Can Europe innovate at war(p) speed? - with the NATO Innovation Fund

Lizzy Galbraith:

Hello, and welcome to Macro Bytes, the economics and politics podcast from Aberdeen. My name is Lizzy Galbraith.

Paul Diggle:

My name is Paul Diggle.

Lizzy Galbraith:

And today we are joined by two very special guests. We have John Ridge, Chief Adoption Officer, and Erin Hallock, partner at the NATO Innovation Fund. Thank you very much both of you for joining us today.

John Ridge:

Thanks very much indeed for having us.

Erin Hallock:

Yes, thank you.

Lizzy Galbraith:

One of the things that we want to discuss is the transformation that we've seen in European defence spending and European approaches to national security over really the course of this decade so far. Of course, we are recording this on the fourth anniversary of the full military invasion of Ukraine that has now become the longest and the most destructive land war in Europe since 1945. And it really has been something that has been transformational for the entire continent, both in terms of how it's transformed policy, how it's transformed some of the long-held assumptions, I think, a lot of European capitals have had around issues like security, resilience, even spending priorities and how they should be approached. So very far-reaching consequences. But to start with, for those listeners that are maybe unfamiliar, John, would you mind just introducing the NATO Innovation Fund and explain what it is that you do and what the challenges is that the fund is trying to address?

John Ridge:

Yes, I mean, first and foremost, I think it's worth just recognising that four-year anniversary. I think that's really important. Having been out there a couple of times in this job, it's extraordinary to see what the Ukrainians have done and the sort of bravery that they have exhibited and the innovation that they've exhibited to hold the Russian advances they have. So first of all, I think it's really, really important to kind of just reflect on what they have sacrificed over the last four years. And clearly, we all hope that war comes to an end as soon as it possibly can. I'll let Erin talk about the investment side of the fund. I suppose just in terms of telling the origin story, I think it's worth reflecting that NATO set up the NATO Innovation Fund and DIANA, the Defence Innovation Accelerator of the North Atlantic. They were set up to recognise this shift that's happened in terms of where defence and security get some of its cutting-edge tech. So in the previous decades, this has been something that's been done in government labs and by government-funded research with traditional defence industry partners. DIANA and the NIF were set up to recognise that many of these cutting-edge technologies were now coming out of the private sector, coming out of venture-backed startups. So DIANA is an accelerator established to accelerate some of these, particularly those early stage, low-technology-readiness-level capabilities. And the NIF set up to provide some venture-stage funding. But I'll let Erin explain the VC side of things.

Erin Hallock:

Yeah, and one thing kind of picking up on what John said, it's, the NATO Innovation Fund is unique in sort of many ways. But first and foremost, it's the only multi-sovereign venture capital fund in the world. And importantly, when NATO set up the NATO Innovation Fund, or as we call it, the NIF, they did so so that it was independent. So we operate entirely independently of NATO, but we have the privilege of using the NATO brand name and we have access to NATO and we have access through our 24 LPs into their ministries of defence. And so the 24 LPs backed NIF with a billion euros to invest in early-stage defence, security and resilience businesses across the LP nations. We invest, so in terms of kind of the flavour of the capital, we invest from seed to series B, about half of our 19 investments are series A, roughly a quarter are seed and roughly a quarter are series B. We don't, we're relatively agnostic as to whether we lead, co-lead or follow. We don't have a red line on that. What's important is being able to help our portfolio companies scale and grow. And John will pick up on that with his role. And then we invest between, kind of one to 15 in a first round, and then we'll go up to 25 in subsequent rounds. The fund is a relatively, sort of, long-dated fund. And so it's very much the flavour of our capital is patient capital.

Paul Diggle:

So great, we’re going to definitely dive into all those areas. But John, could you tell us a little bit more about, the sort of defence capabilities that NATO needs. And I should say you have, before this role, you were in the British army as a Royal Engineers officer. So you’ve seen this both as a practitioner and now involved in the NATO Innovation Fund. So tell us, you know, how was the nature of modern warfare changing and that’s affecting the sort of technologies that you’re looking at and that NATO needs?

