What is the Trusted Capital Marketplace really about?

This post will speculate on the intent behind the DOD’s new Trusted Capital Marketplace, and what will be expected of its managers.

Background.

The Statement of Work says its mandate comes from two sources: Executive Order 13629 signed in 2012, which calls for public-private partnerships; and Section 1711 of the FY 2018 NDAA, “Pilot program on strengthening manufacturing in the defense industrial base,” which appears a bit more relevant.

The SecDef must carry out a pilot program whose activities include: contracts, grants, or OTAs to support capabilities of small and medium sized firms; purchase goods or equipment for testing; “purchase commitments… including cost sharing with funding from nongovernmental sources”; issuing or guaranteeing loans; and here’s the kicker:

Giving awards to third party entities to support investments in small and medium sized manufacturers working in areas of national security interest, including activities to support debt and equity investments…

Now, the government has always been able to contract with small or medium sized businesses, or purchase equipment for test. The government has also been able to enter into public-private partnerships through cost sharing agreements. So that’s not really new or helpful unless special monies were attached to it.

The new thing seems to be the award of funds to third-parties who — like a venture capital firm — would evaluate defense-related firms, invest in the promising ones, and who would benefit from the accrual of interest or equity.

Rationale.

Perhaps the government needs this arrangement because some third-parties have specialized knowledge about emerging technologies and startups that the government can’t match. Why not use them as a conduit for investment?

Besides sounding pretty crony-capitalist, this “search” theory doesn’t seem to be the issue the way Ellen Lord puts it. Rather, the DOD has already identified small, innovative companies. More than 50 of them, in fact. Lord said:

A lot of these companies are small innovative companies that don’t have the resources, sophistication or contacts to reach sources of capital…

Supposedly the DOD knows its own requirements. If it also knows the companies, why doesn’t the DOD just inject capital directly, or better yet, make them self-sustaining using contracts to achieve organic growth?

Perhaps the effort to streamline contract awards has abated. Or, funding is tied up in the near term for established programs and the big incumbent contractors. Remember all that cost growth?

Funding for these innovations might not be there today, but let’s suppose that it will be there tomorrow. The issue then becomes, how do we keep these small firms alive in the mean time? If the Committee on Foreign Investment in the US (CFIUS) blocks foreign investments from, say, China, then these firms are left to struggle and die without a source of capital.

CFIUS investigated 925 cases of foreign transactions between 2008 and 2015.

If the DOD won’t fund these companies itself, why can’t it line up private capital for them? As Ellen Lord reports:

I’m constrained legally from introducing one company to one venture capitalist; however, what we can do is segment the marketplace and then put in companies that need capital infusions that we think have critical technology for us. We can also vet critical providers of capital.

This is where the trusted capital marketplace comes in. The point is to fund fourth-parties who will bring together innovative start-ups and investors (and the investors will use their own funds). As the Statement of Work says of these Managers:

An effective strategy will center on three lines of effort: 1) identify relevant sources of innovation, 2) identify and leverage trustworthy sources of capital that could sustain the sources of innovation, and 3) bring together the right sources of innovation with the right trustworthy sources of capital to accelerate financial arrangements that obviate adversary strategies.

Cheap Talk.

The real question becomes: why hasn’t venture capital invested in these companies that the DOD thinks are important? The answer cannot be a lack of private funds chasing opportunities. The answer has to be: the investors did not see enough upside to investing in these defense-related companies when compared to other companies. Yet this doesn’t seem to be Ellen Lord’s understanding. She finds that there are plenty of investors:

…we have some incredible patriots who have come to us and said ‘We are interested in putting our money somewhere that will make a difference in our national defense.’

More likely, what they are saying is, “Give me the inside scoop — what are your requirements exactly, who and what are you funding, and then when you’ve given me sure-fire information (or something that gives me an asymmetric advantage) I can start seeing an upside into making these investments.”

There are 50-plus identified companies right now. Just put their names on blast. But that is cheap signaling, because if the DOD really thought these technologies are important, then they should provide the funding from the $750 billion requested in FY 2020. Investors probably recognize this as cheap talk.

