UK defence and dynamism

Air Street’s submission to the UK Strategic Defence Review

In July, the UK’s new government launched a Strategic Defence Review to “determine the roles, capabilities and reforms required by UK Defence to meet the challenges, threats and opportunities of the twenty-first century, deliverable and affordable within the resources available to Defence”. As part of this process, to their credit, the reviewers are trying to garner views beyond the usual set of primes.

We believe that European countries have the capital, talent, and technology required to defend themselves. Instead, they lack the political willpower and institutions to mobilize these resources. In our response to the SDR, we outline the lack of ambition that has characterized the UK’s approach to technology in defense, as well as a potential roadmap for change.

You can read our submission in full below.

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Introduction

Air Street Capital is a London-based venture capital (VC) firm investing a second institutional fund of $121 million in AI-first companies across Europe and the USA. We are one of a small number of European VC firms that are willing and able to invest in pure defence start-ups. 

While we are strong believers in investors’ responsibility to act, much of the market remains unconvinced. 

Despite the UK being the third largest venture capital market in the world, there is no meaningful ecosystem of investors in defence start-ups. Early-stage defence investment in the UK remains a grab-bag of individuals, small funds, and government vehicles. These funds collectively have little capital to deploy and are focused on dual-use technology.

This stems from a perception that defence is ‘uninvestable’ for VC. Domestic and international investors simply believe that the government i) is not serious about adopting new technology; ii) does not understand that time is money for start-ups; iii) will, in the final analysis, direct orders to the same oligopoly of incumbents. 

This state of affairs needs to be urgently rectified. As we see every day on the frontline in Ukraine, the shape of conflict has fundamentally changed. The teams that have adapted best to this change have been agile specialists, incentivized to build cheaply and effectively, not the manufacturers of traditional platforms. The Ukrainian military, motivated by a sense of urgency, battle-tested challengers’ equipment and gave them the opportunity to demonstrate their impact at scale. We believe that the UK should be trying to replicate this model as much as possible, rather than maintaining the pretence that it is possible to achieve start-up outcomes by supporting incumbents. 

In this submission, we lay out our analysis of where government thinking about technology and early-stage companies need to change, lay out some potential policy measures, and traps to avoid.

Urgent acceleration in ambition

Despite the contours of future conflict being obvious to even non-specialist observers, Defence appears to have focused on ‘AI-washing’ over adoption. The MOD has produced overlapping plans and frameworks for AI, and run many demo days, but evidence of actual change is thin on the ground. 

Many of these plans and frameworks amount to aspirational lists of capabilities, occasionally with an approximate price tag, but with no clear plans for acquisition and implementation. A good example of this is the department’s Defence Drone Strategy, a 12-page document that amounts to a statement of objectives, padded out with images and case studies.

There appears to be little appreciation of just how behind the curve Defence is. For example, the Department’s Defence Artificial Intelligence Strategy and accompanying playbook, divides capabilities into ‘AI Now’ (mature technology for immediate adoption), ‘AI Next’ (‘next-generation’ or ‘generation after next’ capabilities), and ‘AI Future’ capabilities.

Many of the technologies listed in the latter two categories are both available commercially off-the-shelf and being used in live conflicts around the world. Indeed, no R&D is required to develop better internal document discovery. 

This lack of ambition stems from a number of institutional failings.

Firstly, a lack of education. Senior leadership seem unaware of the current state of the art in AI research and what reasonable performance they should expect from suppliers. This means routine or underwhelming work is hailed as ‘world-leading’. 

This is exacerbated by a second problem, namely, dependence on a small number of defence primes. Despite repeated pledges to diversify the MOD’s supplier base, the department’s own statistics show that the ten largest defence holding companies receive a greater proportion of MOD spend than they did a decade ago. These companies do not attract or incentivize top AI talent and have prioritized share buybacks and dividends over investment into their own R&D. They also have no incentive to improve the education levels of their customers.

Finally, a cultural tendency towards reinventing the wheel. As the Watchkeeper fiasco demonstrates, the bias towards creating bespoke British versions of equipment that already works is frequently counterproductive. It is also a recipe for being ripped off by primes, who can increase the bill with every change in specification. 

Recommendations:

• The proposed timeline in the Defence Artificial Intelligence Strategy needs to be radically revised and accelerated to reflect both technological and geopolitical reality. No capabilities that are available on the market and deployed in current conflicts should be marked as ‘AI next’.

• Defence’s default position should be to buy technology off-the-shelf or to make only light adaptations to off-the-shelf solutions, unless there is a compelling reason to do otherwise.

From SMEs to start-ups to winners

Defence’s attempts to diversify its supplier base are hampered by a category error. The umbrella term ‘SME’ lumps together companies with wildly different goals, needs, and growth potential. A local building materials supplier and a venture-backed AI start-up should not be given the same label, either for the purposes of statistics or policy-making. 

This is not just a matter of semantics. Current policy, as laid out in the Defence Small and Medium-sized Enterprise Action Plan, is focused on integrating small businesses into the defence supply chain. It does not envision these businesses ever scaling and playing more than a supporting role to the oligopoly. 

This signals a lack of understanding in government about the economics of venture capital. VC firms do not invest in “SMEs”, they invest in companies that begin life as start-ups but have the potential to scale into becoming multi billion-pound public companies.