John Ridge:

So a huge spectrum. If I start, if I rewind back to the start of the conversation when we touched on Ukraine, I think Ukraine has taught us some really important lessons around the sorts of capabilities that we will need to have in any future conflict. And the reason that’s important is not because we want to fight wars, it’s because we want to deter them. So if we’re going to be able to deter future conflicts, we’re going to need some capabilities which have come out of [the] Ukraine campaign. So some examples of specific technologies: the un-crewing of systems, so taking humans out of, what we describe in the military as, ‘platforms’. So, you don’t want every platform there to be crewed, you don’t want everything to be around tanks. So, taking the human out of the tank and having un-crewed ground vehicles. We’ve seen this most obviously in the air domain, so ‘drones’ as it’s kind of loosely described. But we’ve also seen it in Ukraine in the maritime domain, so un-crewed surface vessels in the maritime domain have been transformative in terms of Ukraine’s ability to resist the Russian fleet in the Black Sea. So that’s one specific example [of] those technologies, take humans out of the vehicle, the platform. Electronic warfare is another area. It’s extremely difficult to do anything that relies on the electro-magnetic spectrum in Ukraine. And we should expect that to be a feature of any future conflict. So whether that’s navigation, whether that’s communications – either human-to-human or communicating to machines – that’s another feature which is going to be in there. Space capabilities are absolutely critical to everything that goes on in current conflicts and they’re also critical to what we do in civilian life. So communications, surveillance and reconnaissance, all those capabilities which are in space, that’s another set of capabilities which are going to be features. So that’s just a, kind of, some of the areas in terms of specific capabilities. I think what’s really, really, important though is kind of, underpinning that, are two, bring out two systemic things: one is that the lesson, one of the key lessons of Ukraine is that what you field on day one is obsolete on day six. So what we’re seeing there is this really rapid innovation, this incredibly fast response to countermeasures, both on the Russian side and on the Ukrainian side. So that’s a feature of the companies that we invest in, they’re companies that can change their product incredibly quickly, sometimes on a sort of, daily basis. Whereas we’ve got a defence system that’s configured on, sort of, six-monthly upgrades – that’s not good enough for future warfare. And the second, kind of, underpinning capability is around the industrial base. So it’s been extraordinary to see how Ukraine has generated almost from scratch a completely novel industrial base, distributed manufacturing, resilient supply chains. This, again, is critical feature that we’re exploring in the NIF, is how we build that for Europe, how we build that ability to have secure, scalable and resilient supply chains.

Paul Diggle:

Erin, can you tell us more about how you go out and find such companies, with that degree of innovation, but early on in the development of the technology, but that you're hopeful will in time scale to become deployable in the field? How do you actually find those companies? 

Erin Hallock:

Yeah so, I mean, in terms of how we find them, there's a couple of channels that are not, that will be sort of, all other kind of VCs will do the same thing in terms of going to conferences, networking with startups, networking with earlier stage investors who will invest, kind of, at the pre-seed level and then getting deal flow that way. That is synonymous with NIF as it is with kind of other VCs. But one thing that I think is very unique, and this helps our portfolio companies to scale, is our ability to plug into NATO and our ability to plug into the ministries of defence to understand some of those capability gaps and those requirements that John was just touching on. And so, we do have an example in our portfolio where we were working very closely with NATO to understand some of these capability gaps. And what they said and highlighted very clearly was un-crewed surface vessels. So, these are autonomous marine vessels that they said was a capability gap that needed to be addressed. When we heard that, we basically did desktop research, spoke to experts, networked across the ecosystem, and identified a business based in the UK that we thought had leading cutting-edge technology. We made an investment in that business after that. The investment is now, sort of, eight months old, and already with our mission platform group, which John runs, has secured commercial contracts. So, and that's a key differentiator, and I think that's what's most valuable in terms of our capital and what probably distinguishes us most acutely from other investors, is we get those early demand signals. And so, we're not trying to push water uphill when we're speaking to the end user. We are investing in companies that we know is addressing some of these capability gaps.

Lizzy Galbraith:

So, to then move on to how you then are able to progress these companies into actually being deployed. John, you spoke about the really rapid pace of innovation that we've seen in the war in Ukraine and the difficulty that other countries have had in matching that kind of pace. Obviously, the procurement systems in defence have been fairly notorious, I think, for often being really quite slow. We see headlines all the time about projects that have run far later than they should have done, often into the years, let alone months. How do you kind of meet that challenge when you're seeing the pace of war, the pace of innovation move so quickly, but some of the challenges that you're trying to meet aren't necessarily aligning with some of those procurement systems themselves? How do you bridge that gap?

