Not long ago, defense offsets — contractually obligated investments by companies in exchange for procurement deals with foreign countries — were more the concern of national pride than big business. A country, wishing to rub elbows with the big boys at the Farnborough or Paris air shows, might include a clause in a contract so it could gain the building blocks to develop its own program. And companies largely viewed these obligations as more of a nuisance than a critical component of business.
But with the shift in the prominence of the international market in response to stagnant U.S. and European spending, offsets are becoming not only more significant, but also more valuable.
A recent report by Avascent, a strategy consulting firm in Washington, projected that annual global offset obligations will pass $50 billion by 2016, up from $35 billion in 2011. That 42.8 percent spike over five years is getting the attention of senior executives.
“Within a few minutes of any conversation with a company, the topic of offsets would come up,” said Jon Barney, a partner at Avascent and one of the authors of the report. “Companies are out there saying they’re going to grow internationally. If they don’t figure out this piece, they’re going to be really challenged.”
Offset obligations can include a variety of types of investment, from technology transfers to skilled workforce training to infrastructure projects not immediately related to defense. While the obligations can affect balance sheets, international business is still sufficiently lucrative to inspire companies to wade through the offset waters. Profit margins on international commercial deals tend to be higher, increasing companies’ willingness to confront offset complications, said Philip Finnegan, an analyst at the Teal Group, Fairfax, Va.
“It does affect profitability, but generally speaking there is some room for that,” he said. “Exports tend to be more profitable than domestic sales, but clearly there is a cost. That’s where the potential for growth is, and it is still more profitable than domestic sales.”
While international commercial deals can be more lucrative and therefore justify a hit to a margin from offsets, most U.S. company deals don’t have the same profit equation. The vast majority of U.S. deals involving offsets are foreign military sales, in which a company can have its offset expenses reimbursed by the U.S. government, which in turn factors the offset costs into the price tag.
But while the companies are protected from the immediate cost of the offsets, they are required to absorb the expense of any failure to execute the offset obligation in the form of penalties or costs to correct the mistakes. That responsibility can be problematic because companies frequently don’t know what their offset responsibilities are, Barney said.
“Often companies don’t even know the size of their obligations,” he said. “They certainly don’t know who the other partners are, who they could work with in certain countries who also have obligations. So the challenge has been lack of visibility of data.”
Also shifting the landscape is the changing demands of the customer, Barney said. “Companies are facing these larger obligations, and at the same time, the countries that they’re investing in are becoming more sophisticated about investment.”
Instead of pride projects with little economic value, countries are increasingly looking at investment that can spur domestic growth or provide services for citizens.
“Governments are becoming much more focused on what they want from their offset programs and are being much more strategic in their thinking,” said Grant Rogan, founder and chief executive of London-based Blenheim Capital, an offsets services provider. “There is now a focus on using offset programs as a development planning, financial and economic tool. That’s something that hasn’t been used in the past, and sometimes there are disconnects between the buyer and seller in terms of meeting expectations.”
In particular, experts point to the United Arab Emirates as an example of a customer developing offset funds prudently.
“When you think about the UAE, they’ve built up a fair amount based on their offset industry, and they’re in a position to do it because they’ve made some very large acquisitions,” Finnegan said.
The market leverage countries now have with the increased prominence of international sales is pushing companies to accept larger and more demanding offset requirements.
And recognizing that offset offerings can mean the difference in a competition, companies are looking at their offset packages as a potential competitive tool.
“Being more effective on the offset piece will be a differentiator in these markets,” Barney said. “If you’re thinking of making international a big part of your overall strategy, getting the offset piece right is going to be critical.”
The concern that lingers with offsets, in particular agreements that involve developing a defense manufacturing capacity, is that companies will be helping the development of future competitors.
But thus far, offset funds have not yielded that type of problem, said Byron Callan, an analyst with Capital Alpha Partners in Washington.
“It’s been going on since the ‘60s and even before that; it’s not new,” he said. “Where I’d worry and where I’d get concerned is where these countries are spawning enterprises that will compete with the U.S. companies. I can’t think of an instance where that’s happened.”
Whether the increased investment now included in contracts will create competitors isn’t clear, but the underlying facts of the offset obligation are obvious.
“It’s sizable, and it’s going up,” Barney said.