war on the rocks

The Next Military-Industrial Complex, Part I: Riding Venture Capital’s Coattails

November 9, 2017

The U.S. national security establishment is facing the stark reality that the technological innovation needed to help keep its defenses strong resides largely in the private sector. Impelled by this need, top U.S and NATO officials have professed their enthusiasm for a closer embrace of private enterprise. Indeed, the head of U.S. Cyber Command even proposed living with technology companies, suggesting that U.S. operations and private-sector partners be housed in the same location at Fort Meade.

But telling the object of one’s desire it is needed does not ensure a compatible relationship — particularly when the love is unrequited, which is the case in much of the beloved technology community given proprietary, privacy-related, and other concerns that arise with governmental involvement. Before the administration continues to press the defense establishment to renew the public-private partnership, prudence suggests revisiting past efforts to better determine how the revamped relationship should actually take shape as the United States builds the next military-industrial complex.

This blinking yellow light of caution will be examined in a two-part series. The first article explores obstacles to innovation in the supply chain at the emerging company stage, which is typically funded by the venture capital community. The analysis comes at a time of ongoing assessment of the U.S. defense manufacturing and industrial base, as well as supply chain resiliency, following President Donald Trump’s executive order. The next article will explore in detail how private business has been employed in the past to help normalize relations with problematic nations and create stability in other ways. The lessons of the past should inform policy planning and implementation for both the private and the governmental side of the relationship. After all, the idea of tasking the private sector with security solutions is not new. History shows ample reason for policymakers to be concerned when private commercial interests deviate from those of the public.

As the United States considers renewing and revamping the relationship between business and the national security establishment, it is necessary to look at some of the hurdles. Partnering with private entities entails significant entwinement at many levels, ranging from ample return on capital investment to disparate perceptions of what constitutes proper governance and adequate investor control. While venture capitalists have a large say over the direction of the entrepreneurs they fund, it is highly unlikely the government will be equally welcomed into such private corporate deliberative and governance processes. Accordingly, the Department of Defense and other relevant national security players, such as the Department of Homeland Security, must move toward a sustainable “networked” relationship to thrive in the 21st-century private technology ecosystem, rather than seeking to restore a 20th-century “partnership” that is driven by a needy gleam in their eye.

In spring 2015, then-Secretary of Defense Ash Carter launched an innovation initiative in a lecture at Stanford on “Rewiring the Pentagon.” As a “core goal,” Carter sought to connect the Defense Department with private equity to build bridges with the emerging technology community. Before the end of his tenure, Carter put department money where his mouth was and began to take concrete steps in pursuit of a new “partnership,” including the establishment and funding of the Defense Innovation Unit Experimental.

The driving force for this initiative is to improve U.S. security through faster development and acquisition of weaponry, as well as related command, control, communication, and intelligence infrastructure, to put warriors in the best position to succeed. That is hardly a controversial proposition; it may even eventually serve as a rallying point to help rebuild the bipartisan consensus that existed on security matters after World War II.

For many years, the U.S. government and the defense industry were aligned in an effective working partnership, together producing much of the significant technology and operational defense systems for the U.S. military and the armed forces of its allies. The Defense Department and other parts of government drove technological progress by sponsoring research and development for military use. These efforts later spun off civilian applications that helped shape the lives of ordinary Americans, ranging from the internet to GPS, and continued to do so with technology that led to today’s smartphone.

Still, in 1961, outgoing President Dwight D. Eisenhower warned of the increased role of the military-industrial complex in our society. Through unpopular wars abroad and a “cultural revolution” at home, trust in both the defense industry and the government eroded. Private enterprise stepped into the vacuum created by this diminished trust.

The technology sector also matured over the ensuing years. Government defense spending continued to support basic research and development in both the academic and business sectors. But science and technology innovation was increasingly driven by private commercialization. The modern technological revolution, which is largely privately funded at the emerging company level, has created vulnerabilities as well as opportunities. Venture capitalists focus on investment returns and, hence, on product markets; their interest in solving problems of military application is only opportunistic.

Eisenhower and Carter both recognized the centrality of research and development in an ongoing technological revolution that increasingly impacted American national security. Today, that reality requires retooling a military-technology relationship for this century. Defense and intelligence communities recognize that creativity, and hence solutions, are found most often at the start-up and small business levels of the technological base. Yet, such emerging businesses historically have been outside the security contractor supply chain for building kinetic weapons. The existing model’s ability to keep pace in future warfare, particularly in the cyber domain, is in doubt.

