The rapid growth in European defence investment requires new approaches to balancing commercial objectives with stakeholder risk appetite. Building on our first report’s market analysis, we now examine how institutional investors and private capital funds (PCFs) navigate ESG considerations and structure investments to accommodate diverse stakeholder requirements.

The legal architecture of responsible defence investment

Defence investment occupies a unique position in the ESG landscape. Beyond traditional sectors where conventional environmental and social factors dominate, defence intersects with fundamental questions of democratic values, human rights, and geopolitical stability. This complexity manifests in multiple layers of legal and regulatory considerations that investors must navigate.

At the supranational level, some market participants interpreted the EU taxonomy for sustainable activities, as initially excluding defence-related investments entirely. However, it is now commonly understood that legitimate security infrastructure is distinguished from controversial weapons systems, which are excluded.¹ The European Commission's position – that defence capabilities supporting democratic values may align with sustainable investment objectives – creates both opportunity and complexity for fund structuring, however, most defence investments do not directly contribute to environmental or social sustainability objectives.

National interpretations add further nuance. The FCA's March 2025 statement that their "rules should not be confused with financial institutions' own policies" provides crucial regulatory space.² German authorities went further, explicitly stating "regulations on sustainable finance do not restrict the financing of the security and defence industry."³ Yet these clarifications do not eliminate the challenge – they shift responsibility to fund managers to develop frameworks distinguishing acceptable from unacceptable activities, on which they are typically led by their investor base.

Tracking shifting perspectives on defence

The strategic shift from blanket defence exclusion to nuanced inclusion of some elements of the broader defence sector reveals how institutional thinking has matured. French institutional investors, following extensive review, concluded there's "no contradiction" between ESG commitments and defence financing when focusing on democratic protection rather than weapons production.⁴ This shift acknowledges a fundamental truth: in an interconnected world facing diverse security threats, the infrastructure supporting democratic societies needs investment.

Norway's sovereign wealth fund exemplifies this evolution in practice. Despite maintaining specific weapons restrictions (e.g. investment in nuclear weapons production), the fund holds substantial defence positions (e.g. Leonardo and Rheinmetall) through policies distinguishing defensive capabilities from offensive systems.⁵ This approach recognises that modern security encompasses cybersecurity, satellite communications, and protective technologies far removed from traditional armaments.

However, implementation remains complex. Legal frameworks must address:

• Definitional precision: What constitutes a "controversial weapon" versus legitimate defence technology?
• Revenue attribution: How should funds treat companies with mixed civilian-military revenues?
• Supply chain complexity: Where do acceptable component sales end and weapons system participation begin?
• Jurisdictional variations: How can pan-European funds navigate divergent national interpretations?

The strategic shift from exclusion to inclusion creates immediate practical challenges – how do fund managers translate these nuanced perspectives into legally binding documentation that satisfies diverse stakeholder requirements?

Fund documentation in defence

Modern defence-oriented fund structures require bespoke legal drafting. The complexity stems from multiple stakeholder requirements intersecting with regulatory frameworks across jurisdictions. Fund documents must, therefore, address:

• Investment policy parameters that provide clarity whilst maintaining flexibility. Rather than rigid exclusion lists, funds can adopt nuanced approaches – complete prohibition of cluster munitions and landmines, revenue thresholds for conventional weapons systems (typically 10-20%), and case-by-case assessment for dual-use technologies.⁶ This nuanced approach enables participation in the broader defence ecosystem whilst respecting investor’s red lines.
• Governance mechanisms that ensure ongoing compliance without paralysing decision-making. Enhanced Limited Partnership Advisory Committee (LPAC) involvement has become standard, with quarterly reporting on defence exposures, pre-clearance processes for investments exceeding thresholds, and annual policy reviews informed by evolving regulatory guidance. These mechanisms provide investor comfort whilst preserving GP discretion for complex investment decisions.
• Granting excuse rights that accommodate diverse LP requirements without fragmenting the fund. Analysis of recent fund launches reveals that 70% of Article 8 funds and 90% of Article 9 funds⁷ had no exposure to controversial weapons⁸, whilst institutional investors commonly request side letter provisions prohibiting investments in portfolio companies that engage in the distribution, development and/or sale of weapons or ammunition.⁹

While these structural mechanisms provide the scaffolding for defence investment, they operate within a more fundamental tension – the sector's core activities often sit uneasily alongside the metrics and assumptions underlying traditional ESG frameworks.

The legal complexity of ESG integration

Defence investment challenges traditional ESG frameworks in fundamental ways. Environmental considerations may at times conflict with operational requirements such as in cases where military equipment prioritises battlefield performance over GHG emissions. Social factors also add layers of complexity considering workforce development and skills transfer, where defence industries often provide highly specialised technical training and career pathways in engineering, cybersecurity, and advanced manufacturing that benefit civilian sectors, but that may ultimately be applied for weapons development, resulting in social harm to an alternative society. Governance takes on new dimensions when attempting to balance the need for secrecy around sensitive information with transparency and oversight.