John Ridge:

It's hard, I think is the first thing to say. So, we've got a system that's broadly configured to send out quite specific requirements, often very, very complicated requirements, and say to industry, go away and build me a thing that looks exactly like this. And it will be, that normally requires a long process of research and development and prototyping and everything, which is done from the start from that requirements document. Whereas the companies that we've got have generally got pretty mature prototypes. They've got things that basically work. We've got a system that basically wants something that comes in as 100% ready, exactly as it is, comes off the production line, ready to deploy, where many of our companies want to bring an 80% product and say, I want to work with you to make this 100% product so that we know it's keeping up with the latest technology. So, you've got a big mismatch between the system that's doing the acquisition and the system that's doing the delivery through startups and scale-ups. My frustration is that we've done this before. So, I was out in Afghanistan, heavily involved in the counter-ID campaign out there, and we saw our ability to bring these technologies to bear in months in some cases, to deploy them out to theatre, to be able to operate them and to have this really rapid feedback loop. It happens on operations. It tends not to happen in peacetime. So, we're working really closely, and there's some really good. The aspirations are there, and we're starting to see some of the countries in NATO deliver against this. A really good example is the US, with the Defence Innovation Unit (the DIU) in the US, which is taking commercial technologies and basically deploying late-stage prototypes and iterating very closely with the end user. The trick is getting beyond the prototype, and to come to the heart of your question, it's not about deploying two or three of these things. It's about deploying hundreds in some cases. And what that means is that you need to have two things in place. You need to have the money in the programme. So, we're still waiting for the Defence Investment Plan from the UK MOD. That will set out where the MOD intends to invest its money. That must include money for these startups into the areas where they're able to produce these technologies. So, that's the first thing. You need the money in the programme to do it. If it's all locked down on contracts already, you are not going to innovate because you can't scale your prototypes. And then the second bit you need, is an acquisition system that recognises this difference in terms of how startups come to the market. So, you want to run competitions that instead of saying, write me an essay, I'm exaggerating for effect, but write me an essay that tells me how good your thing is, which is how many of the competitions are run currently, to bring your product along in three months, four months, five months, and demonstrate how good it is. And we will fly off or drive off or sail off the best in the field, and the ones who demonstrate that they are the most capable platform will get the contract. That's what benefits both the startups, because they can bring their technologies better, more quickly. And more importantly to me, that benefits the end user who gets that capability in months and not years.

Lizzy Galbraith:

Yeah, I think we've seen that in instances beyond the UK as well. I think the German government's having a similar conversation at the moment about needing to target more of that funding towards some of these more innovative kind of product offers rather than just the traditional. But to move on, Erin, I think one of the things that's become very clear is that the fund's remit is far, far broader than what we might have considered conventional defence. So, we've spoken about data, AI, advanced materials, you also cover biotechnology, space has also been mentioned. Are these areas that are traditionally underserved by private sector, venture capital, bank lenders, you know, your more traditional government funding programmes? Are you identifying a gap that NIF is trying to fill? And do you think there needs to be more private finance coming into this space to support the growth of the sector? I'm thinking, you know, dual use as well as those kind of purely defence startups.

Erin Hallock:

