Executive summary
In 2021, Australia, the United States, and the United Kingdom announced the AUKUS technology-sharing agreement. The agreement – comprised of Pillar I nuclear-powered submarines and Pillar II advanced capabilities – represents a significant deepening of the partners’ defence and security cooperation in the Indo-Pacific region.1
The AUKUS governments have acknowledged that government funding alone will not be sufficient to deliver Pillar II’s advanced capabilities at pace and are consulting with the private capital sector to develop innovative financing solutions for Pillar II technologies. Notwithstanding goodwill from governments and the private capital community, longstanding barriers to private investment in defence present impediments to this cooperation.
This policy brief assesses the AUKUS Defence Investors Network (AUKUS DIN) and the NATO Innovation Fund (NIF) and argues for an AUKUS Pillar II innovation fund with a multi-sovereign public-private structure.
The paper outlines three key lessons for AUKUS partners:
- A trilateral Pillar II innovation fund would allow for the implementation of a uniform investment strategy, aligned to government-defined aims and objectives for AUKUS. Ultimately, this would engender greater coherence among investors about what technology readiness level to invest in and on what timeline.
- There is value in creating an innovation ecosystem to match predictable and consistent capital with promising start-ups. The NIF’s alignment and collaboration with NATO’s Defence Innovation Accelerator for the North Atlantic (DIANA) is instructive insofar as it maps out a model for a fluid defence innovation ecosystem. A future AUKUS Pillar II innovation fund should work in coordination with the AUKUS Pillar II Innovation Working Group or the Pillar II Innovation Challenges to provide a bedrock of reliable capital to operationally-vetted dual-use start-ups.2
- The NIF’s multi-sovereign structure is a good start, but the AUKUS partners should build a trilateral public-private innovation fund to make investments go further, faster. The NIF offers a blueprint for a multi-sovereign innovation fund that is more mature than the AUKUS DIN, but thus far it has only been seeded with government money. Seeding a Pillar II innovation fund with sovereign and private capital will be critical considering AUKUS has only three partners in contrast to the NATO Innovation Fund’s 24.
Establishing a multi-sovereign innovation fund for Pillar II will be an ambitious undertaking. This policy brief argues that overcoming barriers to this goal will be necessary if Pillar II advanced technologies are to be delivered at pace and scale.
Setting the strategic scene
In a deteriorating strategic environment, the governments of Australia, the United States and United Kingdom agree that unlocking barriers to defence innovation has scarcely been more urgent.3 Accordingly, in 2021 they announced the AUKUS partnership to transform trilateral defence cooperation across two lines of effort: Pillar I conventionally-armed, nuclear-powered submarines and Pillar II advanced capabilities. Pillar II promises to accelerate the delivery of advanced capabilities across six technological and two functional areas:
- undersea capabilities;
- quantum technologies;
- artificial intelligence and autonomy;
- advanced cyber;
- hypersonic and counter-hypersonic capabilities;
- electronic warfare;
- innovation; and
- information sharing working groups.4
To date, funding announcements have been opaque, with limited cohesion between the three governments’ investment strategies and budgetary allocations. AUKUS joint statements have also acknowledged government investment alone cannot deliver Pillar II capabilities. Greater government engagement with private capital markets to deliver “innovative finance and investment” is seen as critical to advanced capability development.5
Greater government engagement with private capital markets to deliver “innovative finance and investment” is seen as critical to advanced capability development.
