The Potential of Capital Markets with Frank Finelli & Sam Cole

ACME GENERAL: My guests today are Frank Finelli and Sam Cole. Frank is managing director at the Carlyle Group focusing on investments in the defense and aerospace sector.

Sam is principal and co-founder of Stonecutter Ventures, with a wealth of experience in seeding companies across the defense, technology, manufacturing, and robotics sectors. Frank and Sam, welcome to Accelerate Defense.

Frank Finelli: Well, thanks. It’s so nice to be with you, Ken.

Sam Cole: Yeah. Thank you, Ken.

ACME GENERAL: You both co-authored a recent article in War on the Rocks, along with General Votel, CEO of BENS, Business Executives for National Security. I’d like to start there because I don’t think most people realize, I certainly didn’t, both how significant our advantage is as a nation in terms of the size of our capital markets and what we could bring to bear to drive defense innovation.

But also the depth of our failure to capitalize, as it were, on that advantage. Sam, could you start us off by giving us a sense of the scale that we’re talking about the size of those capital markets, public and private, and compared not just to DOD spending, but to our most significant strategic competitor, China?

SC: Sure thing. The US economy, if you think about the US GDP, it’s roughly in real terms, about $23 trillion as of this last year. The total size of our capital markets is about $56 trillion. That vast pool of capital comprises about $46 trillion in what we call public capitalization, and about another $10 trillion in private money.

If you think about the comparison to the People’s Republic of China, the New York Stock Exchange is roughly four times the size of China’s Shanghai Exchange, and that’s quite a sizable differential there. I think it really understates the magnitude of the difference between our respective capital markets, simply because of the liquidity and the diversity of instruments that are employed in the United States.

ACME GENERAL: Frank, you have written and spoken at length about some of the legal hurdles that DOD faces in accessing that capital.

What are the biggest legislative changes that need to happen, whether it’s creation of incentive programs like risk guarantees, or eliminating some of the contracting bureaucracy? What does Congress need to do to unleash that capital?

FF: Well, it’s a great question, Ken. Congress certainly has to both provide legislation to enable the development of, let me just call them, the tools that would be used to help access the capital markets, but also in really being a catalyst to spur activity here. We have seen across other parts of government, whether it’s with the EXIM Bank, the Department of Energy and their loan program office, Department of Commerce with some of the authorizations that they have under the CHIPS Act, for example.

There are agencies and departments across the government that have loan authority and the authority to provide credit guarantees, in addition to a range of programs under the Small Business Administration, which enable both investment and program funding for small companies across the landscape. We could see those authorizations broadened to include programs for the Department of Defense. I think there’s also a lot of things that the DOD can do within the existing legislation as it stands and its authorities, particularly in collaboration with its industrial base.

Again, this is where I think the innovation of leaders across the Department of Defense is really critical. Just to put this in context, the reason these processes need to change is that DOD has transitioned from being a leader in research and development. Just less than a generation ago, they provided more than half of the science and technology funding for America. Today it’s less than 20%. As we transition from leader to follower in R&D, we have to be able to access capital at the speed of commercial innovation. That’s the fundamental problem that we face.

ACME GENERAL: Frank, you just used the term innovation of leaders, and I want to piggyback on that for this question to Sam. How much of this is a cultural problem? Frank just referenced, and in your article you write about the other parts of government that have figured this out, that have leveraged these markets. You look at Fannie Mae and Freddie Mac, you look at the CHIPS Act, you look at the Inflation Reduction Act.

This is working in other parts of government. The tools appear to be there, the will in Congress appears to be there, but there seems to be this inertial legacy at DOD, and I see you nodding your head. For those who are just listening, I’ll let you riff on that. You know what I’m talking about when I talk about cultural reluctance within DOD to go here.

SC: Yeah. I’m going to start it off, but Frank has a lot to say on this point. The DOD has made great progress with small business technology initiatives. The Office of Strategic Capital should really help to broaden DOD’s interaction with the capital markets across the R&D cycle. But you’re right, fundamentally, I think there’s probably a set of more cultural issues at the DOD. I could just riff maybe four of them.

One is there’s a deep trust in centralized planning, rules, regulations, process, and bureaucracy, which is necessary, but I think has taken on a certain ideology within the department that really barnacles decision-making. The second issue is there tends to be a preference for defense unique solutions as opposed to commercial solutions. That probably goes back really to the 1960s or so.