No, I think, great question. I think what we've seen is, so we've seen the sector emerge from kind of nascent, almost untouchable for private capital. I've been an investor for 19 years, and I can remember things that had elements of dual use coming across my desk. And it was unquestionable whether we could consider them. They were kind of, those opportunities, those startups were effectively kind of dead-on-arrival if they discussed anything with regards to dual use. Because for a lot of investors, that was just not palatable. And so, we've seen the sector go from kind of nascent to last year, the amount of venture capital that went into DSR, Defence Security and Resilient Startups, was 8.7 billion dollars. And that was a 55%-increase over the prior year, and almost a four-fold increase from just five years ago. So it’s gone from kind of nothing to significant. But most of that capital, importantly, I said it was in, kind of the word I mentioned quite quickly, ‘venture capital’. So what we've done, and I think what the industry and the ecosystem has done, is it's proven that there is demand at the early stage to invest in dual-use businesses. And capital is crowding into that space. 8.7 billion is nothing to, kind of, sniff at. But what we're not seeing is, I think, one, enough liquidity in those investments. So, seeing exit opportunities. And two, enough, kind of, bank debt. And I still think there is, to some degree, a bit of a mismatch between private capital investors and the capital-intensive nature of dual-use businesses. These are kind of 10-year development cycles. And so, what I would like to see the sector deliver, you know, if last year was a 50% increase, what I would like to see this year is a broadening across the capital stack. So, there being increased bank debt available, more sort of alternative and flexible funding, and more patient capital coming into the sector to enable businesses to scale up on these 10-year horizons, which is what's required.

John Ridge:

I think one of the challenges for that is those later-stage or institutional investors, if they're not seeing that demand in terms of proper contracts turning into proper revenue, it's even less attractive. So, that's why I keep coming back to governments, certainly on the sort of defence and security side, but it's slightly different on the resilience side. But on the defence and security side, that means governments need to buy this stuff, because it's a kind of monopoly, monopsony type environment. You need them to start letting those contracts, then we start to see the revenues for those companies, and then that becomes really attractive to those other capital providers. That's the bit that's so important. And my view is it's a finite window. So, we've seen this early capital come in, people will start to get twitchy if fairly soon we're not starting to see those contracts come through. And Erin and I were chatting earlier, one of the challenges you get is if you're a BAE or a Rheinmetall or a Thales, you've got deep pockets, you can ride out these, sort of, two-year, three-year programmes where there's this delay on delay on delay. If you're a startup, you absolutely do not. You cannot wait for that time, because you need to go on your next fundraise. And your next fundraise, if you're turning around and saying, hey, well, I've got this kind of promise of a contract that might turn up, that's not good enough to many of those later-stage investors.

Paul Diggle:

Well, tell us more about that adoption process then, John, and how you support them. So there's this concept, right, in VC and the ‘valley of death’ where you're sort of go from innovating to scaling? And part of VC funding is to help firms overcome that valley. And another way of saying that, John, I think is adoption, your remit. So how, tell us more about how you push adoption of these technologies with the alliance. 

John Ridge:

So, I'll extend the kind of ‘valley of death’ analogy, if I may, with my adoption bridge. So, my adoption bridge sees on one bank, you have the startup, and you've got the startup that's got this amazing technology that we know the end user wants, that's pretty mature, but just needs to find a customer. On the other bank, you've got the customer that is probably a ministry of defence, but it might be an industry partner, because it's a complex system, and you're going to integrate the startup subsystem into your complex system. So, you've got these two things, one on one side of the valley, one on the other. What we need to do is we need to work with both the customer side, the supply side, and the demand side. So, we work with the customer side to say, hey, we'll help you find where there's a demand signal out there, where we know that there's a nation, for example, that's got funding and a programme for this, or we know there's an industry partner who really needs that technology. So, we help them understand what that looks like. We also help them get ready to work into defence. So, it's a challenging environment to work in, because you need to think about security, whether that's cyber security, or vetting, or other bits and pieces. So, we'll advise them on that side of things. On the other side of the valley, you've then got the demand side. So, you've got these customers, and we explain to them, hey, there's this whole untapped market that you're not making the most of with these incredible technologies over here. You need to be easier to work with. So, you need a front door that they can go to. You need to be able to have a sensible conversation around how big your tenders are, et cetera, et cetera. So, there's a lot of reform on the sort of demand side. So, once we've done that, then we build the bridge, and the bridge is about saying we found a product, and we found a use case. We're now going to link the two of those things together, and we're going to hand hold the startups through what are sometimes quite ‘Byzantine’ processes to match them to a competition, et cetera, et cetera. So, that's the kind of bridge. Underneath, there are then two planks that we use inside my team. One is the bit that Erin mentioned earlier around demand signals. That all becomes so much easier if you're linking to a known demand in the customer base. So, work really closely with the investment team to make sure we're investing in companies that are producing stuff that end users want. So, that's the first bit. And then the second bit is because it's so hard, we ruthlessly prioritise our efforts. So, we've got 19 direct companies. We've got 32 NATO nations. I cannot join every company to every NATO nation, to every industry partner. So, we're working really hard to build a digital platform, which allows us to do pattern matching and then prioritisation to make sure that the work we're doing has the greatest chance of success and is going to provide the greatest impact to NATO's ability to deter. So, that's the kind of process – supply, demand, bridge, and those two underpinning functions.

