VCs have become more interested in raising funds able to invest in defence, but one big sticking point is that it’s a no go for many of their investors.
It’s an issue that many VCs are wrestling with at the moment, but one that state-backed Estonian investor SmartCap has come down decisively on: it will only back funds with the ability to invest in weapons.
Last month SmartCap announced a €100m fund to invest in defence startups and VC funds — and while it can still invest in dual use funds, CEO Sille Pettai tells Sifted that it doesn’t “accept any exclusions or limitations on weapons and ammunition.
“They need at least to work through the deal flow and be able to source [startups] that are weapons and ammunition-related, even if it’s not their core strategy,” she says.
Pettai says that in the last year, the Estonian LP’s priorities have shifted to defence tech and dedicated defence fund managers as the defence industry has grown — and “not just the generalist VC funds that can do one or two deals.”
It’s not the LP’s only specialised fund: SmartCap still has its €100m climate-focused fund, announced early last year, with funding from the NextGenerationEU recovery fund. “Until last year, the priorities were clearly in the green transition, and it has changed,” Pettai says. “It is rather complicated to invest in green transition and climate tech right now.” SmartCap also has a separate €250m fund to invest in generalist VCs.
‘Don’t complain’
A lot of LP agreements (LPAs) — which include what a fund can, and can’t, invest in — put defence in the same category as things like pornography, and don’t allow VC funds to invest in strictly defence tech or weapons.
SmartCap’s strategy differs from other defence tech investors, such as the €1bn NATO Innovation Fund (NIF), which launched in 2023 and also invests in VC funds. SmartCap is an LP in NIF through its generalist VC fund. NIF previously told Sifted that it doesn’t invest in ammunition manufacturers — a line some industry insiders have privately expressed frustration with considering it is a military alliance fund.
Pettai says she wants SmartCap to be an enabler of the new defence tech being developed to improve the defence capabilities of Estonia and the broader region encompassing NATO allies. It will back funds outside Estonia, as long as they have a presence in the country or are dedicated to building up the Estonian ecosystem, and Pettai adds that SmartCap’s investments ex-Estonia are mainly in the Nordics.
Only bankrolling funds with no weapons restrictions does risk limiting the pool. Pettai says the definitions around this are “in somewhat of a limbo, and being redefined constantly,” but that she estimates less than half of the defence funds out there are actually able to back weapons startups. “Most of the funds [that] position themselves in defence and dual use actually do still have the restrictions.”
However, she doesn’t have much sympathy for VCs bemoaning that they can’t invest in defence. “Some complain because […] the LPs that they have access to have some restrictions, but most of them are fully aware of what they are getting themselves into,” she says, pointing to some big LPs like the European Investment Fund and its restrictions. “At one point you need to make this decision, then don’t complain.”
SmartCap’s strategy
SmartCap has been operating since 2011 and is funded by the Estonian government budget (apart from its green fund). The new defence fund will also invest directly into startups from seed through growth stages and up to €10m per company.
It’s made investments into a number of funds including London-based VC Plural, Antler’s Nordics fund and the NIF. SmartCap’s new defence focus fits with the broader push of Baltics countries encouraging defence tech startups and funds considering their precarious proximity to Russia.
Like other European state-backed LPs, SmartCap requires funds to invest at least 1x of its investment back into Estonia, Pettai says. The new defence fund will invest up to €20m per fund.
“We might not aim for the low hanging fruit, so we’re taking rather higher risks, which often results in the funds having rather challenging fundraising themselves,” she tells Sifted.
One big focus for the LP is to back more first-time funds. “We’re ready to be the cornerstone investor in defence funds, we’re ready to sign the first cheques, and then encourage them to go and fundraise from other investors,” she says, adding that SmartCap is currently working through several potential investments.
But the big challenge is that “all the GPs are rather new in defence; they either have experience in defence and lack an investment track record, or vice versa. We’re definitely taking justified risks here,” says Pettai.
It’s an open-ended question how many startups and funds stick around in the longterm, particularly as peace talks in Ukraine intensify and we may be looking at a post-Ukraine war defence tech industry in the near future.
“Let’s say they are able to close [their fund] in the second half of the end of this year, and the investment period is four-plus years — the question is, what will the market be in five years? They need to exit in 10-plus years.
“The whole defence tech sector has basically been created overnight. There is no historical performance. It’s an emerging sector in Europe, and all these funds need to position themselves right.”
Read the orginal article: https://sifted.eu/articles/smartcap-lp-invest-vc-funds-weapons/