One of the issues is that many of these emerging technologies wouldn’t be major platforms themselves, but would find themselves as 2nd, 3rd, 4th, or lower-tier contractors to a major prime like Lockheed or Boeing. Except with GFE and other special interest areas, the whole process is set up according to major weapon systems. Primes are usually responsible for identifying components and their suppliers which will integrate. In a sense, the primes act like both the TCM Manager and the trusted source of capital investment.

I suppose, however, that the DOD isn’t satisfied with the primes, who often use anti-competitive behavior like buying out promising firms, and in any case, may not be incentivized to fund emerging technology that doesn’t yet integrate onto any current weapon system platform. These companies are fixated on protecting current programs and positioning for follow-ons.

TCM Structure.

If there is little organic investment in the startups, then what will the Trusted Capital Marketplace achieve? It looks like an OTA award to someone who can build a website that will enable three groups: trusted companies with defense-related tech; trusted sources of capital to invest in the companies; and TCM Managers who will identify and vet the other two groups to be a part of the whole thing. Ms. Lord says:

The first step is to set up a website infrastructure to bring providers of trusted capital together with businesses looking for capital infusion.

That will provide the platform for making private deals. One question question is whether there is a kind of winner-take-all proposition with whomever develops the website. Could it be like Facebook or Twitter who take most of the value of the platform from third-party developers? Or could it be like Amazon, where the TCM Managers offer deals on the website which suppliers and investors can “bid” on?

The DOD supposes that after limited funding, the Trusted Capital Marketplace will become self-sustaining. TCM Managers must then be market-makers, earning some kind of transaction fee like stock exchanges do. But they must also avoid conflicts-of-interest, and it would appear, they must compete against each other. What is it that the TCM Manager is expected to do?

In one view, the TCM Manager merely vets and approves the companies and investors. They could earn some transaction fee, but then competition between TCM Managers should force that fee down to marginal cost. So there isn’t much upside to the TCM Manager in this case unless the DOD pays the TCM Manager directly for the service.

In another view, the TCM Manager is a deal maker of sorts, and therefore, must have some privileged information about requirements or specifications. Without some kind of advantage, how will a TCM Manager make itself self-sustaining? But then the big defense primes also have all sorts of privileged information on defense requirements — and they are investing in startups as well — so what does the TCM Manager have that they do not?

Overall, the Trusted Capital Marketplace seems like a novel effort that will have to work itself out along the way. The big defense primes are a current source of trusted capital with deep knowledge of government requirements — but this hasn’t worked in the past and isn’t the intent of the new effort. There have been plenty of US investors splashing around money, but apparently not on defense-related firms. The TCM concept might work if these investors simply didn’t have the information, and the TCM Manager will help supply that information about matching technologies and DOD requirements. But again, that doesn’t seem to be the problem, and if it were, then why doesn’t the government provide contracts?

Alternative ideas.

Here is one idea for making the TCM concept useful. Open up the architectures of major system platforms that is currently held by the major defense primes. Give that highly sensitive information to TCM Managers who can then pass it on to vetted companies and investors, who can then develop at their own expense new components which can integrate and then be demonstrated in relatively short time. This gives TCM Managers valuable information that makes them self-sustaining (though, perhaps it also creates a conflict of interest?) and it gives companies/investors an incentive to join the Marketplace. Otherwise, besides having a formal structure — a website — what does the TCM provide that doesn’t already exist?

Successful tests on open platforms must then have DOD funds available, not in three years according to the POM process, but within a year. It can foster a kind of “combinatorial innovation” that has emerged in the modern commercial economy. Even commercial software development, before Netscape, looked a lot like the 3, 5, or 10 year product development cycles that resulted in physical disks or CDs. If the DOD wants dual-use technologies and private high-tech investment, it will have to start conforming to how business is done in those areas.

 

Update (Aug. 28, 2019): see additional views on TCM and role of vulnerable sole source suppliers.