PRAGUE - Europe's small and medium-sized defense companies are struggling to access the finance needed to drive innovation and grow production lines even as demand soars due to the war in Ukraine and other conflicts, government officials, firms and experts say.

A lack of access to public funding, red tape and banks' reluctance to lend on fears of falling foul of environmental, social and governance regulations (ESG) are all hindering growth for smaller players in Europe's defense sector, they say.

This as global military expenditure hit an all time high of $2.44 trillion in 2023, up 6.8 percent from the prior year and the most since 2009, according to the Stockholm International Peace Research Institute.

"Most of the problems that have existed in recent times for the defense and security industry have continued or deepened," Defence and Security Industry Association of the Czech Republic Managing Director Jiri Hynek told Reuters.

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One small firearms maker told Reuters a cash crunch makes it difficult to sell products in Europe, or take part in government tenders.

This makes it hard to expand and problematic from a cash-flow point of view, the company's founder and chief executive said, declining to name his firm due to the sensitive nature of dealing with local banks.

"It is very difficult to sell products to governments in Europe because I can't get a down payment. If I want to supply the Czech government they will pay me 30 days after delivery so it makes things really expensive," he said.

Reuters spoke to around a dozen companies, government officials and experts in the defense sector, who all said European governments need to tackle how to improve access to financing for smaller companies.

A 2024 European Commission report estimated small- and medium-sized enterprises (SMEs) in the EU's defense sector faced a debt financing gap of between 1 billion euros ($1.08 billion) to 2 billion euros, crimping business growth, forcing firms to reduce operations and search for funding outside the European Union.

Overly stringent and cautious interpretations of ESG criteria often result in exclusion policies by banks and investment funds in the EU, the report said, adding that providing clarity to the financial sector on how to address sustainability risks could improve access to financing.

"In a sector defined by long development cycles and large capital requirements, a lack of funding can hamper a company's ability to innovate, expand, or even maintain its current operations," the report found.

EU and NATO governments seek production boost

The Czechs have launched a program to co-finance small enterprises in the sector but a massive gap in venture capital money in Europe compared to the United States poses a major problem, Radka Konderlova, a Czech defense ministry official in charge of cooperation with industry, told Reuters.

According to Dealroom.co, the United States has secured the majority of venture capital funding in defense and defense application startups among NATO allies with an 83 percent share since 2018.

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The US venture capital market is bigger and more mature than in Europe with specialized investors familiar with navigating complex defense deals and strict security regulations in the sector, the EU report said.

Konderlova and others said the US government's hefty defense spending signals to markets that it will support projects, giving venture capital firms confidence to invest.

She said one small tech dual-use company, which was selected by Lockheed Martin to participate in the development of an alternative manufacturing process for an F35 fighter jet component, had faced problems before the Czech government intervened with a letter to the bank's chief executive officer.

"When we find out about a problem we help companies on a case-by-case basis," Konderlova said. "But we cannot work like this in every case. There is a need for a shift in the banks' systemic approach."

The financing issues come as Ukraine struggles to access munitions it needs to repel a Russian advance in eastern Ukraine.

A survey by the Czech industry association representing the nearly 200 defense companies in the country found that small and medium-sized companies reported deepening problems over the past year in everything from setting up bank loans to an inability to take payments from foreign clients.

Challenge to access public funds

Fenella McGerty, a defense spending expert at the London-based International Institute for Strategic Studies, said while big players have benefited from increased demand, companies further down the supply chain have found it more difficult to do so.

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Unlike bigger enterprises that tend to be listed on stock markets and benefit from exposure to larger global markets beyond Europe, smaller, more highly specialized companies can present a greater risk as they tend to be more component or system-based, she told Reuters.

This makes it more difficult for lenders to not only establish ESG compliance but also gauge long-term market potential. It also potentially poses a reputational risk for banks as components are more difficult to track to determine whether they end up in the "wrong hands," she said.

Access to public funding is also a challenge.

The EU report recommended providing EU-level funding to develop the bloc's defense industrial capacities as well as removing restrictions on access to EU-funded financial instruments.

Another chief executive of a small company sold a limited amount of rifles to Ukrainians with government approval and said his bank canceled the private accounts of not only him but also his wife and children.

"We always had problems but when we changed the name of our company to include 'guns' in it our troubles got much bigger," he said.