Carter’s initiative was neither re-inventing the wheel nor operating in isolation; rather, he sought to build on the foundation that the U.S. intelligence community created at the turn of this century with its In-Q-Tel venture capital non-profit affiliate. In-Q-Tel funds start-up companies whose emerging technologies show promise of solving problems of interest – but only of interest to the intelligence community. The focus to date has been on data and analytic management, detection/sensors, and communication management. Hence, In-Q-Tel’s effects have been far less pronounced because of its narrow focus to serve the “eyes and ears” of U.S. defense.

Prior to Carter’s effort, there were also small programs with highly limited funding that sought to do the same thing, such as the Army’s OnPoint Technologies program, and the DoD Venture Catalyst Initiative (DeVenCI), which took a novel approach. The program provided a forum for increasing the Defense Department’s awareness of emerging commercial technologies developed by non-traditional suppliers, while at the same time giving those potential suppliers more insight into Pentagon needs and requirements. What DeVenCI failed to provide, however, was investment funds. Beyond these prior baby steps and the present experiment, the Defense Department must recognize that the relationship being contemplated will take significantly more funding and manpower than merely paying for shopper forums and skeletal devoted staffing.

This time, the department should not seek to be the driver of the innovation revolution, but rather to tap into it meaningfully by facilitating security-focused product customization. In other words, commercially-driven product development will be adapted to military need and specifications. This is effectively the reverse of the historical model: Rather than spinning off civilian applications from military technology, privately funded product development for civilian use will generate military applications.

In taking this “reverse” approach, the Defense Department needs to recognize that meaningful market entrance at the emerging company level may sometimes best be undertaken in selective coordination with U.S. allies. Today, innovation is truly global; the best minds and products are sought out everywhere. As such, the United States needs to tap the capabilities of private businesses based in allied nations, and not just to secure those countries’ buy-in for weapons programs. It’s also important to understand that the U.S. defense industry is lagging behind in this supply chain revolution in part because of belated recognition of the problem, but also because of the ongoing operational demands of fighting multiple wars in this century already. These conflicts have driven the U.S. supply focus and, hence, its immediate technology needs for a prolonged period.

Against this background of defense supply chain deficiency, risk recognition, and remedial steps led by Carter, the time for the next military-industrial complex has finally arrived. Compared to its counterparts around the world the Defense Department is decades late trying to build a relationship with venture capital. For example, in the 1990s, while In-Q-Tel was still merely an aspiration at the CIA, Saudi private equity funds were selectively tasked with filling the Kingdom’s security needs. While Saudi private investors were looking primarily for return on their capital, their rulers were also examining long-term steps to solve societal problems that could eventually threaten domestic stability. Thus, both sides jointly sought to fashion a unique public-private partnership calculated to promote investment abroad that extracted, as part of the return, a license to eventually market the technology elsewhere. In this way, the Saudis were able to serve development needs at home by exploiting the licensed technology in the arc of instability from Morocco to Indonesia, particularly the Gulf region. In short, both ruler and investor interests were aligned in using the benefits of commercialization to advance the development curve in their region.

Security needs were another factor driving the involved actors to prioritize private investment abroad for eventual use at home. For example, the Saudis were seeking to invest in innovative tracking technology that could pierce through buildings and other urban “clutter.” The Saudi government knew it had a problem with weapons disappearing, both from the Saudi Arabian National Guard armories and elsewhere in their armed services. No one knew at the time whether the weapons and armaments were being transferred outside the Kingdom for use, or being retained within the country by non-state actors, or both.

The Saudi private sector was selectively tasked with looking for an opportunity to invest in start-ups abroad with innovative tracking technology that had broad commercial applications to justify private investment, but could also help solve the country’s security problem. One emerging technology that was considered explored the use of ground-based radio waves for tracking purposes. Because only private equity funds implemented the strategy, the issues that arose were those typical of investor governance of their corporate targets – there were no complexities related to involvement by a foreign sovereign. The Kingdom merely identified the private funding by which to pursue a technology suitable for such investment. Private enterprise then targeted the intellectual property and commercialization rights that would allow exploitation of the successfully developed technology through manufacture and distribution at home and beyond. This was achieved through a marriage of convenience both for commercial and governance purposes, taking into consideration the potentially significant national security considerations also at play. As the second installment in this series will explore, the marriage floundered when private risk/reward did not suffice to pursue the particular governmental need.

Yet the government’s ability to keep the knowledge of the problem closely held, even while tasking a private-sector search for a customized solution, is worthy of emulation. One of the challenges America faces today is the question of how best to disclose a security problem to the private sector. Riyadh’s ability to share a highly confidential problem outside the government in that manner was a function of the unique Saudi private/sovereign relationship, the details of which need not sidetrack U.S. consideration. Still, the U.S. intelligence community has already developed some mechanisms to grapple with classification issues. The CIA’s experience with In-Q-Tel provides an example of best practices. The CIA’s Interface Center uses an “annual problem set” approach to describe its technology desires. This approach seems to have succeeded in bridging classification needs with the unclassified search for solutions by its venture funding arm.