A brief history of private capital’s interest in the defence sector
Historically, “innovative finance” has been wary of funding defence innovation globally.6 Innovative finance most commonly refers to venture capital and specialised ‘deep technology’ funds, but can also include corporate venture funds, private equity, limited partners, sovereign wealth funds, private family offices, and governmental and institutional research funds. The reticence of these stakeholders towards defence capability investment stems in part from the perception of poor investment outlooks, with defence innovation often yielding a low return on investment through common exit pathways such as mergers or acquisitions.7 Moreover, lengthy timelines for defence capability development (seven to ten years) are far longer than the typical three to five year return profile venture capital seeks.8 Venture and other private capital investors have also been deterred by the sector’s focus on hardware technology, which incurs both greater risk and greater capital expenditure to scale than software technology.9
Other barriers such as the rise of environmental, social, and governance (ESG) guidelines that track companies against their impact on these metrics have deterred investors from defence.10 Likewise, challenging global interest rate conditions have slowed venture and private capital activity across the economy with investors forced to adopt more risk-averse strategies.11 Due to its high-risk profile, the venture capital sector has been hit particularly hard, with a report from PitchBook Data and the US National Venture Capital Association indicating a 31 per cent decline in deal flow in the third quarter of 2023 from the same period in 2022.12
Admittedly, barriers to investment in the defence sector have historically presented more of a challenge in Australia and the United Kingdom than in the United States. Until very recently the defence sector was considered ‘off-limits’ to most private capital investors in Australia and the United Kingdom.13 In comparison, US private capital markets have a longer and deeper relationship with the defence sector, which is only growing. This is evidenced by the emergence of defence-focused venture capital funds, such as former Google CEO Eric Schmidt’s America’s Frontier Fund, and the growing presence of traditional venture capital in the defence and dual-use sectors. This includes firms such as Andreessen Horowitz (A16z), Lux Capital, and Founders Fund.14 In the US, venture capital’s long tail in the defence sector goes back to the birth of Silicon Valley itself, whose establishment was the product of close collaboration between innovators, private capital, and the Department of Defense during the Cold War. Despite this, the aforementioned dynamics have tested private capital sentiment towards the defence sector in the current climate.15
Why is private capital interest in defence increasing?
In the last four years, the deteriorating strategic outlook in the Indo-Pacific and the war in Ukraine has shifted perceptions about defence as a ‘social good’ among the venture capital and broader investment community in AUKUS countries.16 With ESG barriers falling and the strategic imperative increasing, ‘sovereignty capital’ investments are increasingly viewed as necessary to protect the West’s technological superiority and edge in military capability.17 In a sign that officials realise they cannot respond to the changed strategic environment alone, this private sector interest has been buoyed by concerted government efforts to incentivise private capital investment in the defence sector in the United States, Australia, and the United Kingdom.18 The creation of the AUKUS Defence Investors Network in December 2023 to encourage private investment in Pillar II capabilities is among the latest examples.19
Figure 1. US venture capital deal activity in defence technology start-ups
Source: PitchBook data as at June 15, 2023, via the Financial Times.20
How can private capital support AUKUS Pillar II?
The launch of the AUKUS Defence Investors Network reinforced the notion that government funding alone is not sufficient to develop and scale innovative technology at the speed of relevance.21 This network is a collective of over 300 venture capital firms, family offices, and corporate venture capital groups that convene for discussions and educational activities about AUKUS Pillar II investment opportunities.22 The group is operated by global advisory firm BMNT across all three AUKUS nations.
Frankly, Pillar II’s focus on dual-use technologies necessitates the risk appetite of venture capital to deliver military capability. This is because progress in most of these technologies is being led by cutting-edge commercial technology firms rather than traditional defence primes. These firms often require significant financial and operational support from private capital to support their growth and the scaling of novel technologies from the prototype stage to the delivery of operational capability.23
Besides this, venture capital is better equipped than government to shoulder the financial risk involved in scaling dual-use technology past the ‘valley of death’ that jeopardises much defence innovation.24 Unlike government, which must demonstrate responsible and risk-averse use of taxpayers’ funds, venture capitalists are rewarded by their ability to execute risky bets on promising technologies.25 It is therefore optimal that private capital take on some of the financial latitude that the AUKUS governments do not have in order to develop and scale Pillar II technologies at pace.
