Shortly after the turn of the millennium, the term „Vice Funds“ made the rounds – funds that exclusively invested in alcohol, tobacco, gambling, and the arms industry. What united them all was their tainted image. But today, the arms industry has distanced itself from that stigma as much as possible. The term defence sector is now the preferred nomenclature. In a recent Commission Notice, the European Commission even outlined how the defence sector can be aligned with the United Nations’ Sustainable Development Goals (SDGs).

This interpretive guidance is part of the EU’s Defence Readiness Omnibus, an initiative aimed at improving conditions for the defence industry by reducing bureaucracy and removing investment barriers. That includes the Sustainable Finance Framework. The Commission emphasises in its document that the defence industry is essential for protecting citizens in the event of an armed attack. From this perspective, it contributes to peace and security – in line with UN SDG 16, which calls to „promote peaceful and inclusive societies.“

According to the Commission Notice, the Sustainable Finance Framework should not be seen as a limiting factor for defence investments – the industry is to be treated like any other. Exceptions still apply to so-called „controversial weapons“ such as cluster munitions and chemical or biological weapons. Authorities like BaFin and institutional investors are expected to take their cue from these guidelines, says Sascha Arnold, infrastructure partner at Ashurst. There remains some room for interpretation, he notes, „but the guidance is helpful for orientation.“

A similar step has been taken by the German Investment Funds Association (BVI), which revised its ESG target market concept at the end of 2024. Previously, sustainable funds were not allowed to invest in companies that generated more than 10% of their revenue from defence. That threshold has now been removed. However, weapons banned under international law remain excluded.

Earlier in the year, the European Investment Bank (EIB) launched a programme to promote investments in security and defence, stating that excluded activities would be „restricted as narrowly as possible.“

The growing number of interpretive aids from public bodies and industry groups are intended to facilitate capital flows into the defence sector. While large, publicly listed defence companies haven’t recently faced financing bottlenecks, small and medium-sized firms face higher barriers. „ESG compliance is a projection screen for many concerns“, says Marc Ruttloff, a public commercial law partner at law firm Gleiss Lutz. The issue often isn’t legal exclusion but rather self-imposed policies and standards, which in the past sometimes led to „over-compliance“ – causing banks to shy away from lending to defence companies.

But Ruttloff sees the mood shifting: „Financial market participants are shedding their reservations and seriously engaging with the specifics of the defence sector, and how ESG principles can be applied to it“, he says.

Some institutions are taking a proactive stance. In March, Deutsche Bank set up a cross-departmental task force for defence and infrastructure. In early July, the bank hosted a European defence conference in London, bringing together defence executives, military experts, and investors. These visible signals, Ruttloff says, could pressure competitors to follow suit.

Smaller banks such as savings banks and cooperative institutions – traditionally close to the SME sector – remain cautious. There are still problems associated with financing mid-sized defence firms, Goller notes. Potential lenders often fear reputational risk. „Yet arguably no other sector is as strictly monitored and documented when it comes to exports and products as the defence industry“, he adds. That message, he says, needs to be communicated more clearly.

The political momentum is also drawing increased interest from private investors, observes Nick Reiff, Director for Aerospace, Defence and Space at consulting firm Strategy&. Private capital is needed to help expand Europe’s defence capabilities. In return, investors are seeing a potentially lucrative opportunity amid rising defence budgets.

The key question remains: Which companies will actually receive funding? „Access to financing has improved, even if it’s not yet where the industry wants it to be“, Reiff says.

Udo Olgemöller, public law partner at A&O Shearman and co-head of the firm’s ESG group in Germany, also sees growing private equity interest in the sector. „Many funds are looking very closely at the defence industry and are building up their industry expertise“, he notes. But many major financial investors are based in the US or UK – that can limit their ability to invest in European defence companies.

The German government, for example, can restrict defence procurement contracts to companies majority-owned by EU investors. As a result, international investors are more likely to look further down the value chain. „They focus on the third or fourth tier of suppliers, which tend to be less heavily regulated“, says Olgemöller. These firms often produce dual-use goods – products usable in both civilian and military contexts – thereby tapping into multiple markets. Cybersecurity expertise for sensitive sectors is also becoming increasingly attractive to investors. „The depth of regulation also helps shape investment flows“, he adds.

The fact that defence and ESG compliance are no longer seen as contradictory in the official narrative opens up new opportunities for private capital. „Investors often have to consider commitments to their own LPs, who earmark part of their capital for ESG-compliant investments“, explains Reiff. Some investors take a middle path: they allow defence investments within ESG funds but don’t count them toward the fund’s sustainable share. „It remains a sensitive topic“, he notes. „Investors want to avoid greenwashing, but the defence industry is attractive. Many are still cautious, especially in how they communicate their involvement.“

In the startup space, Helsing, which specializes in artificial intelligence applications for the defence sector, raised 600 million euros in June – the largest financing round in Germany in H1 2025. Another defence-focused startup, Quantum Systems, secured 160 million euros, making it the fourth-largest round, according to EY.

Newly launched companies face greater challenges. „The financing tickets are still too small for private equity funds – this is where angel investors come in“, says Ashurst lawyer Arnold. He sees bottlenecks in that segment. It’s also unclear whether such young companies will benefit from the government’s planned investment push. German military procurement contracts often go to long-established suppliers with a track record of delivering large volumes reliably.

The new law on fast-track defence procurement, recently passed by the German cabinet, could ease the burden for startups. It allows for advance payments if doing so increases the number of applicants or bidders. It is intended to encourage startup participation in defence tenders.

In legal practice, Arnold expects the focus of advisory work to shift. „Interpretation assistance around legislation – particularly around greenwashing concerns – may become less necessary following these announcements“, he explains. „But we’ll see a greater need for concrete legal guidance on investments in the defence sector.“