Paul Diggle:

Erin, John mentioned the monopsony buyer for defence firms, a single government or an alliance of governments. How much of a problem is that for a startup, facing a buyer like that? And tell us about the work the fund does to match the supply with the demand from these monopsony buyers.

Erin Hallock:

Yeah, I mean, I want to go back a little bit. So, I will get to your question. But I think, you know, the important thing, kind of reiterating what John was saying, between basically by the end of the decade, Europe has to mobilise a trillion euros to modernise its capabilities, rebuild force readiness and rebuild stockpiles. And right now, there's a mass imbalance between acquisition systems and that urgency. It's in some ways, it's helpful if you only have a couple of customers, because you're not chasing the kind of endless number of customers to try to generate revenue. But what is difficult for a lot of our startups is the nomenclature, the language, the competitions, it's all very different. And especially if they're in dual use, so some of our portfolio companies are defence only, and some are defence first, they sort of already get the nomenclature and they're versed and steeped in the process. For those truly dual-use businesses, or for the dual use which are commercial-first, it's completely divorced from everything that they understand. And so, they're starting at ‘T equals zero’ and trying to learn that. And so, having only a couple of customers is helpful. But having a couple of customers that have very long, very complicated, to borrow John's word, ‘Byzantian’ procurement processes is really difficult. And that's why I think to kind of close these capability gaps requires reform in planning requirements, setting procurement processes. And when we're plugged in, we can at least be a very difficult voice in the room to really urge government to reform. But I think that's one of watching the situation unfold in Ukraine. That is what Ukraine is absolutely excelling at. And that's why they're holding the line is because they're doing all of the things that we are telling our ministries of defence you have to do. You've got to procure from startups, you've got to procure at speed, you've got to be comfortable with a beta product, and work with the startup to iterate and innovate. And you've got to look at products as horizontals, rather than looking at them as isolated, fully kind of, sorts of standalone systems. You've got to look across your requirements and see how you can plug-and-play different solutions to solve a capability.

Lizzy Galbraith:

So you've mentioned government reform there. So I think to zoom back out a bit from the kind of company level and go back up to this kind of European-wide issue, we've obviously had the increase in the NATO defence spending target last year. It's now up to 5% or 3.5% of core defence plus 1.5% adjacent. Obviously, that's triggered a fairly substantial increase in budgets. We've started to see money move through the system, not necessarily equally across all member states so far. And it's obviously come at the back of, as well of, a decade and a half or so where budgets were significantly lower. So John, how are you seeing the shift take place on the ground? Where do you put Europe at the moment between that kind of underinvested defence sector that maybe we've had in years previously to something that is ready and capable to meet the challenges that you and Erin have been talking about, that they need to be ready for by the end of this decade?

John Ridge:

I suppose I'd summarise it as kind of patchy, but with green shoots. I think there's some sort of political commitments. We've not seen the really significant budget increases in many parts of Europe. I also think that the tendency will be to take that increase in budget and give it to the normal suspects. So it'll go to the major defence industrial partners who are lobbying and have this sort of historical relationship. They're absolutely configured, they mirror all of the frustrating behaviours inside defence. Don't complain to [the] defence industry that it looks like it does because it's absolutely responding to a set of, it's a rational response to a set of incentives that defence has set in terms of how to procure everything else. It absolutely mirrors the behaviours. So first of all, we need to see those budgets go in as they promised here. We need to go in more quickly. Some of the profiles are really slow and actually I think they need to accelerate those. We also need to see, as I mentioned earlier, an ability to unlock some of that uplift, not all of it by all means, by any means rather, but some of that uplift needs to go to these different suppliers because we know that the capabilities that we're going to need to have are best produced by some of the different companies. And so it feels to me as if there's going to have to be a sort of reset in how different pieces of, ecosystems a horrible word, but how different players in this whole system interact because you've got the traditional defence primes who are absolutely critical to this. They are vitally important. They produce the most complex platforms and we're still going to need some of those. We then have the startups and scale-ups who are producing some of these subsystems, these really novel innovative technologies. You've got a handful of those who have scaled already, the sort of the Tekevas and the Starks and a number of other sort of players in there, the Helsings, who are the sort of neo-primes, is one of the terminologies that's out there for those. And then you've got the SMEs, the supply chain pieces. They've got to work out how they interact in a different way from how they have in the past and all of them need to be able to access some of this uplift in spending. So there is a tonne of work to do. I think going back to Erin's point earlier, we haven't got a lot of time for this. So that needs to happen really, really, quickly. And what we need to see is policies put in place by government that incentivize the right behaviours and shift us away from just kind of piling money into the same old industries and missing out this opportunity to do really novel things.