Table 1. Total venture capital investment in the US, UK and Australian innovation ecosystems from 2023 to 2024
US$, as of July (Q3) 2024
Source: Dealroom.co.26
Analysis of the AUKUS Defence Investors Network
The AUKUS DIN is the first attempt at trilaterally engaging private capital markets to support the development of Pillar II advanced capabilities. Though it represents a positive step towards utilising private capital to spur Pillar II development, the network’s primary purpose is to convene investors for discussion of investment opportunities and risks.27 In other words, it is not an official AUKUS Pillar II venture fund in and of itself. It therefore has limited ability to coordinate an overarching trilateral approach or investment strategy in alignment with government objectives. Because of the AUKUS DIN’s external positioning from government, some in industry have also lamented its inability to demystify what AUKUS governments want investors to fund and on what timescale.28
It bears mentioning as of 8 July 2024, the Australian Department of Defence released an expression of interest for a Pilot Fund to be delivered through Defence, with the support of other relevant agencies and in coordination with venture capital fund managers and other investors.29 The expression of interest notes the government will gauge “appetite, fund size and opportunities for investors to invest equity (or convertible debt) in eligible Australian micro and small businesses (less than 50 employees),” who have developed priority capabilities per the government’s Defence Industry Development Strategy (DIDS).30 The expression of interest does not mention AUKUS Pillar II, however, if the fund does come to fruition it would represent Australia’s first public-private innovation fund for defence capability development. This would certainly represent a strong test case for a trilateral public-private AUKUS Pillar II fund.
Case study: The NATO Innovation Fund
Australia, the United States, and the United Kingdom are not the only Western governments trying to decipher how to best finance defence innovation at pace. Faced with the challenge of the Ukraine war and the prospect of a more bellicose China, NATO has recently established the NIF, the world’s first multi-sovereign venture capital fund for defence innovation. The following passage analyses the NIF to glean what AUKUS partners could learn and adopt from NATO’s approach, which contains one AUKUS partner – the United Kingdom.31
The NIF was officially launched in June 2022 to support deep technology innovators in providing solutions to NATO’s most critical defence, security, and resilience challenges.32 The fund is a partnership between 24 allies who are “limited partners” – investors who provide capital for ventures – and an investment management team staffed with experts from private capital markets and the deep-technology sector.33 The NIF does not include the United States, Canada, or France who opted out of joining the fund due to perceived overlap with existing national initiatives.34 Thus far, the NIF has been seeded exclusively with voluntary government contributions totalling €$1 billion. Notwithstanding this, it has made numerous investments in trusted private sector venture funds focused on early-stage deep technology. The rationale for doing so has been to bolster funding capacity in regions where access to capital has historically been difficult and in which significant deep technology innovation and solutions exist. This includes Eastern and Southern Europe and the Nordics.35
The NIF works in coordination with NATO’s DIANA to connect patient government capital with vetted start-ups and venture capital firms investing in NATO’s technological areas of focus. However, the NIF is not restricted to only investing in firms that have been through DIANA’s accelerator program. The fund is free to invest its capital across a broader range of assets to develop the strongest portfolio possible.36 The NIF’s multi-sovereign structure means that its capital base is orders of magnitude greater than most NATO countries could achieve on their own, enabling investments in the most promising technology to go further, faster. Importantly, this provides a consistent flow of capital, affording the most promising technology start-ups access to financing at critical inflection points, for example between the development of a prototype, receiving a government contract, and then attempting to scale a product, otherwise known as the “valley of death.” By having access to 24 markets within the NATO defence innovation ecosystem, these companies are set up to thrive commercially on the other side.
