Drone Companies Will Eventually Consolidate: Kahyaoglu

I'm really excited for this because I know you all approach this world of defense, m and a, and investing from from very different angles. Sheila, you've been tracking countless, m and a action in the industry this year. I think $55,000,000,000 worth worth of volume. What now? Where do you see still where targets are really ripe for more mergers and acquisitions within defense? Yeah. So space tech and defense tech has been an emerging theme over the last five years that's been percolating in the space. Obviously, the SpaceX IPO was the flagship of that. And then you've had companies like Andrew O'Day, which are still private, but they won two major awards yesterday, actually. One for an army contract and another with the navy to build a new navy shipyard in Baltimore. So you're seeing those two as, like, the flagship of defense tech and then smaller companies we've taken public. One I really like is Voyager, which does missile technology, but also, is looking to build the International Space Station, in 2030. So there's there's been about 11 defense tech IPOs in the last year that we've taken public, and it's good to see the capital behind these companies. Ward, I I would love to know... Well, one would love to know just if you're gonna be behind this IPO volume too, but what specifically you're targeting among companies that you'd like to add to your portfolio? We tend to focus more on lower middle market private businesses between 5 and 30,000,000 in EBITDA. We actually look at the defense market in really seven submarkets really because of the fact that there are multiple ways to to make money. You can look at infrastructure plays. You can look at early stage tech businesses, or you can look at services businesses. There's lots of opportunity in the space for everyone to participate. Anita, what do you think is the most compelling opportunity right now? For me, it's something in between the venture backed companies, the defense tech companies you hear so much about, and the big prime contracting opportunities like the Andoril situation that Sheila described. It's the supply chain that has to serve everybody. It's the... Everything from raw materials to valves and metal components to defense electronics probably at the top of the list in that supply chain. Can we talk about, the food chain beyond the supply chain? Because, Sheila, I think one of the more interesting things, and and you know this better than anyone, is how much the world has changed from the primes to the neoprime competition really coming in. How does that change the dynamics? I think it allows for more opportunity. You know, the Andoril situation, it's half funded by them and half by other capital. So that that allows for more capital to come in and these projects to actually happen. So I think that that's what's allowed the fund flow in the space and the growth. These companies investing in their supply chain and their component businesses. I was interviewing the CEO of Unusual Machines yesterday, and it's a small drone company, but there's 60 small drone companies out there. I would have never guessed that all focus on solely on defense. Is that too crowded, though? 60 drone companies. Eventually... It'll eventually consolidate, and there'll be two to three winners. Ward, I I wonder how it changes the dynamic for you all. Does this mean your exit opportunities are different or where you're looking to actually source deals from has changed too? I think the exit opportunities continue to grow for everyone in the space. There are more and more people with capital. This administration has been particularly supportive of of public private partnerships, and and that's an advantage for all players, whether it's early stage tech companies or more mature businesses. Anita, this IPO market still wide open, or is it more exiting towards other strategics? Well, I think what you're starting to see is all these successful IPOs become the buyers of the other companies. Three wire focuses as both an independent adviser, investment bank, and a coinvestor with these companies. And we're seeing a lot of those recently public companies trying to put money to work both because they've raised it at attractive valuations and trying to make sure that they have products going to market and diversification not concentrated on just one opportunity. By the way, those valuations, I would love to hear from all of you on this. Just how you're seeing valuations in the space that that you track. If it does look like something that is sustainable to continue to see them climb given all of the government and otherwise interest, or if it seems like we're something at a peak evaluations? We look at fiscal year two, so, like, 2027, 2028 numbers, depending on how profitable or free cash flow generation the company has. We're seeing a 10 multiple d rating on EV to EBITDA from the start of the year for our defense tech group from 30 times EBITDA to about 20 times EBITDA, which I would say is more of, like, a great... A decent entry growth multiple for these names. What about So it's coming in from, like, the hysteria in the start of the year. Yeah, Ward. What are you looking at? I think more in the lower middle market where where we play in the middle market, you tend to see high single digit, low double digit businesses, services based businesses from a... From an enterprise value standpoint. Well, I'd say the sectors that we like the best, the electronics, the autonomy, the military space, those are all much closer to the IPO types of multiples. What really drives the difference, and there is a barbell between companies that have great opportunity but haven't proven it yet and those that actually have the contracts and the backlog in hand, and those are the higher multiples. Okay. That gets us back into this idea of risks and, like, too many drone companies and and all of these coming forward. I wonder if that is a risk, that there is just widespread crowding and maybe some speculative companies coming in. Is that fair to say? I mean, is there something to this moment where everybody is sort of rushing in? I think that there's just working capital strains and free cash flow strains on some of these companies as, you know, we took down our numbers for Kratos as an example for next year. I had to double our working capital assumptions because the CEO is dual triple sourcing his solid rocket motors from multiple component suppliers just to meet the demand. Because you don't wanna be like Honeywell Aerospace, which has contracted 25% in the last two months because they missed delivery. So everybody wants to ensure that they have the supply chain there, so for what it's worth. Anita, this gets back to your point about rightsizing the supply chain. I mean, how difficult of a task is that ahead, or do you see this continuing to be a bottleneck for some years to come? Well, it will be a bottleneck for some years to come because it can't happen overnight as much capital and intent as we throw at it. And one of the reasons for that is a lot of the attention both from investors and the government have been on those drone companies, those systems companies. And the companies that support them tend to be smaller, and so they attract smaller middle market investors. They rely on commercial banks, lending arrangements as opposed to the very big dollar numbers we're seeing accumulating in companies like Andoril and Shield AI or that the government is focused on. And so it's gonna take a while for capital to find those situations and address the opportunity that's been presented to me. I guess, Ward, if you're getting in sort of, like, at at at that stage, it sounds like that's a little bit what you're targeting that you see that opportunity there too. It is. I think for us, we... Money follows mission at the end of the day. So from a policy perspective, the US government is changing its policy and where it wants to deploy capital. Over hundreds of drone companies, they're all not going to survive ultimately. And, Ward, do you also have a... I mean, as everyone around this table does a deep extensive background in the sector. And I know you are kind of looking at the competition there, and I wonder if you see all of the PE funds who are now interested in this. If you're concerned about sort of tourism in the defense tech world, if you will. Well, there's always tourism in any in any industry. I think today, there certainly are people in the defense tech space that probably won't survive. Not not every private equity firm survives over the long term. I think what we have found as you move out of the venture and growth equity phase, people do persist and and grow over time. There's lots of analogs around that and and grow over time to look at different opportunities. Sheila, just before we run out of time, how does regulation and policy change with the midterms? What is sort of the midterm risk that you're looking at? Yeah. The... I I think that's a big risk. The president's budget is for 1,500,000,000,000 of defense spending. That's off of a base budget of about 1,100,000,000. So the base budget's growing 11%, but the president's budget request is growing 50%. So the delta there is 350,000,000,000 of reconciliation dollars that could be at risk with the midterms. So that $3.50 is composed of various items, but, like, 47,000,000,000 for drone dominance. So what happens if you don't get that 47,000,000,000 because the democrats take the senate? Does that put some of those 60 companies at risk? Is what investors are so fearful of, and that's why on risk off days like today, even defense is selling off.