The third issue is more of a distrust, I think a more fundamental distrust of industry and the profit motive of industry, and perhaps a misunderstanding of what the incentives are and what the purpose of the private sector is vis-a-vis its various shareholders and stakeholders. Then I think the fourth issue may be the fear of discretion in the acquisition workforce, and that’s more of a talent and a talent management issue. But I would turn it over to Frank, who I think has a deeper understanding of these as well.

ACME GENERAL: Yeah. Frank, I want you to build on that, especially in the way you’ve written about the need to transfer from a defense industrial base to a defense industrial network.

That goes right at the heart of what Sam is talking about when he refers to this bias, this deep trust in centralized planning.

FF: Right. There is no doubt to Sam’s point that the future industrial network has got to leverage the best of commercial technology companies, as well as the traditional defense industrial base, if we’re going to regain any momentum in relative military capability advantage vis-a-vis China. But I think we also cannot underestimate the negative impact, I think, that the broader general counsel community has had across the Department of Defense.

They, I think, have been restricting a lot of dialogue on this particular issue. We need acquisition leaders across the services and the Department of Defense and its agencies to really engage OMB, the Office of Management & Budget, and the Congressional Budget Office to collaborate with them in the development of these tools, so that they can access the commercial marketplace for capital.

You can’t be in a situation where commercial technology is going to become increasingly the source of what we’re going to try to be bringing into the military programs. The speed of commercial innovation is measured in a number of months. Our funding cycles are roughly 30 months until you can get funding addressed and through legislation to support a program with a commercial technology company. That disconnect has got to be addressed, and the capital markets are part of that solution.

We certainly recognize that there are not established processes for how to do that in many respects. This collaboration between DOD both from the acquisition program perspective, the DOD’s legal community, OMB and CBO and the Congress, have to develop approaches for these tools and how they’re going to score the use of those tools from an appropriation perspective. That’s all very tough work that’s going to have to be done, but it’s critical to leveraging commercial technology and accessing capital at the speed of commercial innovation.

ACME GENERAL: I want to talk about that, the bias for dual use. I want to talk about funding cycles, but let’s hit leadership before we go there because you’ve brought up the need for a different kind of leader within the acquisition community. General Hinote at the most recent Defense Innovation Board meeting said that we have to have strong leadership throughout DOD to fix long-standing cultural and structural concerns.

You have written, and this is a direct quote, “That we need to develop an architecture of education training and exchange programs at the Pentagon, that builds experience and expertise among defense professionals in basic finance, capital markets and financial engineering.” That’s an aspect of leadership I never was exposed to as a Navy pilot. I’m trying to imagine you as an artillery officer, Frank, even contemplating that kind of professional detour.

Give us the roadmap here. How do we build that awareness into leadership training and leadership priorities at the Pentagon? I’ll throw this to either of you.

FF: Well, again, I think it’s a fair point, Ken, but again, this is a capability that can be developed across the acquisition architecture with some specialization. I think the people that need to have the real expertise, are the ones that are going to be developing the tools and the processes under which these processes for accessing the capital markets can be applied. Dr. LaPlante, I think, has done excellent work trying to establish the framework for this.

Certainly, Dr. Jason Rathje with the Office of Strategic Capital, has real expertise in trying to leverage his experience and academic background to develop some of these tools which can be used. They’re, quite frankly, I think doing an excellent job learning lessons from the programs that reside elsewhere across government. Certainly, this is a new process for the Department of Defense that is going to require thoughtful leadership. But again, this is not frontier work here.

This is largely adapting processes and commercial practices that have well been in place across the capital markets that Sam described earlier.

ACME GENERAL: Love it. That’s what I was hoping to hear. Sam, can you speak to this idea of, and again, pulling from the article, “A rapid response team of financial analysts, traders and portfolio managers to mass capital, connect capital to companies and innovators, et cetera”?

SC: Yeah. There’s already an acquisition team in place. I think this is a matter of educating that particular force, recruiting into it, retaining high-quality people who have some measure of expertise in finance. Finance is not, we’re not talking about high energy physics here. There are programs that are available, whether it’s CFA programs or MBA programs, where if you run your civilian potentially military acquisition officials through it, they’re going to get a sense of the technical approaches to finance.

They’re also going to develop a network of connections into the finance community in the United States that they could reach out to. They’re going to develop good instincts about how to approach these problems of capitalizing big, sophisticated projects. This is, I think, more of an education and training objective. Something, by the way, which the Department of Defense is particularly good at training their professionals. This is, I think, not a skill issue.