In June 2024, the fund deployed equity investments into six start-ups developing capabilities in areas of strategic focus for NATO, including “novel materials and manufacturing, AI, space and robotics.”37 Following this, in July 2024 the NIF announced a partnership with the European Investment Fund (EIF), a pre-existing fund attached to the European Investment Bank Group which provides equity and debt financing to small and medium-sized businesses to support the growth of the European Union’s innovation ecosystem.38 The announcement previewed cooperation to incentivise the private capital funds to deepen their engagement in the defence and dual-use sectors. This included a commitment to “regular dialogue and knowledge sharing” to improve awareness among the broader European investment community about the opportunity in defence and dual-use assets, as well as the development of novel financial products to support the unique needs of firms in these sectors.39
Successes and shortcomings of the NIF
Though a young initiative, the NIF’s multi-sovereign venture capital structure represents a breakthrough method of collaboratively funding innovative technologies at pace.40 By injecting government funds into promising start-ups and successful venture capital firms, the NIF not only gives these start-ups a better chance of delivering advanced defence capability to NATO, but also improves the likelihood of private investor interest in these areas due to increased government demand signals. The NIF’s integrated investment strategy, which is aligned with NATO technology and capability objectives, can provide a consistent flow of capital, due diligence and scaling support to start-ups that meet a standardised technology readiness level.41 This is superior to the AUKUS approach, which lacks focus as it consists of siloed budget line items from the three governments, with private investors thus far encouraged to invest in advanced capabilities at their discretion.42
By virtue of working in tandem with DIANA’s innovation activities, the NIF is able to invest in start-ups that have already been operationally vetted and to provide critical ancillary support to innovators, such as financial due diligence and technical expertise.43 This results in faster scaling and contracting of the best technology and is something that would be particularly beneficial in the AUKUS context to ensure capital is deployed in alignment with government and operators’ preferences.
Despite early signs of success, the NIF has thus far only been seeded with government contributions. Though a valuable test case, its multi-sovereign funding model is arguably a missed opportunity to drive innovation further and faster by incorporating private capital. Moreover, the United States, Canada, and France’s refusal to join the fund due to perceived overlap with existing national initiatives raises concerns about duplication risks creating a barrier to entry for some countries, particularly industrial competitors.44
Lessons for AUKUS Pillar II
Lesson one: A trilateral Pillar II innovation fund could facilitate a uniform investment strategy aligned to government-defined aims and objectives for AUKUS.
As the NIF illustrates, creating a multi-sovereign innovation fund for Pillar II could vastly increase the volume of capital and associated financial expertise available for start-ups producing relevant advanced capabilities. Importantly, a trilateral approach to financing would also provide the opportunity to set a uniform investment strategy across the AUKUS governments and their private capital markets. Ultimately, this would engender greater coherence among investors about what technology readiness level to invest in and on what timeline. It would also ensure private capital is deployed in alignment with government aims and objectives for Pillar II. Though close consultation between private capital investors and the AUKUS governments will be key in this regard, the three governments should adopt a light-touch approach in terms of their degree of involvement with the fund. A 2010 study produced by the National Bureau of Economic Research found that government-backed venture capital is most effective when bureaucratic support is limited to financial investment. Moreover, the study suggested that greater degrees of government engagement in venture capital funds such as active control over business decisions tends to lead to less positive outcomes.45 To that end, the investment management team of an AUKUS Pillar II innovation fund should be made up of professionals from the venture capital industry with backgrounds in defence and dual-use technology investment. Outside of financial contributions to the fund and consultation to ensure portfolio start-ups deliver operationally relevant capabilities, the three governments should limit their control over the fund’s business activities.46
Creating a multi-sovereign innovation fund for Pillar II could vastly increase the volume of capital and associated financial expertise available for start-ups producing relevant advanced capabilities.
Lesson two: There is value in creating an innovation ecosystem to match predictable and consistent capital with promising start-ups.
The NIF’s alignment and collaboration with NATO’s DIANA is instructive insofar as it maps out a model for a fluid defence innovation ecosystem. A future AUKUS Pillar II innovation fund should work in coordination with the AUKUS Pillar II Innovation Working Group or the Pillar II Innovation Challenges to provide a bedrock of reliable capital to operationally-vetted dual-use start-ups.47 For dual-use start-ups already engaging with the Pillar II ecosystem this would afford access to capital at a critical inflection point, enabling passage through the “valley of death” where they might otherwise languish waiting for a government contract to scale their technologies.
Lesson three: The NIF’s multi-sovereign structure is a good start, but the AUKUS partners should build a public-private innovation fund to make investments go further, faster.
The NIF offers a blueprint for a multi-sovereign innovation fund that is more mature than the AUKUS DIN, but thus far it has only been seeded with government money. Seeding a Pillar II innovation fund with sovereign and private capital will be critical as the technology-sharing agreement contains only three partners in contrast to the NATO Innovation Fund’s 24 partners. For Australia, the United States, and the United Kingdom a public-private fund structure is appealing because it empowers venture capital and other private investors to take on some of the financial latitude that the AUKUS governments do not have. For private capital, it offers the prospect of investment opportunities in a growing sector, with the possibility of selling dual-use technology in both government and commercial markets.