Paul Diggle:

John, how do you think of questions of having a single versus multiple platforms of different weapons technology? So one complaint you sometimes hear people say about Europe is, well, there's so many platforms, you know, there's all sorts of different main battle tanks or fighter jets or whatever it is. And the US has kind of one or a small number of each of those. And that's a problem. But the sort of ecosystem story you're telling sounds like a proliferation of platforms. So tell us about the trade-off there.

John Ridge:

Yeah, there is definitely some truth in that. So if you have, if you have far too many suppliers of a particular platform type, you don't get the efficiencies of scale that you're able to achieve in the US or in some of our adversaries who are able to get those efficiencies by having a very small number of platforms. You do, however, build markets in different parts of Europe, which I think is important. I think one of the interesting emerging models is where you take a base design from country A and they say, do you know what, we will export this base design and we will build factories in countries B, C, D, E and F. But you can all have a slight variation on it. So the sort of underlying IP is very similar, but we'll build this in a modular way. So you can then put your own sensors on that, your own vectors, potentially your own software. So you can have a slightly different model that applies across there. What that does is that standardises it enough that you get some of the advantages of scale, but you're then getting the sort of the special sauce for each country. And critically, you're also getting the jobs and the manufacturing and the supply-chain benefits in the countries that are building it for their own markets. So to me, that feels like quite a neat way of getting around some of those challenges. The future is definitely going to be about modularity, because that's how you do your upgrades. So platforms that come out that say ‘this is the thing that you're going to have, and it looks like this for a year’, I'm afraid I'm not sure that's a particularly viable business model for much longer.

Paul Diggle:

Erin, could you talk to us about the push, the buy European push, that you see amongst the European defence sector and a lot of the headline 5% of GDP numbers that Lizzy was talking about. There are efforts to point that particularly towards European defence funds or startups. I suppose NATO Innovation Fund is acting that out because your members are, if I'm not mistaken, largely European NATO members. And I guess that's where you're finding your opportunities. So, yeah, tell us more about, does that constrain you or is that part of the strategic aim to source this from within Europe?

Erin Hallock:

Yeah, I mean, I think for me, what it is, is it's a discussion around resilience. And resilience is built, it's not declared. And it requires sustained commitment from government, from innovators, from investors. But to some extent, you know, this this conversation is a little bit about, on showing capabilities again and rebuilding, storing Europe's industrial base. It's also about commercialising the IP and innovations that are created within Europe. It's also about creating jobs and vibrant economies. So that's part of the discussion. But it also goes back to this speed point. If you're going to do rapid innovation, you need to do that, sort of, in parallel with the end user in close proximity. And that doesn't work when you're doing it across great borders. I think where one of the discussions, I think it's where maybe if there's a deficiency or a challenge in the conversation, it's and this is where you lose the economies of scale. You can't have production in each country. You can't, you know, so to be very extreme, you can't have a drone manufacturer producing drones in each allied country that is only for that country. So drone manufacture for Germany, for Norway, for Sweden, for Finland. It doesn't work like that. It's about collaborating across.

Lizzy Galbraith:

Okay, I think we will end things there. Thank you so much, John and Erin for a fantastic discussion that has been incredibly interesting and incredibly timely as well. So thank you both for joining us today. Please remember to like and subscribe to the podcast on your platform of choice. And we will speak on the next one.

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