as shown in the table below. 

The decline in private funding requires a focused federal interest to ensure necessary technologies are created and commercialized. The U.S. government has a vested interest in this sector as it helps protect national security and outpace the United States’ direct space competitors, China and Russia.

Government space lifeline

Government funding trends for defense and space-related technology are on the rise. The government is also diversifying and innovating channels to funnel funding to the space market through loans and other transaction agreements. There are three key funding developments in fiscal year 2023 that we expect to ignite the space industry:

1. The Biden administration’s fiscal year 2023 budget made historic investments in science and technology. Spending levels for basic and applied research topped $100 billion for the first time, and spending for total federal research and development (R&D) topped $200 billion for the first time. 

Another key objective is promoting world-leading research and innovation that boosts American industries and creates quality American jobs in emerging technologies. The budget provides $1.4 billion for NASA’s space technology R&D portfolio, an increase of $338 million above fiscal year 2021 funding, to spur U.S. leadership in space technology.

In addition, defense funding for space is outpacing the budget of NASA and the Commerce Department’s National Oceanic and Atmospheric Administration. The fiscal year 2023 budget for the U.S. Space Force was $1 billion more than the budget of NASA, as shown in the table below.

2. The Office of Strategic Capital (OSC) was established in 2022 to connect capital with companies developing critical technologies vital to national security. Critical technologies such as advanced materials, next-generation biotechnology and quantum science often require long-term financing to bridge the gap between the laboratory and full-scale production. The OSC intends to work across policy, acquisition and research efforts to scale investments between science and technology-focused organizations, such as the Defense Advanced Research Projects Agency, and commercially oriented organizations, such as the Defense Innovation Unit.

While existing agencies rely on grants and contracts to deploy capital, OSC uses nonacquisition-based tools, such as loans and loan guarantees.

The OSC's initial program is the Small Business Investment Company (SBIC) Critical Technologies Initiative (CTI). In partnership with the U.S. Small Business Administration, OSC will support licensing purpose-built critical technology funds eligible for nondilutive CTI investment from the U.S. government.

The following illustration provides an overview of the funding workflow of the SBIC CTI.

OSC has also discussed three potential program activities:

• Loan program initiative: OSC would work with an interagency partner to support the extension of loans or loan guarantees to companies that are scaling critical technologies.
• Transition acceleration program activity: OSC would contract Department of Defense (DoD) research, development, testing and evaluation funds with private capital for larger investments in critical technology when projects are aligned to out-year procurement program funding.
• Global critical technology scout: OSC would contract with nonprofit organizations to scout and scale critical technologies that emerging international companies develop.

The following illustrates how OSC plans to address current gaps in scaling critical technologies to capabilities.

3. Space-based intelligence is a key component of global security. It supports fact-based government decisions to combat many threats, including climate change and piracy. This has sparked international demand for U.S.-based space technology and products. We expect this demand will keep exponentially increasing while funding the U.S. space sector through contracts and investment.

We anticipate that the pace of M&A activity will pick back up as investors take advantage of the U.S. government programs and funding sources described above.

The takeaway

Serving the federal government is a respite for businesses during challenging economic times. The Biden administration and the DoD have made it clear they have a vested interest in the success of space innovation and defense technology advancement.

We think the OSC will entice private investors to look closely at this ecosystem through its SBIC CTI program. Strong funding channels and the alignment of the space sector with the U.S. technology growth strategy create a unique opportunity for a long-term investment with the expectation of robust returns.