The Climate Investment Funds, a multilateral climate fund containing two smaller funds – a Clean Technology Fund and Strategic Climate Fund – is an example of where a similar fund structure has been used in another sector to crowd in private capital investment.48 The US$5.8 billion fund is made up of capital from nine donor countries, including Australia, the United States, and the United Kingdom. It supports climate action in over 70 low-and-middle-income countries by deploying innovative financial instruments to scale climate projects. These include equity, grants, contingent grants, concessional loans and guarantees which are implemented through partnerships with five multilateral development banks.49 Importantly, the fund’s governance body includes private sector representatives and the fund has been able to leverage significant private sector capital contributions by derisking investments in contexts where the “commercial or political risks are too high to attract purely private capital.”50 Ultimately, this public-private model has led to the scaling of climate solutions at a greater pace than could be achieved by one party alone.51
To determine how best to establish a trilateral Pillar II innovation fund, Australia and the United States – who unlike the United Kingdom are not members of the NIF – should send representatives to NATO Innovation Fund headquarters to observe best practices for the AUKUS partners. Australia’s observer status at the NIF could likely be justified under the NATO-Australia Individually Tailored Partnership Programme for 2023-2026, which emphasises engagement “on issues of common interest” including global security issues, science and technology.52
Possible barriers to the creation of a multi-sovereign public-private AUKUS Pillar II innovation fund
For the AUKUS partners, the road to creating an AUKUS Pillar II innovation fund will likely face some barriers. Firstly, because AUKUS is not an alliance and therefore does not have a comparable level of maturity in its governance structures to NATO, it may take some bureaucratic massaging to develop a trilateral Pillar II innovation fund. This does not mean that it is impossible. The ambitious AUKUS agenda to date, which has included reforming US International Traffic in Arms Regulations and conducting coordinated Innovation Challenges, points to strong reserves of trust among the AUKUS partners and a willingness to develop novel channels of cooperation.53 The three countries are also Five Eyes members and have had alliances or close engagement with each other for over a century.54 Notwithstanding this positive sentiment, Australia and the United Kingdom will also need to ascertain why the United States elected not to join the NIF. Though this has been chalked up to “duplication” with domestic initiatives, it is possible that concerns about industrial competitiveness and the prioritisation of a ‘Made in America’ approach were a forcing function here.55 Despite the foregrounding of “allies and partners” by the Biden administration – including in the 2023 National Defence Industrial Strategy – the awkward juxtaposition between ‘Made in America’ and the mandate for increased defence industrial cooperation with allies and partners arguably constrains more ambitious forms of alliance cooperation and integration.56 Assessing the ability of the United States to overcome these hesitations insofar as they relate to a trilateral AUKUS Pillar II innovation fund will give some indication as to the likelihood of a future JAUKUS (AUKUS + Japan), KAUKUS (AUKUS + Korea), or AUKUS ++ (Japan and Korea) Pillar II innovation fund. Finally, to utilise private capital to develop Pillar II, the AUKUS partners will need to consider how to detect and prevent “adversarial capital” from infiltrating a future AUKUS Pillar II innovation fund.57 The NIF has not yet had to confront this challenge head-on as it has been established with sovereign funds, though it does award some of this funding to select venture capital firms investing in the ‘deep technology’ sector.58 An appropriate first step might be to assess how existing initiatives could be leveraged to build a trilateral digital database of ‘clean’ capital providers. One obvious place to start is the US Trusted Capital Digital Marketplace initiative.59
Bridging the gap between the AUKUS Defence Investors Network and a more ambitious multi-sovereign public-private innovation fund for Pillar II will not be easy. However, if the AUKUS partners can collaboratively harness the power of their private capital markets towards mutually beneficial innovation goals, they will succeed in delivering advanced and asymmetric capabilities at a pace and scale not possible alone.