This is a will issue and an understanding that they need to adopt this type of skill set, if they want to fully leverage the capital markets in the United States to start financing and catalyzing real acquisition procurement innovation efforts in the defense department.

FF: Ken, I would add that DOD brings a lot of advantages to this. Look, it’s not going to be establishing the market clearing prices here. DOD can leverage its expertise in running competitions. These are just different competitions with counterparties in the financial marketplace. They can develop these sets of terms with the counterparties that are there, and then let the markets price what they would be willing to provide this capital. That’s based on a risk-adjusted return.

One of the advantages, I think, that the department has under guarantee programs, has been significantly demonstrated by the EXIM process and others, is that they can get very favorable response from a pricing perspective from the capital markets. I think running those competitive forces with trusted players, there’s a deep set of those. I’m quite optimistic that this can be done leveraging DOD’s expertise and running competitions. It’s just a little bit of a different competition than buying a defense article or a service, if you will.

ACME GENERAL: Got it. Well, let’s get to the point of it, which is speeding up the processes we need to get the war fighters, the tools they require. Frank, you’ve talked about the speed of the Chinese innovation cycle. We’re not just talking about the need to expedite DOD cycles compared to other parts of our government.

We’re talking about strategic competition. In a recent podcast, you suggested that the Chinese innovation cycle might be five times faster than what we’re seeing here in the US. Can you explain?

FF: Well, again, I’m not an expert in Chinese innovation cycles. We sourced that fact for the article that we wrote with General Votel. But the two areas that I’m very interested in are one, the speed of innovation on the Chinese side. I think this is an area where we would really call for more research to assess that. The second one is the level of Chinese investment on a purchasing power adjusted basis.

There’s no doubt that the level of military spending is very different, perhaps 800 billion on the US side, something just short of 300 billion on the Chinese side. But when you peel it back and look at the proportion of the investment or the proportion of their budgets that are dedicated to investment in procurement of the development of science and technology, add to it their asset securitization accounts, which are dedicated to technology development.

And put a purchasing power adjusted multiple to it, it’s very possible that the Chinese are not only out innovating us on a speed basis, they’re also out investing us. That’s something that I think we really do need to pay attention to.

ACME GENERAL: Sam, how worried are you about the free flow of capital and the reality that our markets are not firewalled from the global economy?

How do we erect just the right barriers to ensure that we’re not giving access to our technology to folks who we don’t want to give it to? Is foreign investment in this area a risk from where you sit?

SC: Yeah, this is a great question. I’m not a particular expert in this area, but I would say that just empirically from my own work in business building and finance, I still see lots of Chinese capital that is searching out opportunities in the United States, particularly around technology. The interesting feature of that is that it’s not confined to the most obvious. In other words, they’re not going after necessarily. There’s the capital that is flowing into UAVs and other obvious technologies is pretty visible.

What’s not visible is the capital that’s flowing into things like raw materials that are necessary for batteries or new technologies for manufacturing phosphoric acid, which is a necessary input into LFP batteries, which are now 50% of the batteries on Teslas. This is the kind of stuff that is beneath the surface that is going on. It’s very difficult to detect. I tend to be more concerned about the capital that’s flowing into the United States and ferreting out these technologies and financing them.

Then the technology that’s flowing in the opposite direction over to China, because I think the US government could send out the right signals and businesses are particularly sensitive to that.

ACME GENERAL: Frank, all of the tech that Sam alluded to is dual use. That has really become a catch word in this space, which actually gives me pause. Whenever a phrase becomes so ubiquitous that it’s like a shibboleth, it makes me want to question it.

If we get the cycles right and if we give DOD the tools it needs to access capital markets, and field the tech it needs after the R&D cycles, how wedded are you to the idea that dual use has to govern all of these decisions?

FF: Well, I don’t think it does. The reality is that this technology that is being developed is going to be developed for various end applications. That’s going to take specialization to be incorporated into products or services that would be used to support military capability. Again, you may have fundamentally dual use oriented technology at the core of some of the capability in these programs, but it’s going to have to be adapted again for military use.

I think this is something that has been demonstrated time and time again with some of the work that In-Q-Tel has done, and some of the other early stage technology initiatives across the Department of Defense, whether AFWERX with the Air Force, the Army Futures Command, of course. Those initiatives I think are all very good because they’re identifying some of this core technology, but then providing the insights on how to adapt that core technology to a purpose that would support military requirements.

I think it’s extra work, if you will, that has to be done. You can’t just say, “Boom, here’s the technology,” stick it into your military product. It doesn’t work that way.