Another government issue is how best to figure out which emerging technology has potentially suitable military or security applications. This task is complicated by compartmentalization of knowledge and specialization within the defense establishment. The government needs to determine how those most familiar with a problem can identify and channel it in timely fashion to those specifically tasked with finding an outside, private-sector technical solution. There are ongoing efforts in this regard, such as the use of venture capital consultants, as well as the Army Venture Capital Initiative, which interfaces with the deputy secretary of the Army for Acquisition, Logistics and Technology. But results are inconclusive given the lack of sufficient Defense Department funding for meaningful investments side-by-side with venture capitalists or private equity.

This all leads to the next challenge —bringing the emerging companies into the defense supply chain. In the past, the defense community has tried to do this with more developed enterprises, and too often the result was problems with project management and integration. But there are many potential upsides of engaging emerging companies, ranging from a far more pervasive and timely grasp of technology developments, to supplementing and diversifying the supplier base.

To these ends, the United States will need to wean itself from a traditional reliance upon its existing defense contractors as it selects potential subcontractors with an eye to integrating the emerging company level of the technology base. Networking through and co-investing with venture capitalists will help the Defense Department, the Department of Homeland Security, and other agencies identify innovative technology developments in the private marketplace. This may well result in a web of contract developers and manufacturers for what is oftentimes a niche defense market, rather than a dedicated base at this particular level. Regardless, the lack of trust between the government and private sector remains a hurdle to such cooperation, as does the narrow venture-capitalist focus on control and timely return on investment.

Commercial reality, then, is a barrier to the private sector generally — and the venture capital community specifically – in “partnering” with government agencies to these ends. There are certainly overlapping interests, such as mutual cyber vulnerability and the need to develop and upgrade that defense, especially for critical infrastructure. But venture capitalists investing in emerging enterprises maintain a significant amount of control over corporate governance, personnel, product direction and asset allocation. That kind of governance control of portfolio companies, which investors typically charge as the price of admission for their capital contributions, will not likely play well when it is Uncle Sam trying to call those shots. Reduced to essentials, the Defense Department and other agencies don’t have the requisite expertise to provide appropriate commercial direction to emerging companies. Nor is there necessarily market demand for the government investment dollars that private equity otherwise supplies to command such control.

Hence, a more likely future path than partnership will be “collaboration” through focused development and licensing agreements. As with In-Q-Tel, the contracting approach will look more like the one employed under the “Other Transactions” authority that Congress grants to the Defense Advanced Research Projects Agency, than the approach involving the daunting Federal Acquisition Regulations. In addition to these arms-length contracting techniques, there can still be side-by-side investment with private-equity investors, but without the intrusive business oversight and directive rights that private investors otherwise enjoy in the overall enterprise.

To explain, the use of special-purpose corporations for the dedicated defense development activity at the emerging company would help accommodate multiple government needs, while preserving the private company’s overall “freedom to operate.” A dedicated entity would ease private concerns about providing greater transparency to oversight regulators, a requirement that early-stage companies typically do not have to deal with. After all, the Defense Department will never have the latitude of private investors because, as a public institution funded by taxpayer money, it must provide a level of transparency and fairness. A segmented approach would also facilitate the use of “work programs” as well as seconded personnel, as with In-Q-tel. In any event, given that such companies would have a cyber target pasted on them by virtue of their defense work, the government would have to fold at least the special purpose company, and perhaps the affiliated entities as well, into the protective lair of early warning and defense assistance.

In all of these ways, the government could better harness a highly skilled, expensive tech work force that remains skittish about public-sector defense work. However, the bottom line — with which venture capitalists and the private sector are primarily concerned — is that the next military-industrial complex will not be another public-private partnership per se, but rather a new “security technology network” implemented through collaboration, licensing, as well as other contract and relationship structuring techniques with which the emerging technology private sector is already comfortable. Compared to more expansive investment partnership models that intrude unduly into private business governance and asset allocation of an emerging enterprise, the private sector is much more likely to accept this arrangement when the defense establishment comes courting now and in the future. The Defense Department and other national security agencies aspiring to renew and revamp their private-sector relationships ought to embrace 21st-century concepts to adapt their antiquated notion of dedicated weapon- building partners to the reality of today’s emerging technologies.

 

Philip D. O’Neill, Jr. is an international arbitrator whose global international legal practice spanned over three decades. He taught National Security Law at Boston University Law School for many years, and also International Business Transactions at the Fletcher School of Law & Diplomacy. He is the author of two national security books published by Oxford. This article is drawn from a paper presented at and used in the curriculum for “Geo-economics and National Security” at the Naval War College.

Image: Defense Department/Clydell Kinchen