Investing early in private companies is an inherently high-risk endeavor. Most investments will not succeed. To justify taking a risk with their investors’ money, VC firms need to believe that there is a realistic chance of a successful exit with significant upside. Currently, only a small handful of firms believe that this opportunity exists in UK defence.

The ‘SME mindset’ is exemplified in the Defence and Security Accelerator (DASA). DASA awards small grants that might be valuable to individual research groups or regional businesses, but it has next-to-no track record of helping early-stage innovators scale to the next stage of their journey. With much of its day-to-day operations managed by a defense prime (which happens to be the biggest single recipient of DASA grants), it is not a serious vehicle for proto-winners. 

With the government-sanctioned gateways for startups largely a dead-end, their only realistic alternatives are either to pursue single-source procurement or to subcontract from the primes.

Single-source procurement is theoretically a workable avenue for start-ups, but is contingent on access to a strong network of insiders and granular familiarity with MOD budgeting. It leads to seed capital that should be spent on developing better products being used to pay lobbyists and advisers. 

Subcontracting from the primes can be a quicker entry route for start-ups, but it has crucial limitations. Not only is intellectual property under threat, but primes can restrict start-ups ability to compete with them in the future either via contractual terms or by gatekeeping customer relationships. By itself, this model will not drive the investment required to create a thriving ecosystem. 

Recommendations:

• DASA and any other vehicles for awarding innovation grants should be barred from awarding any contracts to companies that are at Series B or later.

• Build inhouse capacity and remove prime contractors from the operation of accelerators or innovation units. 

• Unbundle hardware and software components of major contracts by default, allowing companies to bid for one or both.

• Make interoperability a requirement instead of guidance, without exceptions.

A radical reset

For the next generation of capabilities, the priority should be to move away from the system of paper-based requirements as quickly as possible. 

While Defence has the best understanding of the challenges that it faces, neither civil servants nor the forces are expert in designing technical solutions. Additionally, the system of paper-based requirements is one of core pillars of the primes’ advantage over new entrants, due to both their ability to shape them and to respond to repeated changes.

For capabilities like affordable mass, autonomy on the edge, and real-time situational awareness, the government should invite potential suppliers into a real competition. Different bidders’ capabilities would be tested against each other in a series of practical trials, with one bidder eliminated per round. Between rounds, entrants would have the opportunity to iterate on their product. 

As well as providing a real test of capabilities, the process would also reflect how modern technology is actually developed, from MVP through cycles of iteration. 

For this process to succeed, it could not be run as another version of DASA. It needs to be a competition for real, long-term, multi-million pound contracts - not innovation grants. In his 2009 review of defense acquisition, Sir Bernard Gray suggested that defence procurement could be run by a separate organization, under private sector leadership. While this was rejected at the time for being too politically contentious, it could be revived in narrower form to focus on the question of advanced technology. This could be a means of both avoiding prime capture and bringing in outside expertise.

Recommendations:

• Create an advanced procurement agency, with control over a significant proportion of MOD procurement spend, freed from civil service business and pay scales to operate a version of the competitive system outlined above.

• Grant this organization ARIA-style legislative safeguards to prevent it falling victim to changes in political direction.

Dual use isn’t enough

In our interactions with government stakeholders, a frequent refrain is that investors could avoid these acquisition problems by focusing on start-ups that build dual-use technologies. The rationale being that by acquiring private-sector customers early, this removes the risk of depending on long procurement cycles. This is theoretically appealing, but practically unwise.

Firstly, many of the crucial AI-enabled capabilities that defence needs are unlikely to experience meaningful demand in the private sector. For example, there are likely no real commercial use cases for drone swarming technologies.

Secondly, it delays getting crucial capabilities to the frontline. Start-ups working on dual use will inevitably focus on prioritizing the most responsive customer and will focus on establishing product-market fit in those industries. By the time Defence buys from them and the technology is adapted to fit its needs, it will likely be out-of-date.

Thirdly, revealed buyer preferences. Defence does not have a strong track record of purchasing dual-use technology, due to exactly the biases we described around bespoke technology and overspecification. This last point is not a UK-specific problem, it is endemic in many defence establishments, and has worsened as the market power of the primes has increased. The notorious 1993 ‘Last Supper’ in US defence was a significant accelerant, even though the greater use of dual use technology became official Pentagon policy in 1995.

Interim steps

The competition reform would require a radical shift in how the UK procures technology and would naturally take time to implement. There are some smaller steps that Defence could take in the meantime. However, it is important to stress that by themselves these are not an adequate substitute for more radical reform. While they will make life for existing founders easier, they will not catalyze greater investment by themselves. 

Recommendations:

• Overhauling current framework contracts to remove the arbitrary entry windows. These were designed for bureaucratic convenience and can potentially leave start-ups waiting for years before being able to bid for work.

• The current system of clearances creates a chicken and egg scenario, where start-ups are unable to win work without clearances, but unable to obtain clearances without work. This often results in either costly subcontracting arrangements or having to spend additional money hiring staff with clearances from previous roles. The MOD should hold clearances on behalf of start-ups at a cost, as they do for contractors and their own employees.

• The requirements for holding classified information, laid out in the Facility Security Clearance Policy and Guidance, are costly for start-ups and MOD-provided facilities frequently in remote locations. The MOD could create a compliant facility in central London and sublet space to start-ups.