ACME GENERAL: You’ve both addressed the need for attracting the best talent. Frank, I believe it was in a podcast, you lamented the fact that within DOD, recruiting has hit a brick wall.

FF: In parts of DOD.

ACME GENERAL: In parts of DOD. Yeah, I’m talking about enlisted ranks. I think that was the context for your comment.

FF: Well, not necessarily. Some of the services are doing quite well in recruiting, others are not. The Army has been highlighted, of course, for the challenges. I think this is fundamentally about the ability to leverage best-in-class analytics and data approaches to accelerate the speed or increase velocity, if you will, in your recruiting processes. Look, Walmart hired 250,000 people over the last year or so. I think Amazon was around 400,000 if I’m not mistaken.

They’re hiring people that have physical requirements, academic requirements, drug requirements, so on and so forth. Whether they’re all fit for military, not sure, but I think those that they hired that they would like or were they to want to enlist in the military would largely be accepted, but they’re just hiring them at a much, much faster rate. The pipeline processes they have generated staggering velocity, and so they generate engagement.

They leverage data analytics and social media to capture the attention of candidates. This is something where I think the DOD needs to step up their game, in terms of really leveraging the promise of. Or not promise, the demonstrated capability of analytics and data to support faster and more effective recruiting processes.

ACME GENERAL: I want to pivot slightly to the moral dimensions of this, and it’s something I try to get at in every episode. Sam, from your perspective, when it comes to recruiting talent into the tech, and I guess to a lesser degree, the finance sectors to support our national security.

Have you experienced the same kind of sea change that so many others I talked to have in how people view America’s place in the world and the need for robust defense? It wasn’t just a few years ago, that the tech giants were having a hell of a time convincing people that America were the good guys.

SC: Yeah. Listen, It’s a complicated communications and media space these days, and you tend to hear what you want to hear based on what your predilection is, your ideological predilection. Obviously, over the last three years in particular, we’ve had a pattern in this country of people retreating to their corners and their particular tribes. I tend to be pretty optimistic about the United States and its potential, and the willingness of people to serve and the recognition they have of the extraordinary opportunities afforded by our country.

I have three kids myself, and one of them will be serving in the Army in three years. He’s going through ROTC right now. I see his friends who are serving in ROTC, and I’m pretty optimistic. As Frank alluded to, it’s incumbent really upon the defense department, like it is incumbent upon companies, to make compelling arguments about why people should be serving. Beyond the fundamental belief in country, there’s lots of opportunities in this country and we got to be in the mindset of sending the right message and making the right pitch.

That service is not only in the interest of the country, but it’s in the interest of the individual. There’s a lot of virtues to it, so I tend to have a more optimistic view on this.

ACME GENERAL: Frank, how about you?

FF: Yeah, I was honored to serve. I went to West Point to swim on the swim team, which is a dumb idea. You ought to have a better reason than that.

ACME GENERAL: At least go to Annapolis.

FF: Well, Annapolis has a… I wasn’t good enough to swim at Annapolis. But my goodness, it was a tremendous opportunity and I’m very grateful for it. It’s an honor to lead American soldiers, period, full stop. My son served as well, did tremendous service in combat, and I know he feels the same way. We’re very grateful for his service.

I, like Sam, am optimistic about the opportunity the military provides. It is really something special. All the services should be applauded for the experience that they provide, the skills and the sense of honor and duty that service members gain and hopefully carry into the veteran community. But it takes leadership, no doubt about it.

ACME GENERAL: Let’s talk about BENS for a minute, because I’m lucky to have two execs from Business Executives for National Security. You have positioned the organization, and here’s another quote, “To lead the discourse on the need to transition the defense industrial base from a hierarchical structure with limited companies and industries, to a more networked approach.”

I think just in the course of the last 30 minutes, you’ve laid out the case for that. How is it being received though? The barriers are pretty high. The inertia we’ve talked about is massive. Are you getting through, Sam?

SC: Yeah. Listen, this is an enormous effort. I think the good news is that, and you see this reflect in the media, there are a lot of folks who are very focused on this problem right now. That’s the first step is realizing that you have a problem before you even start to formulate solutions to address it, but again, I’m pretty optimistic. Once a big problem is recognized in this country, that the forces can be brought to bear to solve it.

There’s a lot of intellectual capital across the think tank space across organizations like BENS, that are not only recognizing the problem but are trying to formulate solutions. They’re interfacing with government and military, the national security establishment writ large. We have a lot of folks in government who are very focused on this issue and the sub-issues that sit under the future industrial network.

