Government agencies engaged in the procurement of military equipment are becoming more demanding in what they expect from defence contractors. Generally, the purchasing country expects some of the work in building the equipment to be contracted out to a local company. This is the case with the sale of Hawk aircraft by British Aerospace to Indonesia. Certain parts of the aircraft are assembled locally and there is some technology transfer. These types of offset deals are taking a new twist.

Many purchasers now require civilian projects as part of the offset programme. Says Tim Runge, director with Newcourt Capital's offset and structured trade team in Toronto: ?Meeting offset obligations through the application of civilian projects is a relatively new area for defence and aerospace companies and is an area of increasing interest to many serious players in the business.?

According to the UK's Department of Trade Industry (DTI) website, entitled ?Offset-Investment Brokering', countries such as South Africa are looking for investment in job creation, training and the formation of management skills. Malaysia, on the other hand, is looking for investment and technology transfer to catalyze economic development. According to an industry source, civil offset programmes are growing in popularity and becoming a fact of life. ?Failure to deliver on the civil contract can mean penalties of up to 8.5% of the value of the defence contract,? says the source. The UK government is trying to involve UK civilian companies in the business and the DTI, along with Defense Export Services Organisation, have teamed up to aid the process. Says the industry source: ?The purchaser country usually expects the civil project to be added as a bonus, self-financing and not to be priced into the defence contract.?

For defence contractors to get involved in these areas means stepping quite a long way out of their core competencies, which increases the risk profile. However, says Runge ?defence companies should be encouraging civil, as opposed to defence offsets, which typically require local production of the defence product?. He adds: ?Cost competitiveness comes from economies of scale associated with producing at one or a limited number of production facilities around the world ? not at numerous ones. By focusing on civil offset fulfilment, these economies are maintained.?

But this does leave the question of dealing with the greater risk derived from operating in areas outside defence. The industry source agrees: ?That's why it is important that the defence contractor finds a capable civilian firm able to deliver on that side of the contract.?

According to Runge the investment banking community can help. ?Investment banks with an understanding of the offset business can provide significant value, and prove to be more economical,? says Runge.

But what is the best way to structure these projects? Runge gives an example where Newcourt identified a project in a country that has broad-based community support for a project. The community in question had been hit with a plant closure, and job losses. As a result there was strong political support for a job-creative project. ?That made the project attractive as one that could help the company meet its offset obligations,? says Runge. Newcourt advised its client to take an equity position in the project. Says Runge: ?Newcourt would also arrange the project debt. The trick in being able to structure a transaction like this one, is the negotiation with the government offset authorities and the level of support it is willing to provide.?

The level of support has a direct impact on what the financial commitment the defence company will make in the project. In this case the defence company would have an equity position in a profit generating enterprise. Instead of being a cost, the outlay is an investment and one that some day should earn a significant return.

This is a classic case of turning a potential liability into a profit-generating opportunity Says Runge: ?To manage the risk, offset investments should be managed in a diversified portfolio that spans countries and industries. This portfolio should be kept separate from the main supply contract. While each project will be on a stand-alone basis with its own costs, risks and rewards, if the project doesn't meet the risk profile of the ?offset-investment portfolio', it should be dropped.?

As defence companies explore other non-defence related businesses, banks will have to deliver financial solutions and assist in building partnerships to make these projects work. This means being able to evaluate offset risk. Large defence contractors such as British Aerospace and Boeing already have in-house project finance teams who are dedicated to putting together financial packages with the assistance of investment banks.

The latest trend towards civilian offset projects can ? if handled well ? deliver great benefits to both parties in the transaction. The host country receives a cheaper weapons system, because it's been produced to maximize economies of scale and it has a politically and economically beneficial civilian project. The contractor, on the other hand, develops another revenue stream and builds an edge over less savvy competitors.