Legal structuring can address these tensions through:

• Outcome-based frameworks that evaluate defence investments through their contribution to security and stability rather than simplistic product categorisations. A satellite communications company providing connectivity for disaster response and humanitarian operations will likely contribute positively to societal resilience, regardless of military end user.
• Proportionality principles that recognise the difference between primary weapons manufacturers and companies within diversified manufacturing and technology verticals that sit below primes on the defence value chain. Legal frameworks should enable investment in companies where defence represents a minor revenue stream or where civilian applications predominate.
• Downstream R&D benefits acknowledging that today's military technology becomes tomorrow's civilian innovation. GPS, the internet, and countless other technologies emerged from defence research. Legal frameworks should accommodate this innovation pipeline, whilst balancing the risk of harm to civilians.

Regulatory fragmentation

The fragmented European regulatory landscape creates unique challenges for defence investment. Unlike single-market funds, pan-European vehicles must navigate:

• Multiple sustainability regimes: SFDR, ESMA’s guidelines on fund naming, each in the EU, SDR in the UK (which doesn’t currently apply to overseas funds), and various national rules create sometimes overlapping but non-identical requirements. Defence positioning for funds disclosing under either Article 8 or 9 of SFDR requires careful analysis of how military applications affect sustainability objectives.
• Divergent licence requirements: Export control regimes remain stubbornly national despite EU harmonisation efforts. A technology acceptable in France may face restrictions in Germany, complicating portfolio company operations and exit strategies.
• Political risk variations: Defence investment acceptance varies dramatically between Eastern European states like Estonia and Poland (increasingly supportive), Western European states with large defence industries like France (traditionally supportive), and neutral EU members like Austria, Ireland, and Malta (remaining cautious).¹⁰ Legal structures must accommodate these variations whilst maintaining fund cohesion.

Beyond pure legal structuring, successful defence fund formation may require bespoke investor communication. The sector's complexity demands education and training alongside transactional and documentation support. Some effective approaches could include:

• Detailed policy briefings that move beyond boilerplate language to explain the rationale behind defence inclusion. Why does democratic security align with ESG objectives? How do defensive capabilities differ from offensive weapons? These explanations build investor confidence in GP judgment.
• Case study illustrations demonstrating practical policy application. A satellite communications investment supporting both military coordination and disaster response illustrates dual-use benefits. A cybersecurity platform protecting hospitals and military networks shows defensive technology in practice.
• Regular dialogue that helps maintain investor confidence through transparency. Quarterly letters detailing defence exposure evolution, annual investor days featuring portfolio company presentations, and responsive communication when controversial events occur build trust essential for long-term partnerships.

Defence liability landscape

While clear communication builds investor confidence, managers must also navigate the sector's distinctive legal risks and liability considerations that require careful structuring:

• Regulatory liability from evolving sanctions regimes and export controls requires robust compliance frameworks and appropriate indemnities. The Ukraine conflict demonstrated how quickly sanctions landscapes can shift, potentially stranding investments or creating compliance challenges.¹¹
• Reputational considerations extend beyond traditional investment risk. Association with controversial events, even indirectly through portfolio companies and their supply chains, can damage LP relationships and lead to a governance issue. Legal structures must include appropriate disclosure frameworks and decision-making protocols for sensitive situations.
• Operational complexities from classified programmes and government contracts create information asymmetries challenging traditional governance models. Legal frameworks must balance transparency obligations with security requirements.

Evolution in fund terms

Liability considerations have catalysed fundamental changes in how defence funds structure their terms, specifically through:

• Extended commitment periods acknowledging longer regulatory timelines. Where traditional buyout funds operate with 3-5 year investment periods, defence-focused vehicles may require 5-7 years to accommodate security clearances and regulatory approvals.¹²
• Specialist portfolio monitoring systems addressing the complexity of dual-use technologies and classified programmes. Private equity firms increasingly leverage industry-leading portfolio monitoring tools (eFront, iLevel, BlackMountain) and proprietary platforms to track defence investments while managing information asymmetries inherent in government contracting.
• Extended hold periods reflecting the sector's capital-intensive nature and lengthy development cycles. The average holding period of US and Canada private equity buyout funds spiked to 7.1 years year to date from 5.7 years in full year 2022 with defence investments often requiring even longer timelines due to regulatory approvals and programme maturation.¹³

The path forward

Defence investment's gradual transition into mainstream portfolios reveals the flexibility of private capital to respond to geopolitical realities. This report has examined the legal innovations enabling this shift – frameworks that reconcile security imperatives with stakeholder values through nuanced approaches rather than binary choices.

The diversity of approaches – from granular exclusion lists to strategic alignment and reconciliation – could lead to important conversations between investors and GPs to establish where the guard rails lie in establishing responsible defence investment. Meanwhile, the sector's inherent complexity demands governance structures sophisticated enough to manage, complex supply chain risks, classified programmes and dual-use technologies while maintaining investor trust. Importantly, successfully navigating this environment hinges on reframing defence as essential infrastructure for democratic resilience.

The legal structures pioneered today will determine whether private capital can effectively support European strategic autonomy whilst maintaining legitimacy. For fund managers navigating this terrain, the opportunity extends beyond returns to shaping democratic resilience. The challenge is ensuring these frameworks remain principled yet adaptable as the nature of security itself evolves.

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This article is part of our "rethinking European defence" series:

‍Part 1: Market dynamics and sector opportunities

Part 2: ESG framework evolution and fund structuring

Part 3: Executing transactions amidst regulatory complexity