It’s an enormous enough problem that it’s going to take massive amounts of effort, large numbers of people, real intellectual capital, extraordinary leadership, but the country has proven that it’s able to tackle these types of challenges in the past. I’m confident we’ll be able to do it in the future, and there’s certainly forces mobilizing to do that just now. To Frank’s point, recognizing that there is a huge challenge out there in China.

That challenge can not only impact our national interests, but our national way of life, I think is a real motivating factor for many to get this resolved.

ACME GENERAL: I don’t know about you two, but when I interact with junior officers these days, they give me extraordinary hope in our ability to overcome these challenges. I think that’s where the ideas and the energy are going to come from, if the powers that be, if the decision makers can listen to them.

Frank, it sounds like you’ve got that in your family. How high is your level of faith in the ability of the coming generation to help us fix this?

FF: My goodness, the quality of the folks that my son served with and their leadership capability, dwarfs what I think about from the friends I served with years ago, many of whom rose to the most senior ranks in the military. Gosh, we’re so proud of their service and absolutely distinguished. There’s a lot of special stuff going on here. I think BENS is particularly well situated with roughly 400 CEOs as members, most of whom don’t come from the defense sector.

This is what’s so encouraging, is that I do think that the ability to drive an informed debate across key power centers in America, are going to lead us to the right set of priorities here. I’m encouraged that we are getting good reaction. We certainly appreciate your interest in speaking with us about this very, very important topic. Again, I think as more people become aware of not only the military, but the economic threat associated with China, there’s going to be more and more interest in this area.

ACME GENERAL: I want to zoom way out for our last question. I always have this tendency of getting philosophical at the end. We’ve spent the better part of half an hour talking about the need to outpace China to not share critical technology, to isolate them where possible.

Do either of you ever step back and worry about that world, where envisioning where global interconnectedness is on the decline and where spheres of influence become more rigid and defined? It sounds to me like Cold War redux.

FF: Well, the good news is due to technology, global connectivity is increasing. You can’t stop that. Policy is a little bit of a different issue. What I focus on a little bit more, is the nature of China’s engagement and how it’s maybe enhancing its global economic security through this whole of nation integrated industrial policy. Lots of people may think that their Belt and Road Initiative has been a failure, but the reality is that they’ve got financial agreements with 146 or 147 countries that are collateralized by rights on critical infrastructure assets.

That’s a huge base of power for China. We don’t have anything like that in the United States, and certainly we have a range of treaties and so on and so forth. But again, we don’t have that integrated, industrial global strategy that China does. Again, it’s a big world, commerce is growing. I’m absolutely confident that nations will find opportunities that support their interests. This is a policy area that the US needs to spend, really, really dedicate attention to, in my humble opinion.

ACME GENERAL: Sam, could you close us out with a reflection on the contest of values here? There’s obviously strategic competition, economic competition, but at the end of the day, I would imagine your son is joining the military to defend a value set.

We are starting to realize that there are fundamentally different worldviews, and at the end of the day, that is what this is about and that’s what we’re fighting for.

SC: Yeah. I think there’s probably lots of vectors of challenges here and things that we should be “fighting for.” My concern, and I think if this gets a little bit to what Frank was just intimating, my concern is that you, in this bifurcation of the world, you basically have two, and this is not such a contemporary problem. This has been historical as well. You have states which tend to be more authoritarian, less freedom oriented, less free market oriented, less about liberal democracy.

You have states that the US, Europe, Japan, et cetera, who tend to be believers in individual liberty and free markets. Those are very fundamentally disparate points of view on the way people should be living their lives, and their individual and community responsibilities versus the role of government. I think that’s a bit of what’s at stake here. When we get to this notion of globalization versus retrenchment after 30, 40 years of expanding free trade.

I think really what we’re getting at here is you have a system within authoritarian states that disadvantages liberal democracies in free markets vis-a-vis their industrial policy. Now, whether that disadvantage is short-term or it’s more persistent and longer term is unclear. I tend to think that those advantages will be shorter term and that free markets will ultimately prevail. But certainly as a country, I think we should be thinking about free trade in the context of free countries.

And where we are interfacing with authoritarian states, we got to take a different approach. Because the approach of the last 30 years vis-a-vis China, has not worked well in terms of the resiliency of our supply chains, our independence and the health of working class communities in the United States.

ACME GENERAL: Well, Sam, that’s a great note to end on. Frank and Sam both, thank you so much for your time.

SC: Thank you, Ken.